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Hugh's Views Issue 2: December 13, 2001
I am struck by the implications of guarantees and captives. The first reflection, subject of this article, began with the drying up of terrorism coverage, and the second has to do with fronting (next time). Buyers tell me that at the end of 2001 their brokers are saying that terrorism could become excluded from property coverages, starting in 2002. Self-insurance would be forced on insureds just when they felt most exposed, most at risk. If the exclusion is driven by the almost-colluding world reinsurers, there may be still be some primary net capacity of $1-5 million available as sublimits in some all-risk forms, but not enough to count in case of real need. This exclusion or restriction of insurance at just the time when insureds want it the most has happened before, as the grey heads in the public press keep reminding us. I remember the crises in product liability coverage, professional liability, even property coverage for high-risk exposures such as petrochemical plants and nuclear power plants. In these historical cases there was always a little coverage available at high prices, but there wasn't enough capacity to cover serious exposures. A single-owner captive is of little use when insurance capacity is scarce, except to formalize self-insurance at much higher levels than before . Worse, when the captive's owner is called upon to give a separate guarantee to, say a fronting company, the tax position of the deductions for premiums paid to the captive is jeopardized. Group-owned captives may not have this problem. A group-owned captive, or specialized mutual can only offer a partial solution to a lack of capacity, up to the limit of its resources. But there is one kind of captive that can offer higher capacity. That is the group captive whose modus operandi includes promises by the members to pay more, to recapitalize, to put up more money when called - usually after one large and fairly remote loss suffered by one of the members. It's a kind of post-loss financing. Examples of this kind of post-loss financing come to mind. The original Nuclear Mutual began with insured limits far in excess of its resources in terms of capital and surplus, but with provision for assessments of up to fourteen times the already hefty premiums. OIL, the energy company venture, began with a formula by which the member with the heavy loss paid back, over time, the others who had financed him. Many Cayman-based healthcare captives use small capital bases to insure much larger limits because of similar post-loss assessment provisions. P&I clubs, another kind of mutual, operate on the basis of limited additional calls. What struck me about these examples was that where post-loss financing in the form of promises or guarantees was present, the captive companies continued and thrived. All the examples cited are among the oldest and most succesful captive or captive-like structures in existence. They all began with some form of post-loss financing promise; some still depend on it. So why aren't group captives taking on higher risks, using post-loss financing guarantees? Ina Barker1, formerly director of AIRMIC in the UK and former RM of a large pharmaceutical company, reminds me why there weren't more of these post-loss financing group buying deals. In those days (the 80s and 90s) information and risk management itself was rudimentary; so competitors in the same industry really didn't trust each other enough to be willing to finance, much less pay for each others' heavy losses. There was another reason, she reminded me. That was that the participants always kept changing - they would take on new businesses, merge with others, and discontinue major activities. Constantly re-underwriting everything seemed to the RMs of the time a daunting proposition, while the financial consequences of guaranteeing others' losses bothered their financial management. In my view, there should be more post-loss financing in group captives. This is because
Managers and non-executive board members: recommend to your client captives whose members are struggling with capacity problems to look into a do-it-yourself post-loss financing arrangement! Those with terrorism exposures will have to, whether they like it or not. 1The section on Ina Barker's input to this article previously appeared in Captive Insurance Company Reports of January, 2002. Can't get enough of Hugh's oft-irreverent views? You're in luck! Follow this link to all of Hugh's pearls of wisdom:
Hugh Rosenbaum, one of captive.com's friends and valued contributors, is a freelance consultant. Hugh can be reached by telephone at +4420 8883 6729 or by e-mail at hughro2@yahoo.com. Learn how you can spend a day with Hugh! Visit Hugh's Captive Consulting and Music Websites
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