THE TOPIC

NOVEMBER 2009

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," in which firms retain rather than transfer risk.

During the liability crisis of the 1980s, when businesses had trouble obtaining some types of commercial insurance coverage, new mechanisms for transferring risk developed, facilitated by passage of the Product Liability Risk Retention Act of 1981. These so-called alternative risk transfer (ART) arrangements blend risk transfer and risk retention mechanisms and, together with self insurance, form the alternative market.

Captives—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—and risk-retention groups—in which entities in a common industry join together to provide members with liability insurance—were the first mechanisms to appear. Other options, including risk retention pools and large deductible plans, a form of self insurance, followed. 

ART products, such as catastrophe bonds, weather derivatives, and microinsurance programs are also emerging as an alternative to traditional insurance and reinsurance products. 

RECENT DEVELOPMENTS

• Catastrophe Bonds: In October 2009 the World Bank launched its MultiCat Program, a catastrophe bond issuance platform that gives governments and other public entities access to international capital markets to insure themselves against the risk of natural disasters. The program allows participants to buy insurance coverage for multiple perils, countries and regions. The types of events that may be insured are earthquakes, floods, hurricanes and other wind storms., Mexico was the first country to avail itself of the program, with a $290 million catastrophe bond offering managed by Goldman Sachs and Swiss Reinsurance Co. The bond will pay investors unless an earthquake or hurricanes triggers a payout to the Mexican government.
• Captives: A March 2009 Spotlight Report in Business Insurance (BI) magazine focused on the captive insurance market. Key trends highlighted in the report include:  
  
  
  
  • There were 5,211 captives in 2008, up from 5,119 in 2007, according to BI surveys.
  • The economic downturn has affected existing captives and captive formations, with credit concerns and the high cost and short supply of capital taking a toll.
  • Kentucky and Utah led the states in captive formations in 2008, with 36 and 31 new formations, respectively. Vermont has 551 captives, the most among the states. It is the third largest captive domicile worldwide, behind Bermuda with 960 and the Cayman Islands with 777 (see chart).
  • There is increasing interest in using captives to fund employee benefits, as companies look for ways to trim their spending on healthcare and retiree benefits. Captives can reduce benefit costs by an average of 5 percent to 10 percent. In 2008 the Bureau of Labor Statistics approved a record six applications from employers seeking approval to fund benefits programs through captives.  
• An August 2009 report by A.M. Best examines conditions in the captive market, based on a composite of 186 captive companies.  The group’s net income declined by about 66 percent, reflecting realized losses of $1.2 billion for the year,  nearly 40 percent of which resulted from one company’s investment losses. However, net underwriting income rose during the same period (from $700.5 million to $768.9 million), evidence of the sector’s underwriting discipline and its tendency not to rely on investment income.  Overall, the captives generated $1.8 billion in gross investment income in 2008, down 7 percent from $2.05 billion in 2007.  During the same period, net premiums written dropped by 4.5 percent, pretax operating income fell 12.8 percent, admitted assets declined 5.5 percent  and year-end surplus dipped  5.1 percent.  The combined ratio (after policyholder dividends) deteriorated from 93.4 in 2007 to 93.6 in 2008. The report notes that captive formations have continued despite a softening commercial insurance market, and foresees a “stable” outlook for the sector.  

Risk Retention Groups:   

