Captives and Other Risk-Financing Options
Traditionally, businesses and other organizations have handled risk by transferring it to an insurance company through the purchase of an insurance policy or, alternatively, by retaining the risk and allocating funds to meet expected losses through an arrangement known as self-insurance.
During the liability crisis of the 1980s, when businesses had trouble obtaining some types of commercial insurance coverage, new mechanisms for transferring risk developed.
Captives were the first to appear. A captive is a special type of insurance company set up by a parent company, trade association or group of companies to insure the risks of its owner or owners. Other options soon followed. These included:
- Risk retention groups, insurance companies organized by a group of businesses or institutions in the same line of business to provide liability insurance for the owners or organizers.
- Risk purchasing groups, organizations in which firms engaged in similar businesses or activities band together to purchase insurance coverage from a commercial insurer.
- Large deductible plans, in which businesses opt to retain a larger portion of their exposure through policies with large deductible amounts.
Today the alternative market features a host of innovative products, including:
- Catastrophe bonds, which package catastrophe risk as securities that are bought and sold in the capital markets.
- Weather-based derivatives, financial tools that let businesses hedge their risk of losses from weather.
- Sidecars, reinsurance companies that contain a specific portfolio of risks financially supported by a sophisticated non-insurance investor, such as a hedge fund.
Estimates of the size of the market vary.
Self-insurance and captives accounted for 90 percent of the alternative market in the mid-2000s, according to 2006 report from Conning Research. The study estimated that the alternative market accounted for about 30 percent of the commercial risk protection market, with workers compensation accounting for the largest share of the alternative market (43 percent), followed by liability (35 percent, excluding auto), automobile (12 percent) and property (10 percent).
Other alternative risk mechanisms include pools, in which member corporations or insurers share risks, as in aviation and nuclear power plant pools.
An October 2012 study on the global commercial insurance market by Swiss Re put global commercial insurance premiums at about $600 billion in 2010, with traditional commercial insurers accounting for 90 percent of the market and captives and other self-insurance mechanisms accounting for the remainder. Global captive premiums were estimated at $55 billion 2010, with U.S. corporations representing 50 percent to 60 percent of the volume.
Alternative market mechanisms account for about 25 percent to 35 percent of the U.S. commercial market, A.M. Best reported in its “State of the Captive Insurance Market 2012" webinar.
- The Securities and Exchange Commission and some state regulators, including New York, have grown concerned that some insurance companies may be moving business to captive insurers to mask their financial health. Insurers insist their captives are appropriately funded and fulfill all regulatory requirements.
- In its December 2013 report the Federal Insurance Office mentioned the regulation of captives as one of its recommendations on how to modernize and improve U.S. insurance regulation. The report said states should develop “a uniform and transparent oversight regime” over the transfer of risk to reinsurance captives.
- In December 2013 The Wall Street Journal reported that the Securities and Exchange Commission exchanged letters with five publicly traded companies about their use of captives and what the impact would be if state regulators prohibited their use.
- A September 2013 report by Fitch cautioned that the growth in the number of captive domiciles could lead to a lack of oversight by jurisdictions seeking to attract captives.
- On June 12, 2013, the New York Department of Financial Services released the results of its investigation into the use of reinsurance captives by life insurers based in the state. The DFS contends that insurers shift blocks of claims to these entities, many of which are located offshore, to take advantage of looser reserve and regulatory requirements. Claiming that such transactions can mask an insurer’s true financial strength, the report calls on state regulators and the Federal Insurance Office to conduct their own investigations of what it calls “shadow insurance” transactions.
- The number of U.S. captive domiciles has grown to include 31 states and D.C. in 2013, up from 20 states a decade earlier, according to the Captives Insurance Company Association.
- There were 250 risk retention groups (RRGs) at year-end 2013, down from 261 from a year earlier, according to the Risk Retention Reporter. There were 10 new RRGs and 21 retirements. The District of Columbia had the most new groups, four, but two groups in the state were retired. While healthcare led RRG formations in 2013, with seven new groups, the sector also saw nine retirements.
