Captives & the reinsurance market

From strange bedfellows to comfortable partners

By Michael J. Moody, MBA, ARM

There is little doubt that the alternative risk transfer (ART) market has made a significant impact on the commercial insurance industry. With estimates in the 50%-plus range, the ART market may not be the “alternative” any longer.

Nowhere is this more visible than within the ranks of the captive insurance community. Growth of the captive market has been nothing short of meteoric over the past 30 years. Captives have developed from a small group of property captive insurance companies domiciled in Bermuda, to a mainstay of the commercial insurance market today.

And despite a continuing soft market, most industry observers believe that this growth will continue into the future. For example, Aon’s Global 1500: A Captive Insight, which looked at the top 1,500 companies globally and found that “more than half (53%) of the G1500 companies do not have a captive at the parent level.”

As the captive market has matured, it has included a variety of captive structures. By far the most-used captive form has been the single-parent captive, which currently accounts for about 70% to 75% of the total captive marketplace. Other popular forms of captives include: group and association captives, rent-a-captives, protected cell captives, and agency captives. However, one form of captive that has received significant attention recently has been the Risk Retention Group (RRG).

Off to a shaky start

The reinsurance/captive relationship over the years has developed into a win-win situation for many captives and some reinsurers. However, it was not always that way. One of the primary concepts of the captive movement has been the ability to purchase insurance-related services from the most appropriate service provider.

But early on, this approach, known as unbundling of services, was unique and controversial. Few reinsurers were going to test the concept. It took quite a bit of time for the insurance industry to accept the unbundling concept. But as the concept caught on, some service providers were able to see the value of this approach and as a result, unbundling has become a common practice today.

Further, since early captives were primarily begun as a response to major availability issues in the commercial market, most reinsurers were reluctant to take on any of these risks. Reinsurers however, did finally find a way to begin accepting risks on a direct basis from their captive customers. However, many reinsurers continued to have additional considerations that were of interest to them from an underwriting standpoint. These are still important considerations and include: the type of coverage, industry segment, size of the premium, established vs. startup captive. All of these factors—plus a number of other ones—will ultimately determine the reinsurer’s appetite for the captive’s business.

The perfect platform

One of the most successful group captive structures has been the Risk Retention Group (RRG). RRGs grew out of federal legislation that was originally passed by Congress in 1981 and amended in 1986. In brief, RRGs are captive insurance companies that are designed to provide liability coverage for their owners. The owners must be in the same general business and by virtue of the federal preemption, they can operate in all 50 states while being licensed in only one state.

This marked the first time the federal government had gotten involved in the insurance business, but the Products Liability Risk Retention Act was initially required due in large part to a total lack of product liability coverage in the commercial insurance market. The amendment was required because of a similar lack of general and professional liability coverage just a few years later.

Captives began to gain favor with commercial insurance buyers due to the advantages that were noted from these formations. Most captive experts have generally identified three broad advantages that accrue to captive owners. Since many captives were formed during hard markets, one of the key benefits that a captive can provide is coverage affordability and, in the worst-case scenario, coverage availability.

A second benefit that is widely attributed to captive ownership is cost savings. These savings come from a variety of sources and usually include reduced expenses, and investment income from holding claims reserves. Savings have also been projected from buying excess loss protection (reinsurance) on a wholesale basis rather than on a retail basis (traditional insurance policy).

The third advantage from captive formations is control and, as time has shown, this has been the real wild card in the equation. This control issue has proven to be the greatest advantage of the captive movement. Captive owners quickly found that they could begin to make a direct impact on their own losses by embracing proactive risk management strategies. Successful captive owners have been able to develop risk management strategies that not only provided industry specific loss reduction techniques, but also established aggressive claims management procedures that provide for long-term claim costs reductions.

By controlling their own destiny, many captives have actually been able to effect lasting changes in their industry segment. Whether it is a specialized segment of the medical malpractice market or specific challenges of another professional liability exposure such as agents and brokers errors and omission coverage, captive owners have developed “best practice” risk management programs that have advanced the professions.

And for their part, reinsurers have been willing to reward those captives that can consistently produce better-than-average claims results. Captive owners have been able to obtain stable, competitive pricing from their reinsurer as well as develop long-term contractual relationships. In fact, many of today’s reinsurers have worked to establish more of a partnership relationship with those captives that can demonstrate industry improving risk management programs.

Captive basics

Most captives have established a strong foundation for their operation based on prudent funding. Within this element are specific requirements for proper capitalization preferably provided by the insureds. This aspect is important because it is one method of assuring that the insureds have “skin in the game.” Additionally, prudent funding also includes actuarially determined rates that support the ongoing operation of the captive. The final aspect of the prudent funding requirement is an appropriate level of reinsurance.

For years, reinsurance has been a common method for captives and all insurance companies, for that matter, to protect themselves from unexpectedly high losses. Reinsurance has been used to provide protection for both per-occurrence losses as well as aggregate annual adverse loss development.

Further, reinsurance has also been used to help captives leverage capital. When considering the proper capital and surplus amounts, many regulators, for example, will take into account the amount of reinsurance available. In essence, captives can reduce their capital requirements through the use of more reinsurance.

Leveraging the amount of reinsurance has become an important part of most captive programs. In addition to being able to modify the amount of reinsurance as needed for capital requirements, captives can also adjust the amounts of reinsurance based on the competitiveness of the commercial market.

Traditionally, captives will tend to take higher retentions during hard insurance markets and then adjust them during the softer markets. Such was the case during the soft market of the 1990s that saw many captives adjusting their retentions based on market conditions. This process, commonly referred to as arbitraging, frequently found captives taking lower excess of loss and/or aggregate reinsurance attachment points.

Conclusion

While the captive/reinsurance relationship may have initially gotten off to a stormy beginning, over the years, both parties have seen the value of working together to develop a true partnership affiliation. Today’s captives have proven to be an excellent partner for reinsurers who are looking for long-term business. Reinsurers, for their part, have learned that, by in large, organizations that choose to have “skin in the game,” via capital and surplus in their captives, are typically better customers than the average commercial accounts.

One would expect this relationship to grow even stronger in the future as both participants continue to find more value-added applications to incorporate into the captives’ reinsurance programs.