• The number of risk retention groups (RRGs) in the U.S. rose from 265 in 2007 to 272  in 2008, according to the Risk Retention Reporter. RRG premiums written rose by 0.6 percent from $2,559.1 million to $2575.0 million during the same period. The survey projects that in 2009 premiums will fall by 0.5 percent to $2,562.3 million and the number of groups will drop top 269.
• Healthcare, with $1,503.5 million in premiums, was the dominant RRG sector in 2009, accounting for 58.4 percent of the market.
• Taxation: In February 2008 the Internal Revenue Service (IRS) withdrew a proposed rule that would have removed favorable tax treatment for companies that use a captive to cover the risks of their corporate affiliates and file a consolidated tax return covering the affiliates and the captive. The proposed rule would have affected hundreds of captives and removed a key tax break for captive sponsors.
• Microinsurance: Munich Re, one of the world’s largest reinsurers, has launched a microinsurance flood insurance program for Jakarta, Indonesia. The pilot project is the first of its kind and is intended to provide millions of poor people with protection from the devastation of floods that regularly strike the city. Munich Re developed the policy with the insurer Asuransi Aahana Tata and GTZ (Germany’s government international development agency).  Under the program residents of the city can buy an unlimited number of insurance cards, which cost $4.80 each, during the dry season. If water levels reach a certain height during the next rainy season, each card can be redeemed for a payout five times the original amount of payment. The project could be profitable in three years. The program is one of several implemented by insurers to provide low cost insurance in developing countries (see background:  Microinsurance). The four billion people around the world who live on less than $2 per day represent an annual market for insurance services worth from $80 to $90 billion, according to Datamonitor statistics cited in a 2009 study by consulting firm Arthur D. Little. The study stresses the importance of educating potential customers, citing the efforts of the South African Insurance Association, which has set up a consumer education program to raise financial literacy in the country.
• Capital Markets: A 2009 study by Guy Carpenter, a part of Marsh and McLennan Companies, reveals a sharp fall in 2008 catastrophe (cat) bond issuance, both in terms of risk capital and number of transactions. Cat bond issuance volume fell 62 percent to $2.7 billion that year, down from a record $7 billion in 2007. There were 13 transactions completed during 2008, compared with 27 in 2007. At year-end 2008, total cat bond risk capital outstanding was $11.8 billion, a 14.5 percent decline from $13.8 billion in 2007. The study notes that, despite the declines, catastrophes bonds have shown resiliency during the economic downturn. Issuance volume, based on number of deals and capital, was at the third-highest annual level since cat bonds were introduced in 1997.
• An April 2009 update to the study reports that three catastrophe bonds were issued in the first quarter of 2009, bringing $575 million in fresh capital. The amount of risk capital marks a 6.5 percent drop from the $615 million recorded for the same period in 2008. The number of transactions is equal to that of 2008’s first quarter. While Guy Carpenter notes that it is still too early to conclude that the cat bond market will not be impacted further by the financial crisis, it sees the resumption of issuance activity on a scale consistent with the beginning of 2008 as a positive sign.

BACKGROUND

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," in which firms retain rather than transfer risk.

During the liability crisis of the 1980s, when businesses had trouble obtaining some types of commercial insurance coverage, new mechanisms for transferring risk developed, facilitated by passage of the federal Product Liability Risk Retention Act of 1981. The 1981 law, which provided for the formation of risk-retention groups and purchasing groups in the areas of products and completed operations liability, was expanded by 1986 amendments to include all areas of commercial liability, except workers ompensation. To facilitate their operation, the Act exempts both risk retention and purchasing groups from many of the state laws which normally apply to insurance organizations. The hardening of the commercial property insurance market in the wake of the September 11 terrorist attacks has led to a push by some groups, including schools and real estate firms, to expand the scope of the Risk Retention Act to commercial property, surety and commercial automobile lines.

Growth of Alternative Markets

Rising rates and a shortage of sufficient amounts of coverage in some commercial insurance lines, a trend which began in 2000 and intensified following the September 11 attacks, spurred businesses to look at a number of alternative risk transfer (ART) vehicles, including captives and risk retention groups. Today’s alternative market is dominated by two mechanisms: self insurance, in which businesses retain rather than transfer risk, and “single parent” captives, set up by businesses to insure their own risks. While these mechanisms account for 90 percent of the alternative market, Conning Research anticipates growth among other alternative mechanisms, including capital market securitizations, government pools, group captives and risk retention groups. A 2006 Conning study estimates that the alternative market accounts for about 30 percent of the commercial risk protection market. Based on MarketStance data the study estimates that workers compensation accounts for the largest share of the alternative market (43 percent), followed by liability (35 percent, excluding auto), automobile (12 percent) and property (10 percent).