- The number of purchasing groups (PGs) increased from 878 at year-end 2012 to 912 at the end of 2013. The healthcare sector saw the largest gains, with 16 new groups, followed by property development with 11.
- Catastrophe bond issuance reached a record $7.1 billion in 2013, surpassing the 2007 record of $7.0 billion, according to reinsurance broker Guy Carpenter. Risk capital outstanding reached a record $18.6 billion, up from $14.8 billion a year earlier. Competition from capital markets, including catastrophe bonds, helped drive property reinsurance prices down 11 percent worldwide as of January 2014, Guy Carpenter reported. U.S. rates fell 15 percent. Other contributing factors included abundant capacity and low catastrophe losses in 2013.
- In July 2013 the New York City Metropolitan Authority sold the first catastrophe bond designed to protect against storm surges. A number of other public entities have raised funds through cat bonds, including the California Earthquake Authority and state property insurance plans in North Carolina, Massachusetts and Alabama.
- A January 2014 Fortune article highlighted a sharp decline in publicly traded snow derivative contracts. In 2013 no snow contracts traded, down from 510 trades in 2011. The article cited a lack of snow in recent years and the fact that ski resorts, a logical buyer, never showed great interest. An active market remains for contracts tailored to a single company.
CAPTIVE GROWTH, 2005-2013
LEADING CAPTIVE DOMICILES, 2012-2013
CAPTIVES BY STATE, 2012-2013
TOP TEN CATASTROPHE BOND TRANSACTIONS, 2013
CATASTROPHE BONDS, ANNUAL RISK CAPITAL ISSUED, 2004-2013
CATASTROPHE BONDS, RISK CAPITAL OUTSTANDING, 2004-2013
PREMIUM FOR RISK RETENTION GROUPS BY BUSINESS AREA, 2010-2011
NUMBER OF RISK RETENTION GROUPS BY BUSINESS AREA, 2010-2011
NUMBER OF RISK RETENTION GROUP INSURED BY BUSINESS AREA, 2009-2010
The concept of captive insurers, insurance companies created to insure the risks of their owners, was introduced in the 1950s, when fire protection engineer Frederic Weiss formed subsidiaries to cover the risks of an industrial client in Ohio. Since that time several states and overseas jurisdictions have emerged as popular domiciles for captives. There are currently nearly 5,000 captives worldwide.
Captives may be a “single-parent” captive -- owned by one entity -- or have several owners. They may insure the risks of organizations other than their major owners. Wholly owned captives are companies set up by large corporations to finance or administer their risk financing needs. If such a captive insures only the risks of its parent or subsidiaries it is called a "pure" captive.
Associations or groups of companies may band together to form a captive to provide insurance coverage. Professionals such as doctors, lawyers and accountants have formed many captives. Captives may, in turn, use a variety of reinsurance mechanisms to provide coverage. Many offshore captives use a fronting insurer to provide the basic insurance policy. Fronting typically means that underwriting, claims and administrative functions are handled in the United States by an experienced commercial insurance company, since a captive generally will not want to get involved directly in running the insurance operation. Also, fronting allows a company to show it has an insurance policy with a U.S.-licensed insurance company, which it may need to do for legal and business reasons.
The rent-a-captive concept was introduced in Bermuda in the 1980s and remains a popular alternative market mechanism. Rent-a-captives serve businesses that are unable to capitalize a captive but are willing to assume a portion of their own risk and share in the underwriting profits and investment income. Generally sponsored by insurers or reinsurers, which essentially "rent out" their capital for a fee, the mechanism allows users to obtain some of the advantages of a captive without having the expense of setting up a single-parent captive and meeting minimum capital and surplus requirements.
An offshoot of rent-a-captives, the segregated or protected cell captive, was introduced in Guernsey in 1997. A protected cell captive offers participants many of the benefits of a group captive but with lower startup costs. The arrangement offers more security to policyholders by isolating assets and liabilities as if each participant were a separate company, called a cell, doing business with the core company. Actual numbers of segregated cells may be underreported because some captive domiciles don’t report the number of cells within them.
Most jurisdictions have established a specific regulatory framework based on the structure and operation of captives.
