The Alternative Insurance Market: A Primer

The insurance marketplace continues to evolve. In the mid and late 1980s, headlines in the trade press talked endlessly about the hard insurance market and the widespread adoption by many large corporations of alternative market techniques. This decade brings news of market consolidations and softening insurance prices. In addition, today's insurance buyer has become more sophisticated and the traditional market has responded by expanding their offerings. The result is that the line between traditional and alternative markets has become blurred. Most carriers are now offering and writing what previously were considered alternative structures such as large deductibles, retros and captives.

As the market continues to soften coverage is available for most risks, although some can not find the required capacity. This article examines the expanding list of program structures, and the ability of the traditional market to support these structures to meet the needs of risk managers. The structures discussed include self-insurance, captives, rent-a-captives, finite risk, basket aggregates and the capital markets.

Self - Insurance

Large organizations can reap several benefits from self-insuring. However, these benefits can quickly disappear if the organization does not have a plan for paying losses when they occur. The day of settlement is not the best time to explain the need for $1 million to pay a loss.

A good self-insurance program requires an understanding of the firm's exposures and the expected loss levels, including the variability of those loss projections, and the program also includes a method for funding losses.

The primary benefits of self-insurance are the reduced costs and increased control. It is typically the most economically efficient structure with non-loss (frictional) costs running from 3 percent to 25 percent of the total loss and expense costs dependent on whether the program is regulated, the size of the program and the state the company is located in. No capital is required and if the self-insurance program is not regulated than the reserves may not require any securitization. The corporation has the flexibility to raise or lower its retention amount depending on the market pricing for excess insurance. Directly retaining losses increases the internal sensitivity to loss results, and offers the corporation greater control over the claims management process.

The disadvantages of self-insurance are in the administrative and financial areas. When the risks remain with the corporation, unexpected loss payments can create problems particularly where no reserves have been funded. If a division is sold or liquidated, the reserve and claim management issues can become complex. If a self-insurance program is regulated, the administrative issues can be demanding especially for organizations converting from a bundled insurance program.

Self-insurance regulations are promulgated by each of the states and differ from state to state. The discussion that follows will be generally true, but before implementing any program, the details for each of the applicable states must be researched. Regulations for jurisdictions outside of the United States are beyond the scope of this discussion.

Establishing regulated self-insurance programs require approval from the appropriate regulatory agency which also monitors these programs. Approval is primarily contingent on the financial condition of the corporation. When new corporations are formed which are owned by a qualified self-insured, the new subsidiary must also be approved by the state. A qualified self-insured is usually required to securitize the loss reserves through cash, letters of credit and/or bonds. If the program is discontinued, that funding and securitization is required until all losses and IBNR are closed out.

Non-regulated self-insurance offers significantly more flexibility than a regulated program. One advantage of non-regulated self-insurance is that reserves do not need to be funded. The program can be established immediately and any changes to an insured's needs are restricted only by the time it takes to implement the new structure. A non-regulated program should be periodically reviewed so that management is aware of the exposure(s) and loss costs. If a portion of the entity is sold funding of the loss reserves may be required.

Most self-insurance programs cover the primary layers where there is less variability in the loss results than in excess layers. Common coverages for self-insurance include workers' compensation, general liability, product liability, auto liability and property. Workers' compensation and auto liability can only be self-insured as regulated programs. They require loss projections and loss reserving. Reserves, even when funded, are not tax deductible. These funded reserves create an opportunity cost for the organization as compared to using the funds to invest in the operations of the company.

Many corporations with a large concentration of employees in a state are qualified to establish a self-insured workers' compensation program. As a general rule, it is financially beneficial to self-insure if an organization has in excess of $1 million of workers' compensation losses in an individual state. Today, many entities are in-effect self-insuring a portion of their workers' compensation losses by taking a large deductible on their insurance coverage. An insurer with a deductible program does not have to formalize their self-insurance program with the state, however, the insurance carrier will typically require some securitization of the loss reserves.