Federal Taxation

A number of regulatory rulings since 2001 have favored captives. In June 2001 the Internal Revenue Service ruled that it would allow premiums paid for captive insurance to be tax deductible, signaling it would no longer invoke its long-held “economic family” theory. The IRS first espoused its theory in 1977 in Revenue Ruling 77, which held that a policyholder, its noninsurance subsidiaries and its captive form one “economic family,” and the premiums paid within the family are not deductible because the risk was not shifted from the policyholder. In various rulings in the 1980s courts rejected that reasoning. In February 2008 the Internal Revenue Service (IRS) withdrew a proposed rule that would have removed favorable tax treatment for companies that use a captive to cover the risks of their corporate affiliates and file a consolidated tax return covering the affiliates and the captive.

Federal Regulation

Captives that are owned by publicly held companies now 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.

The alternative market has also been affected by the Terrorism Risk Insurance Act (TRIA), enacted in November 2002 to provide a federal backstop for terrorism insurance. The U.S. Treasury Department has taken the position that domestic captive and risk retention groups chartered in the United States or its territories are to be considered “insurers” under the act, which requires commercial insurers to offer terrorism insurance coverage. This means that all domestic risk retention groups and 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. Some observers believe TRIA will prompt companies without significant terrorism exposure to locate their captives offshore to avoid the surcharge, on the one hand, and spur captive formations on the part of companies seeking to take advantage of the federal backstop, on the other. In 2006 SL Green Realty Corp. formed a captive, Belmont Insurance Company, to help protect it against terrorism-related risks. The captive received its license from the New York State Insurance Department on September 16, 2006. (see Insurance Issues Update: Terrorism Risk and Insurance paper.)

State Regulation

Captives

In 2008, there were captives in 22 states and three U.S. territories, according to Business Insurance (March 9, 2009). The leading domicile for captives in the United States is Vermont, which first passed captive legislation in 1981. Vermont has seen its captive business rise significantly over a 16-year period, from 230 captives in 1992 to 557 by 2008. Hawaii, with 165 captives in 2008, is the second largest U.S. domicile, followed by South Carolina with 163. (see chart above)

Risk Retention Groups (RRGs)

The federal Liability Risk Retention Act partially preempts state insurance laws to permit risk retention groups to be regulated by a single state, even though the groups operate in multiple states. According to a September 2005 Government Accountability Office (GAO) report, this partial preemption has resulted in “a regulatory environment characterized by widely varying state standards.” The GAO reports that most RRGs are domiciled in six states that permit them to be chartered as captives—which are less strictly regulated than traditional insurance companies—rather than in the states where they conduct most of their business. As of April 2006, 18 states permitted RRGs to be regulated under captive charters, according to an article in the Risk Retention Reporter. The states are home to over 95 percent of RRGs, according to the article.

The GAO report recommended that state insurance regulators adopt consistent regulatory standards for RRGs and that Congress consider granting the partial preemption only to states that adopt the standards and establish minimum corporate governance standards for RRGS.

• A report on RRGs, released by A.M. Best in July 2007, found that A.M. Best rated-RRGs showed a significant increase in profitability in 2006, reflecting strong risk management and loss control programs among these groups. The groups posted a combined ratio of 92.40 after dividends, which the study notes is better than those posted by most traditional insurers. Rated RRG's policyholders’ surplus and assets increased in 2006, with surplus reaching $668 million and total assets climbing to $1.91 billion. The medical malpractice line dominated the RRG sector, accounting for 43 percent of the rated rrgs, followed by "per occurrence" other liability (29 percent).

Alternative Market Mechanisms

I. Captives

Captives may be owned by one entity or several and 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.

While the leading domicile for captives in the U.S. is Vermont, offshore captives covering U.S. risks are predominantly located in Bermuda, where they enjoy tax advantages and relative freedom from regulation. The Cayman Islands, Guernsey, the British Virgin Islands, Luxembourg and Barbados are also significant centers for captives.

