How Do Captive Insurers Use Reinsurance?
May 20, 2019
A captive is an insurance or reinsurance company set up exclusively to insure or reinsure the risks of the group to which it belongs. A captive insurer may operate as a direct insurer or a reinsurer.
What Is a Direct Writing Captive?
A direct writing insurer issues insurance policies to its insureds. A captive insurer operating as a direct insurer insures the risks of the group and purchases reinsurance on the commercial reinsurance market. This reinsurance is not designed to deal with high-frequency or low-severity loss occurrences. Reinsurance attachment points—that is, the level where reinsurers assume the liability to pay losses commences—are rarely below $250,000 per occurrence.
What Is a Reinsurance Captive?
A reinsurance captive does not issue policies directly to insureds and typically operates on a nonadmitted basis. A reinsurance captive reinsures the risks insured by one or more fronting companies. The fronting company is a licensed, admitted insurer that issues insurance policies to the captive's parent company without the intention of assuming all (or any) of the risk. The risk of loss is then transferred to the captive through the reinsurance agreement.
What Is Reinsurance?
Reinsurance can informally be described as insurance purchased by an insurance company. But here's a more technical definition: reinsurance is a transaction in which one party, the "reinsurer," in consideration of a premium paid to it, agrees to indemnify another party, the "reinsured," for part or all of the liability assumed by the reinsured under a policy of insurance that it has issued. The reinsured may also be referred to as the "original" or "primary" insurer or the "ceding company."
Facultative reinsurance is also called "per-risk" cover. The reinsurer underwrites each risk (insured exposure, peril, and hazard) separately and retains the right to decline any specific piece of business. This might mean, for a captive owner, that the reinsurer agrees to provide blanket property limits for all insured locations except one (perhaps on a floodplain or in an earthquake zone). Or the reinsurer could put a sublimit on the amount of reinsurance provided for a specific peril (perhaps liquor liability).
Treaty reinsurance is an automatic or "obligatory" contract—all risks insured within a defined underwriting class are ceded and assumed. The reinsurer does not underwrite each individual piece of business. Treaty reinsurance could be used in a group captive program where a reinsurer appoints a managing general agent (MGA) to underwrite the business on its behalf. The MGA signs an agreement with the insurer defining the underwriting guidelines. The captive issues policies to each insured, and provided the policy is within the treaty terms, there is automatic reinsurance above the captive's retention.
Unlike the facultative reinsurer, the treaty reinsurer may not become involved in any aspect of investigating or agreeing to settle claims. The MGA is given not only underwriting but also claims settlement authority. It is for this reason that MGAs are required to be licensed. If a captive manager performs the functions of an MGA, it must therefore be licensed in the state where it performs these functions.
A reinsurer may transfer some of the risks it has assumed to another reinsurer. This process is known as retrocession.
Direct reinsurance performs six major functions for an insurer (whether a captive insurer or traditional insurer), briefly described below.
- Capacity management. Insurers of any size usually require greater capacity than their own financial resources permit. Large line capacity is needed to handle large loss exposures, such as a large building worth many millions of dollars. Premium volume capacity is limited by regulatory requirements that an insurer's annual premium writings should not exceed some multiple of the insurer's policyholder's surplus (the premium-to-surplus ratio).
- Premium surplus relief. Because of the way premiums and expenses are accounted for, a rapidly growing insurer may find it difficult to meet regulatory premium-to-surplus ratio requirements without reinsurance.
- Stabilization of results. Insurers buy reinsurance to ensure that their earnings remain relatively smooth on a year-to-year basis.
- Catastrophe protection. Insurers are exposed to major catastrophe losses from natural forces and man-made disasters. Such events may result in large property and liability claims for a single insurer.
- Business withdrawal. Sometimes an insurer no longer wants to write a particular line of coverage, seeks to withdraw from a specific geographic territory, or wants to cease its operations entirely. Under any of these circumstances, the company can reinsure its entire book of business.
- Underwriting expertise. An insurer may seek to write a line of coverage for which it does not have any prior experience or particular expertise. In these situations, the ceding insurer will often seek the reinsurer's knowledge of this line of business as part of its strategic decision-making process leading to the eventual purchase of reinsurance.
With a fronting arrangement, the captive acts as a reinsurer rather than a direct insurer. A commercial insurance company ("fronting company") is licensed in the state(s) where a risk from the captive is located. The insurance policy is issued on the fronting company's paper. Then, through contractual agreement ("fronting agreement"), the risk is transferred to the captive. The insured receives a policy from the fronting company, but the risk covered by the program actually resides with the reinsurance captive.
Fronting arrangements allow captives to comply with laws, imposed by many states for auto liability and workers compensation insurance, that require insureds to provide evidence of coverage written by an admitted insurer.
The primary purpose of fronting is compliance with insurance regulations. However, an important secondary purpose is to access services such as claims handling and risk control, as well as excess risk transfer capacity, from the fronting insurer in a cost-effective manner.
By utilizing the licensing of the fronting company, the captive insurer does not have to maintain licenses in each of the state(s) where business is written. Another favorable reason for utilizing a fronting company is to enhance the potential to achieve tax-deductibility of premiums paid. By using a fronting company, the insured may be bolstered in its ability to deduct its premium payments for the insurance placed through the fronting company and ultimately through the captive.
When a licensed insurer issues a policy, it is assuming a primary legal responsibility to pay a covered claim. The risk is then allocated through the fronting/reinsurance transaction, but the primary liability to pay the claim stays with the front. Generally speaking, the insurer cannot escape this primary liability even if the reinsurer (such as a reinsurance captive) that is supposed to be sharing the risk cannot or does not perform. Conversely, if the front fails, the insured may not only lose coverage while forfeiting premiums paid to date but could also even remain liable for future premium obligations to the front.
This article is based on information in Captives and the Management of Risk , Chapter 9.
May 20, 2019