Casualty and property coverages are commonly self-insured through deductibles or self-insured retentions. In this case, the company retains a lower layer and insures at higher levels. A deductible program will require security for the exposure since the carrier is responsible if the insured can not pay the deductible.

Self-insurance programs that are properly managed and funded can offer companies greater control over their insurance costs. But, management should recognize that the amount of administrative work required for self-insurance is dependent on the amount of regulation. Regulatory compliance requires communication with the state agency and possibly actuarial reviews. A successful self-insurance program is also dependent upon management of the loss exposure and communication within the organization.

Captive Insurance Companies

Some people predicted that interest in captive insurance companies would wane in the 1990's as the market softened, however interest has remained high as evidenced by their continued growth. Organizations have found that the flexibility of a captive insurance company is a strong benefit even during the soft market.

A captive is an insurance company that primarily insures the risks of its owner and is actively managed by the owner and/or insureds often with the assistance of a captive management company. The assets of a captive are owned by the insureds. Captive insurance companies have been formed in as short a time frame as a couple weeks, although a more realistic time frame is ninety days. This includes preparing a business plan and an application, and receiving approval by the domicile.

A pure captive is one that insures the risks of a single owner including its owned subsidiaries. The pure captive may also insure customers and affiliated entities. Group captives are owned by the policyholders and are often formed to support a risk retention group. This article will focus on pure captives.

A captive insurance company offers the insured greater control of their program and the opportunity to expand their options. Like self-insurance, a captive allows the insured to unbundle claims management services. In other words, claims may be handled internally or through a third-party administrator providing the insured greater control of the claims

The formalized nature of a captive facilitates greater understanding within management of losses and preparedness for loss payments. The insured has greater control of the policy form since they are the primary reinsurer. Depending on the coverage, a captive insurance company can insure the owner directly without the use of a front company, and the captive can cede portions of the risk to reinsurers. The captive is a licensed insurance entity (although generally not admitted in any of the U.S. states) and thus able to insure the risks of a company's affiliated businesses and/or customers.

A captive insurance company is typically more costly than self-insurance due to license fees, directors fees, management expenses and audit fees. This method of risk financing also requires a capital commitment by the parent company. Captives can be structured with tax deductibility for the parent company premiums but this is an uncertain area that is often challenged by the IRS. Owning a captive also requires administrative time by the owner sine it is a separate financial entity with its own financial statements. Although a captive manager completes these statements, the owner needs to monitor results and may be required to conduct an annual Board of Directors meeting within the domicile.

The following chart illustrates the premium and claim payment flows for a pure captive insurance company. As shown, the program is a fronted program whereby a licensed carrier issues the policy. The captive and other reinsurers assume portions of the risk from the fronting carrier.

Captive Insurance Company Cash Flows

The annual operating costs for a typical captive insurance company are $50,000+ including captive management, legal, audit, actuarial and licensing costs. Premium taxes and fronting fees will increase the premium costs by 5 percent to 15 percent. Captives also have capital and loss reserve requirements. For pure captives, the insured may be able to loan a majority of those funds back to its parent company for use in their operations. Most domiciles offer significant investment flexibility to pure captives. Group captives tend to be limited to the more conservative investment options of commercial insurance carriers.

Captive insurance companies should be not be looked at as a short term solution. While this alternative method of risk financing is very flexible, it usually does not make sense to form a captive to fill a need for one year. The unwinding issues make the short term use of a captive unfeasible. To close a captive, the open claims and IBNR need to be commuted back to the ceding company or insured. Insurance policies and reinsurance agreements may also need to be commuted. The insurer may not be willing to commute the exposures and/or the portfolio transfer may be costly. Tax implications and regulatory issues are also involved. As a result, many organizations find the use of their captives increases and decreases over time, and occasionally captives may be left dormant until needed.

The most common exposures insured by captives are casualty and property exposures. Surety coverages are less common as the captive would be essentially insuring the financial soundness of its parent. Captives are most typically used to assume the primary risks of the insureds and may use reinsurance support for some of the exposure. Some captives are involved in fronted umbrellas and higher layers where they are quota sharing those exposures. In most cases, the captives cede excess layers to reinsurers.