The U.S. Treasury Department has taken the position that domestic captives chartered in the United States or its territories are to be considered “insurers” under the Terrorism Risk Insurance Act (TRIA), enacted in November 2002 (and updated in 2005 and 2007) to provide a federal backstop for terrorism insurance. This means that all domestic captives, except those writing medical malpractice and other lines excluded by the act, are required to offer terrorism coverage to their insureds and are subject to the law’s 3 percent surcharge provision.
Captives that are owned by publicly held companies also have to comply with all the regulatory compliance and governance requirements stipulated by the Sarbanes-Oxley Act, enacted in 2002 to increase the accountability of boards of publicly held companies to their shareholders.
Self-insurance can be undertaken by individual companies wishing to retain risk or by entities in similar industries or geographic locations that pool resources to insure each other’s risks.
A wide variety of industries participate in self-insurance pools. Respondents to a July 2006 Business Insurance survey of public entity risk pools included cities/towns (26 percent of respondents); counties, school districts and special purpose districts (14.5 percent each); housing authorities (10.5 percent); transit districts (8.5 percent); and higher education (4 percent). The majority of pools (79.3 percent) provided property/casualty coverage, 13.1 percent provided employee benefits and 7.6 percent provided both. Commonly covered risks included general liability (73.9 percent); followed by auto/equipment liability, auto physical damage and property (67.4 percent each); and employment practices liability (65.2 percent).
The use of higher retentions/deductibles is increasing in most lines of insurance. In workers compensation many companies are opting to retain a larger portion of their exposure through policies with large deductible amounts of $100,000 or higher. Large deductible programs, which were first introduced in 1989, now account for a sizable portion of the market.
III. Risk Retention Groups
Risk retention groups (RRGs) – insurance companies set up to cover a group of related insureds – were introduced under federal laws passed by Congress in the 1980s to help businesses, professionals and municipalities obtain liability insurance, which had become either unaffordable or unavailable. The Product Liability Risk Retention Act of 1981 enabled RRGs to insure product liability risks. The Liability Risk Retention Act (LRRA) of 1986 expanded permissible risks to include most commercial liability coverages, with the notable exception of workers compensation.
Under LRRA, RRGs must be domiciled in a particular state. Once licensed by its state of domicile, an RRG can insure members in any state. It need not obtain a license in a state other than the one where it was chartered. A report by the General Accountability Office (GAO) released in September 2005 noted the important role in expanding the availability and affordability of liability insurance for certain groups. It called on state regulators to enact uniform regulatory standards for RRGs and suggested that Congress consider enacting corporate governance standards.
A December 2011 GAO report examined the financial condition of risk retention groups and their regulatory environment. The report concluded that RRGs have generally remained profitable, with their share of the commercial liability insurance market rising from about 1.2 percent in 2005 to 3 percent in 2010. Through the federal Liability Risk Retention Act, Congress partially preempts state insurance laws to allow RRGs licensed in one state (the domiciliary state) to operate in all other states (nondomicilary states). The GAO found that while most RRGs are domiciled in one of a small number of states, they write the majority of their business in other states. The report recommended that Congress consider clarifying provisions of the LRRA regarding registration requirements, fees and coverage to cut down on disputes that have arisen between state regulators and nondomicilary RRGs.
Like captives, risk retention groups must offer terrorism coverage under federal terrorism legislation.
IV. Risk Purchasing Groups
Risk purchasing groups (PGs) were introduced under the Liability Risk Retention Act (LRRA) of 1986. A purchasing group is comprised of insurance buyers who band together to purchase their liability insurance coverage from an insurance company. This contrasts with RRGs, which act as insurance companies, issuing their own policies and bearing risk. Another key difference between the two entities is that RRGs typically require members to capitalize the company whereas PGs require no capital. Both entities are regulated under state law and must adhere to certain stipulations under LRRA. Like risk retention groups, risk purchasing groups must be made up of persons or entities with like exposures and in a common business. Purchasing groups are now domiciled in over half the states.
V. Catastrophe Bonds
Catastrophe bonds - risk-based securities sold via the capital markets - developed in the wake of hurricanes Andrew and Iniki in 1992 and the Northridge earthquake in 1994. These megacatastrophes resulted in a global shortage of reinsurance (insurance for insurers) for such disasters.
