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Reinsurance Basics for Captives

by John Prescott and Deborah Lambert, Johnson Lambert & Co.

In both the development stage of a captive and for ongoing operations, one of the most important decisions management must attend to concerns reinsurance. In short, the reinsurance program selected can make or break a captive program. Management must consider:

  • If they need reinsurance
  • If needed, what type of reinsurance is most appropriate
  • What level of reinsurance is required to ensure an appropriate mix of surplus protection versus the potential for retaining profit within the captive
  • How to purchase reinsurance (brokered versus direct)
  • Whom to purchase the reinsurance from

Not surprisingly, the breadth and complexity of captive reinsurance programs mirror the vast range of complexity associated with captives insurers. It's not unusual for a captive to simply purchase reinsurance to cover all of its losses for the life of the captive. In this scenario, it's likely that the captive was created primarily to gain access to the reinsurance market. On the other end of the spectrum, a captive may purchase multiple types of reinsurance from several reinsurers, in amounts that vary from one contract year to the next, with profit sharing or other specialty features that greatly increase complexity of the reinsurance program.

Functions of Reinsurance

Whether setting up a captive or managing ongoing operations, captive owners and risk managers purchase reinsurance to serve a number of different functions. Some of the functions of reinsurance include:

  • Stabilization of profitability
  • Provides large limit capacity
  • Catastrophe protection
  • Supports high growth in premium volume
  • Provides help with the underwriting process
  • Facilitates withdrawal from a particular risk or line of business

Stabilization of profitability: As captive owners and risk managers know, losses incurred sometimes fluctuate widely from year to year. Large swings in losses incurred can make it difficult, if not impossible, to forecast profitability of a particular line of business, or in total. While showing profitability in a pure captive may not be as critical as it is to say, a risk retention group or commercial insurer, most business owners like to see a reasonably steady flow of profits to protect their capital and surplus and to support growth, if necessary. Purchasing reinsurance is particularly helpful in smoothing the peaks and valleys of a captives loss experience, as generally the law of large numbers doesn't apply to captive operations.

Provides large limit capacity: Captives frequently provide a high limit of insurance on one or a limited number of policies. For example, a hospital captive may wish to insure the excess professional liability exposure of its parent. A captives capacity for retaining such coverage is limited by capital and surplus, regulatory and other factors. Partnering with a reinsurer to accept a particularly high risk allows the captive to provide lines of coverage and limits that would otherwise not be feasible.

Catastrophe protection: Captives insure property-liability coverages which are frequently concentrated in geographic or economic regions. Catastrophic exposures such as hurricanes, industrial explosions or the like can tremendously effect loss experience. Purchasing "cat" coverage is therefore also related to the stabilization function described above.

Supports high growth in premium volume: As with any business, new endeavors are particularly risky. As a company enters into a new line of business, geographic region, or adds significant premium volume, it may wish to purchase some kind of reinsurance. Risk retention groups, in particular, may wish to temper the risk of accepting large increases in premium volume, as their writings are generally more sensitive to market forces than pure captives.

Provides help with the underwriting process: Partnering with a reinsurer can greatly improve a captive's ability to accurately underwrite a risk. Reinsurers accumulate vast underwriting knowledge working with large numbers of primary insurers across a wide variety of business lines. This expertise can be particularly helpful to captive insurers who generally have limited in-house underwriting capacity.

Facilitate withdrawal from a particular risk or line of business: For a variety of reasons, a captive may decide to withdraw entirely from a particular risk or line of business. Once a decision is made to withdraw, management frequently enter into agreements with reinsurers to accept all outstanding loss and loss expense reserves associated with that book of business, at an agreed upon price. Due to the time value of money, the captive can generally pay the reinsurer an amount that is somewhat less than the total estimated liability for loss and loss expense at the time of transfer.

Types of Reinsurance

Many different types of reinsurance exist to meet the needs of primary insurers. The most general classification of reinsurance is treaty versus facultative. Treaty reinsurance is when a primary insurer and reinsurer agree in advance that the primary insurer will cede a certain line(s) of business to the reinsurer in accordance with the terms of the reinsurance treaty. Treaty reinsurance is referred to as an obligatory contract as the primary insurer is obliged to cede the business and the reinsurer is obliged to assume the business, so long as the terms of the treaty are met. A treaty arrangement is popular when a group of homogenous risks are being insured. Unlike treaty reinsurance, facultative reinsurance is non-obligatory. The primary insurer in not obliged to cede the business and the reinsurer is not obliged to accept the risk. Facultative reinsurance agreements are individually underwritten and are common for large limit risks that are not homogeneous in nature. Keep in mind that a captive could be either the primary insurer or the reinsurer.