Captives require some additional support services including a captive manager, financial auditors, actuaries, legal counsel and bankers. Most organizations use a captive manager within the domiciled location to manage the financial books and coordinate all local actions including regulatory communications. The financial statements are typically audited and the loss reserves are evaluated by an actuary. Legal counsel in the domicile provide services to support the incorporation of the captive and the annual Board of Directors meeting. The captive funds are invested in a bank within the domicile although this is generally not required.

Tax issues for captive insurance companies are complex and uncertain. While there are precedents, there is no firm formula to insure that an organization will be able to obtain tax deductibility. The basic premise is that the captive needs to be operating like an insurance company with sufficient capital, proper premiums, a spread of risk and risk transfer for the parent organization to receive a tax deduction. Offshore captives have additional tax implications, including but not limited to, their engagement in trade or business within the U.S., withholding taxes and branch profits taxes.

Captive domiciles are available within the United States and offshore in the Atlantic/Caribbean, Europe and Asia. Comparing and contrasting the domiciles is beyond the scope of this article, however the most frequent domiciles for U.S. companies are Bermuda, Cayman Islands, Vermont and Hawaii.

Rental Captive Insurance Companies

A rental captive program is very similar to a captive insurance company program. The difference is that the insured does not own the captive, instead they "rent" the usage of the captive insurance company. A corporation may use a rental captive because they are not large enough to form their own or for internal reasons, for instance, they just do not want to have ownership of a captive insurance company.

The benefits and disadvantages of a rental captive program are similar to the pure captive program. The differences are that there is less management control and administrative oversight required for a rental captive program. A capital investment is not required, however, the aggregate exposed liability may need to be fully secured depending on the rental captive owner. The insured is also exposed to the solvency risk of the rental captive.

The structure below illustrates the premium and claim payment flows for the rental captive. The structure differs from the captive program in that the insured does not own the captive, instead the insured's ownership rights are through a preferred stock shareholder agreement with the rental captive.

Rent-A-Captive Cash Flows

Establishing a rental captive program requires additional legal agreements other than those needed for an owned captive program. The flow of legal liabilities is shown in the following chart. Captive insurance companies have a reinsurance agreement with the front company. In a rental captive program, the insured also has a shareholder agreement with the holding company whereby the insured purchases one share of a special class of preferred stock in the holding company. The insured receives a dividend related solely to the underwriting and investment results of their program.

Rent-A-Captive Legal Agreements

Rental captives cannot be admitted carriers, so another insurance company (fronting company) will be needed. Front companies typically require security for unearned premiums, outstanding loss reserves and IBNR from the captive insurance company. The most common method of providing security is through a letter of credit or trust account. An insured in a rental captive program needs to provide security to the front company and has to indemnify the rental captive against adverse underwriting results. This indemnification is typically secured. Rental captive requirements for this security vary, with some requiring that the total aggregate liabilities assumed by the rental captive be secured as illustrated in the following chart.

Rental Captive Securitization of Aggregate Limits of Liability

The expenses for a rental captive program consist of a rental fee to the captive owner and usually a management fee of 1 percent to 2 percent based on assets held by the rental captive. The investment options may not be as varied as those for an owned captive because of the security requirements of the holding company.

Implementation of a program is relatively quick, taking only a couple weeks except for the more complex programs. The time to implement a program is primarily dependent on the legal issues for the shareholders and indemnification agreements with the holding company. The amount of time a company utilizes a rental captive can be shorter than a captive program. This is particularly true where the holding company is affiliated with the fronting company and willing to negotiate some type of commutation beforehand.

The tax implications are similar to those of a captive insurance company since the underwriting results are independent of others within the rental captive, but depend on the facts and circumstances. There is not as much published guidance on rental captives as there is on wholly owned captives.

