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SCCIA Third Annual Educational Conference and Membership Meeting

Hugh’s Views from Charleston

(Hugh Rosenbaum, one of captive.com's most popular and highly-respected contributors, gave the last presentation at the third South Carolina captive conference. The presentation gave Hugh's view of how captive insurance is a development along the continuum of alternative risk financing, He summarized the highlights of his presentation for us in this article.)

Notice how captives are down towards the insurance end of this continuum, and how financing, or more precisely, risk financing, is down towards the non-insurance end.

Risk managers, treasurers and corporate finance executives are looking for ways of financing their larger risks, insurable or uninsurable, for both accounting and operational reasons. Ideally they would like to transfer them to others entirely, but in the absence of willing risk takers, they seek ways of financing them. Financing them involves either pre-loss funding or post-loss funding, or some mix. One of the problems, of course, is that the mix that makes sense operationally may not be feasible in accounting terms; and vice versa.

Here’s an item illustrating the kind of development along the continuum that I am talking about:

$20 out of the $24 billion of new money that was raised for the insurance business in the past year has gone to entities in Bermuda, some of which are former captives. By mid-2002 12 Bermuda entities were writing premiums of more than $1 bn; three years ago there were none.

Another item is the reminder of the number of captive mutuals that “went public” and became commercial insurers. ACE and XL (among the companies in Bermuda, above) are two of them. Medmarc, originally a medical device group captive, then RRG, is another. So are the Factory Mutuals. Most of the examples in this category are examples of steps back along the continuum.

I think the development of the future will be in the other direction – for captives to evolve into controlled financing subsidiaries. But before that can happen there are a couple of misunderstandings blocking the way -- a lack of understanding of each others attitude towards risk financing, and a lack of common language for risk analysis.

Lack of understanding: My personal experience shows that neither the financiers nor the buyers trusts the other side, as yet. I have heard investment bankers say "product liability securitization? Forget it - no-one would trust the pharmaceutical companies." I have heard risk manager-buyers say "15% rate on line for a financing deal? Forget it - I can just imagine what they would do with my money." Risk of moral hazard, is the old-fashioned term for this stand-off. Worse, the risk takers do not really understand the ideas, products, or presentations of the investor-promoters. As for underwriters, they seem to understand commodity insurance like motor and fire, but as for liability – real liability – they don’t understand it yet, as the Tillinghast actuaries keep on telling me. And there are very few insurance analysts who thoroughly understand non-life insurance accounts as presented to shareholders. We have a slogan in the risk management consulting business: “you’ve got to be able to understand the risk before you can finance it.” Well, there is a lack of common understanding of insurable risk that underlies the lack of understanding of the new integrated risk financing deals.

Integrated risk analysis before integrated risk financing: Since I’ve mentioned integrated risk financing, a distant goal that may never be attained, but which is constantly brought up as a good idea or deal, what is called for first of all is agreement on the simple risk analysis that applies to all such deals. There are models of risk analysis agreement in other areas. The best example is catastrophe modelling for hurricanes and earthquakes.

There are several models that provide widely varying results, but the methodology is similar. We need a GENERAL BUSINESS RISK MODEL, like the cat models for hurricanes in another mode. Your business risk model may be different from my model but we all agree on the simple underlying risk analysis technique. Then the interpreters like Felix Kloman who call for standards of and agreement on the terminology of risk management, must do their jobs to assure both sides that they are talking about the same things. Finally, the new, independent risk assessors, the EQEs and RMSs of the risk assessment world, working with the relational databases becoming available with internet-level speed and breadth need to be recognized by both sides – the investors (financiers) and the risktakers.

Captives are leading it: What this is leading up to is that it seems to me that captive insurance companies and their regulators already have such a model, or models. We use them to demonstrate the financial outcomes for proposed and ongoing captives. We use them to argue against demands for LOCs, and to show how our risk gaps are managed. In a way, they are simplified forms of risk-based capital models, and I am sure, there are other names for them, too. Dynamic financial analysis models are sometimes used, but rarely by owners of captives. My point is that there are common models for talking about how much risk any given captive is taking, large or small, property or casualty, and they could be used as a step towards a simplified general risk model that would bridge some of this misunderstanding.

So if the continuum of risk financing is changing, and if ARF – advanced risk financing – is developing, then the message for captive domiciles and captive associations in those domiciles is that it’s not just captives, but involves some VISION as to how captives are evolving and changing. At captive gatherings I find the people – some people – who understand this, and are capable of applying their high standards and utmost good...sense to developing this kind of vision.

With such a vision of captive insurance as part of an evolving risk financing environment, domiciles like South Carolina could make it into the “big leagues.” Without one? Well … they have proven that they know how to put on good conferences!

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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!