Another general classification of reinsurance is based on the manner in which the primary insurer and reinsurer share the risk. Pro-rata reinsurance allows the primary insurer and reinsurer to share an agreed upon percentage of the premiums and the losses. Captives commonly use pro-rata coverage for base layers that involve significant claim activity as it helps provide surplus protection which is especially important if a captive is thinly capitalized. Two types of pro-rata reinsurance include quota share and surplus share. Under quota share, the captive cedes a fixed percentage of premium and loss for every risk accepted. Surplus share agreements are similar to quota share, except that not every risk is ceded to the reinsurer. Rather, only risks exceeding a minimum dollar amount are ceded. Under a pro-rata agreement, reinsurers typically pay a ceding commission to the primary carrier for the cost of issuing the policies.

Excess of loss reinsurance is utilized to cover risks in excess of an agreed upon threshold. Typically, these contracts are structured such that the base layer of coverage (or primary layer) is retained by the primary insurer and the reinsurer is responsible for losses that exceed the base layer. Captives use excess of loss coverage where they have the capital and surplus capacity to bear risks for a number of smaller claims, but not the capacity for one or more high value claims. Excess of loss reinsurance can be purchased on a per risk basis or on a per policy basis, or a combination of the two. For example, a captive may purchase excess per risk property coverage for all individual claims in excess of $500,000, and per policy excess coverage if aggregate property claims exceed $3,000,000. This type of arrangement can provide a great deal of flexibility to the captive.

Financial reinsurance is a somewhat distinct class of reinsurance that has evolved in the last decade or so that is unlike traditional reinsurance. The motivation for entering into a financial reinsurance transaction is more closely linked to an investment decision, rather than minimization of risk. According to Statement of Financial Accounting Standards No. 113, for a contract to qualify as reinsurance (and reinsurance accounting), the following conditions must be met:

  1. The reinsurer must assume significant insurance risk from the underlying insurance contracts.
  2. It must be reasonably possible that the reinsurer may realize a significant loss from the transaction.

The accounting guidance defines insurance risk to include both underwriting risk and timing risk. A characteristic of financial reinsurance contracts is that they transfer little or no underwriting and/or timing risk. Mortgage insurance captives, which have become popular in the last five years or so, have to be particularly careful to structure their reinsurance contracts to meet the requirements noted above. If the requirements for risk transfer are not met, the reinsurance "premium" essentially gets treated as a deposit on the books of the ceding insurer.

Specialty Features of Reinsurance Contracts

It's not uncommon for captive reinsurance contracts to include specialty features such as contingent profit commissions and swing premium calculations. As their names imply, these contract features can enable a reinsurer to share profitability on a program back with the captive. Obviously, captive owners get excited about the possibility of sharing in the profitability of the business they generate, but the programs are also beneficial to the reinsurers in that they help promote long-term business partnerships. The advantage of contingent profit commissions is that they generally don't penalize the captive for a poor underwriting year. In an unprofitable year, the captive simply doesn't get a commission. However, for purposes of the calculation, the reinsurer may carry forward underwriting losses to a subsequent year pursuant to a "deficit carry forward" provision in the contract. Also, it's important to note that if loss experience (which includes the liability for incurred but not reported losses-IBNR) turns unfavorable in subsequent years, it is possible that a captive can record a loss relating to the contingent commission program as prior year profits generated are reversed from earnings. Lastly, accounting guidance requires that companies book anticipated earnings on profit commissions on a full accrual basis. Therefore, if the contract calls for cash settlements at some future date-say in years three through eight after the close of the contract year-the earnings on the contingent commission may precede the cash receipts. If the captive is a tax payer, this may create a larger than expected tax bill.

Summary

Reinsurance requires a great deal of attention from a captive's management team. A program should be monitored to be sure the intended functions of the reinsurance are being met as the captive evolves. Few decisions will impact the overall success of a captive program more than those relating to reinsurance. The above information is intended to bring a bit more familiarity to those captive owners and risk managers who are considering setting up a captive or are altering the reinsurance structure of an existing company. However, the reinsurance market is complicated and the above barely scratches the surface of possibilities available. So do your reinsurance homework and make sure your program is the right one for your captive! 

This article is reprinted with permission of the Self Insurer Publishing Corp. and the Palmetto Insurance Journal