Finite Insurance

During the 1990's, a significant amount of attention has been placed on finite insurance programs. This is an insurance arrangement in which the limit of coverage, the time period involved and the premium paid acknowledge the time value of money. The liability is generally limited in the aggregate. While risk transfer takes place, typically most premiums are put into an experience fund which accrues interest and pays losses. The insured has the right to all money within the experience fund which can be paid back as a profit commission at the end of the transaction or applied to ongoing programs.

An example of how the experience fund works is shown in the following chart. In the example, the insured has implemented a three year program with annual premium payments of $1 million. The fund accrues interest at an the annual rate of 5 percent, and there is a $1.5 million loss during the program. As demonstrated in the chart, the experience fund accrues interest on a tax free basis. Many of the finite risk programs are with offshore insurers, such as in Bermuda, where the investment income is not subject to taxation.

One of the benefits of finite insurance is that it can stabilize volatile underwriting results by spreading losses over multiple years. The transaction may allow an organization to change the timing of the recognition of income. The corporation may also be able to obtain favorable tax treatment for the transaction. Since most programs are for multiple years, program stability can be enhanced and the frequency of marketing efforts can be reduced. Finite insurers will also put up some capacity, not available in the traditional marketplace, to support these transactions.

The most significant downside for the transaction is that it can be costly when compared to its benefit. Typically there is a significant transfer of timing risk but not a substantial transfer of underwriting risk. Timing risk is the risk that losses will be paid out sooner than expected. Insureds may also be required to fund potential losses which were only identified as liabilities on the balance sheet previously. The effort in developing a program requires a major commitment by the insured since the accounting and tax issues are complex and uncertain.

The frictional costs range from 5 percent to 10 percent. They consist of a fee to the finite insurer that is dependent on the size and structure of the program. A federal excise tax may also apply as many programs are domiciled offshore. The other cost is the opportunity cost of committing funds to the program. The funded amounts are usually not used for the operations of the insured, thus the funds earn investment income at a set rate, generally a short-term rate such as the 90-day T-bill rate. Some programs are structured on a funds withheld basis where the insured retains a majority or all of the funds until losses are paid. Programs can also be structured where the funds are loaned to the insured's foreign operations.

A program requires 90 days to a year to develop and then it is usually in place for three to five years. Upon completion of the policy period, there will likely be funds remaining in the experience fund. They can be returned to the insured, but this can have adverse tax and accounting consequences. Another alternative is to apply them to a future program, possibly with expanded coverage, to enhance the likelihood of the fund being depleted.

Any line of coverage can be in a finite insurance program. Difficult coverages are more common because of the lack of capacity or high pricing. Fidelity and surety coverages are not common because they relate to the financial viability of the firm. A program may be structured as a basket aggregate to fund primary losses. For intermediate layers, it can be used to stabilize the impact of infrequent but periodic losses and a program can be used to develop a fund for excess layers. Basket Aggregate

Carriers have begun offering basket aggregate programs whereby the insured agrees to retain a single aggregate retention instead of multiple occurrence retentions for each line of coverage. While individual policies are required for certain coverages, the insured buys essentially a single policy to cover a large number of exposures including workers' compensation, casualty, property, D&O, professional liability and others. It can be likened to an expanded version of a multiple line retro since it uses an overall aggregate. The insured is likely to require specific excess layers for certain lines of coverage, such as property or excess liability, above the basket aggregate protection as illustrated in the following structure diagram.

Basket Aggregate

The program is not appropriate for all organizations and there is limited support within the marketplace for this type of structure. Currently only three issuing carriers are supporting these programs. The basket aggregate program can best be utilized by corporations where losses are spread over a number of different coverages. If most of the insured's losses are from workers' compensation claims, they will likely not realize any benefits from an aggregate since it will be just structured around the workers' compensation program.

Certain industries such as the hospitality or medical industry are exposed to multiple catastrophic losses in different coverage areas. For example, if a large fire occurred at a hospital, it could suffer catastrophic property, general liability and workers' compensation losses. The basket aggregate protection from the carriers could be quickly eroded requiring the excess property and casualty carriers to drop down. For this reason, excess carriers may price their program assuming they will have to drop down to the insured's basket aggregate or lower which will increase the overall program costs.