Tapping into the capital markets allowed insurers to diversify their risk and expand the amount of insurance available in catastrophe-prone areas. Insurers and reinsurers typically issue cat bonds through a special purpose vehicle, a company set up specifically for this purpose. Cat bonds pay high interest rates and diversify an investor's portfolio because natural disasters occur randomly and are not associated with economic factors. Depending on how the cat bond is structured, if losses reach the threshold specified in the bond offering, the investor may lose all or part of the principal or interest.
Zurich Financial's Kamp Re was the first major catastrophe bond to be triggered. The $190 million bond was triggered by 2005's Hurricane Katrina and resulted in a total loss of principal. The 2011 tsunami and superstorm Sandy in 2012 also caused losses on some bonds.
During the financial crisis of 2008, cat bonds were also exposed to counterparty risk – the risk that a party in a contract cannot fulfill its obligation. Lehman Brothers was a counterparty on four catastrophe bonds when it filed for bankruptcy; Lehman’s role was to invest the bond proceeds and guarantee a rate of return on them. At bankruptcy, Lehman was unable to guarantee the value of the proceeds it held, driving down the price of those cat bonds to between 25 and 60 cents on the dollar. The problem also drove the entire cat market 10 percent lower, according to a 2010 Towers Watson report. Since then, the bonds have been more tightly structured to avoid a recurrence of the Lehman problem.
The catastrophe bond market has continued to grow. The bonds are actively traded. The number and amount of the bonds can have a significant effect on prices in the reinsurance property market.
VI. Weather-related hedges
Developed initially by an energy company in the late 1990s and now being offered by insurers, reinsurers and hedge funds, weather derivatives typically are indexes derived from average temperatures, snowfall or rainfall. Contracts can be tailored to meet specific needs and may take the form of an option or swap. A weather option is a trade that pays an agreed upon amount at a specific time, based on the occurrence of certain weather conditions, such as summer temperatures more than five degrees below average. A weather swap is an exchange of funds between two entities likely to experience different conditions. Money changes hands for every point above or below a certain threshold. The contracts can either be sold by traders, largely through the Chicago Mercantile Exchange, or can be set up as over the counter contracts that are placed directly with capital providers such as hedge funds or reinsurers.
A sidecar is a financial structure that allows sophisticated investors to take on the risk and return of a book of insurance business. A typical sidecar exists for a finite period to reinsure a specific book of property catastrophe business.
Usually, the reinsurance company creates the sidecar by creating a separate subsidiary known as a special purpose vehicle. According to a Willis primer on the subject, the sidecar is funded by investors who want to reinsure a specific set of reinsurance contracts. The reinsurer cedes part of the contracts to the sidecar, meaning the sidecar receives premium and pays claims commensurate with the terms of the contract. The reinsurer handles the sidecar’s administrative needs. Generally, the sidecar is fully collateralized, meaning the sidecar has sufficient assets to pay the maximum amount of claims it could sustain in a worst-case scenario
Most sidecars are designed to last between one and three years, sufficient time to administer almost all claims after most catastrophes.
The earliest sidecars began after the September 11, 2001, terrorist attacks, but the structure gained popularity in 2005 and 2006, after hurricanes Katrina, Rita and Wilma. Those storms prompted rating agencies such as A.M. Best to require reinsurers to hold much more capital than before. The sidecar allows the reinsurer to write more business than their capital base would otherwise allow.
Investors in sidecars are usually sophisticated money managers such as hedge funds and private equity firms. The sidecar gives them the chance to achieve a high return on an investment, and the return rises or falls independent of the traditional stock and bond markets. These investors prefer catastrophe risks to other insurance risks because a catastrophe’s occurrence is well-defined (either it happens or it does not) and losses settle faster than many other insurance arrangements, so capital can be quickly redeployed after the sidecar expires.
OTHER SOURCES OF INFORMATION:
- The Risk Retention Reporter follows developments among risk retention groups and purchasing groups.
- Artemis covers a variety of insurance-linked securities, including catastrophe bonds.
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