The costs for a basket aggregate are largely dependent on the underlying structures. The insured can retain their basket aggregate retention through self-insurance, captives, finite insurance or a combination of methods. It is a significant change from most insured's current structure and thus, will likely take a minimum of six months to implement.

Capital Markets

The financial markets have started to enter the insurance marketplace although the number of transactions is currently very small. The capital market alternative consists of the use of bonds or finance structures rather than insurance to transfer risk. Mechanisms include standby liquidity, premium securitization, event bonds and options. Currently most of the interest in these mechanisms is coming from insurance carriers looking for capacity and from states requiring special catastrophe programs.

A lot of attention has been placed on this mechanism since the capacity of the financial markets has been estimated at $15 trillion as compared to the insurance industry's surplus of $15 billion. However, much of the financial market's capacity is concentrated in pension funds, mutual funds and insurance company investments which tend to have more conservative portfolios than insuring earthquakes or windstorms.

The Hawaii Hurricane Relief Fund is an example of the blending of the insurance and financial markets. The fund was created in 1993 by the legislature to provide hurricane coverage for property located in Hawaii. The intent of the fund is to provide $1 billion of wind storm coverage. The funds come from a combination of finite risk insurance and a line of credit. The line of credit is not insurance, it provides cash at the time of the loss. The loan payment will be funded through a combination of premiums and assessments.

This alternative may continue to develop as a significant alternative since it is receiving a great deal of attention in the way of resources from various organizations. In addition, the amount of capacity that may be available is substantial.

Implementation

A formalized study of the corporate risk profile offers a valuable tool to help examine the insurance and risk management issues impacting the organization. This should be conducted to determine the most appropriate risk financing structure for an organization. The study becomes a multi-purpose document as it examines the feasibility of implementing new alternatives, and it becomes the business plan for the future programs. If a captive insurance company is implemented, the application will incorporate many of the study components. A study can also be a significant document assisting in the education of the organization's senior management. A common problem for risk managers is increasing senior management's understanding of the company's insurance program.

Typically, the study begins with loss projections and retention selections for the various lines of coverage. An examination of program structures will be included with recommended structures. An economic analysis comparing the financial benefits of the structure with corporate sensitivities can help determine what structures should be pursued.

A cash flow model can project the impact of the retention options and structures on the company's financial statement. The cash flow projection is performed again during the marketing process when the quotes are obtained. As illustrated in the following chart, the costs are identified in the year they are expected to be paid and are adjusted for potential tax effects including premium deductibility. The after-tax cost is then discounted to current year dollars to find the actual estimated cost of the program.

The economic analysis should be run at different sensitivities (or "what if" scenarios) to evaluate the impact of different loss projections, premium deductibility and investment returns. The cash flow model may not clearly identify the most appropriate structure, but it will provide an understanding of the financial impacts of the alternatives. The costs of the structures can also be evaluated as a comparison to economic measures used by senior management to increase their understanding of the insurance program. In the following example, the forecasted loss amount has been varied and the graph compares the cash flow model's cost to net income.

What It Really Means

The variety of structure options available to corporations is increasing. To implement the most appropriate structure, a solid understanding of the organization is required including the exposures facing the entity, expected environmental changes, new products planned, and the goals of the organization. In many cases, a blending of structures will be required.

The establishment of the structure is a dynamic process and requires constant adjustment. Today's risk manager is required to have a broader understanding of the organization to be prepared for these developments. The insurance carriers, brokers and other consultants that are willing to evaluate and develop new ideas can contribute to their development.

Authored by Gregory K. Myers, a Senior Vice President with Becher and Carlson Companies. This article was published in the Fall, 1996 issue of the John Liner Review. Reproduced with permission.

Becher and Carlson Companies is part of Am-Re Global Services , Inc. a group of companies that offer integrated brokerage, risk management consulting, and captive management services worldwide. Mr. Myers is located in their Woodland Hills, CA. office. (818) 715-0800.

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