Captives may be established to provide insurance to more than one entity. An association or group of companies may band together to form a captive to provide insurance coverage. Professionals—doctors, lawyers, accountants—have formed many captives over the years. Captives may, in turn, use a variety of reinsurance mechanisms to provide the coverage. In particular, 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 20 years ago 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 (PCC), was introduced in Guernsey in 1997. A PCC offers participants many of the benefits of a group captive but with lower startup costs. A PCC offers more security to policyholders by isolating each participant's assets and liabilities as if they were a separate company, called a cell, doing business with the core company. The mechanism has helped fuel the growth of the captive market. Actual numbers of segregated cells may be underreported because some captive domiciles don’t report the number of cells within them.

Captives are expanding into the employee benefits arena, with approval facilitated by a May 2003 ruling in which the Department of Labor gave final approval to Archer Daniels Midland Co.'s plan to use its Vermont captive to reinsure group life insurance benefits—a decision that was expected to open a new frontier for captives.

II. Self Insurance

Self insurance can be undertaken by single 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

A risk retention group (RRG) is a corporation owned and operated by its members. It must be chartered and licensed as a liability insurance company under the laws of at least one state. The group can then write insurance in all other states. It need not obtain a license in a state other than its chartering states. A report by the General Accountability Office (GAO) released in September 2005 notes that while RRGs accounted for about $1.8 billion, or about 1.17 percent of all commercial liability insurance in 2003, the groups have played an important role in expanding the availability and affordability liability insurance for certain groups. According to the GAO, more RRGs formed in the years from 2002 to 2004 than in the previous 15 years, with about three-quarters of the new RRGs offering medical malpractice coverage. The report called on state regulators to enact uniform regulatory standards for RRGs and for Congress to consider enacting corporate governance standards.

IV. Risk Purchasing Groups

Like risk retention groups (RRGs), purchasing groups must be made up of persons or entities with like exposures and in a common business. However, whereas RRGs are liability insurance companies owned by their members, purchasing groups purchase liability coverage for their members from admitted insurers, surplus lines carriers or RRGs. Laws in some states prohibit insurers from giving groups formed to purchase insurance advantages over individuals. However, purchasing groups are not subject to so-called "fictitious group" laws, which require a group to have been in existence for a certain period of time or require a group to have a certain minimum number of members. The Risk Retention Act of 1986 specifically provided for purchasing groups to be created to purchase liability insurance for members of the sponsoring groups.

Four states with hospitable regulatory climates accounted for the majority of the purchasing groups formed during the 18-year period from 1987 to September 2004: Texas (289); California (227); Illinois (183); and Delaware (102). When retired firms are taken into account, the five states with the greatest number of operational purchasing groups, as of September 2004, were: Illinois (110); Texas (80); Delaware (75); California (57); and New York (55). Purchasing groups are now domiciled in 44 states. As of April 2008 there were 744 purchasing groups, according to the Risk Retention Reporter.

V. Catastrophe Bonds and other Alternative Risk Transfer (ART) Products

In its 2003 study Swiss Re identifies two segments of the alternative market: alternative carriers, such as captives and risk retention groups, and alternative risk transfer (ART) products, such as insurance-linked securities and weather derivatives, developed to meet the financial risk transfer needs of businesses. One such product, 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—megacatastrophes that 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. Power failures, terrorism and sport events were among the risks covered by catastrophe bonds in 2003, according to Risk Management Solutions. With investor interest driven principally by hurricane activity in the United States, annual issuance of catastrophe bonds reached a record $4.7 billion in 2006, up 136 percent from $1.99 billion in 2005, according to Guy Carpenter.

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 cat bond momentum continued into 2007, with publicly disclosed issuances increasing by 49 percent to $7 billion, according to Guy Carpenter's 2008 review of the cat bond market.  In addition, 27 transactions were completed in 2007, also a new high.

Cat bond activity slowed in 2008. At year-end, total cat bond risk capital outstanding was $11.8 billion, a 14.5 percent decline from $13.8 billion in 2007, according to Guy Carpenter's 2009 review. The study notes that, despite the declines, catastrophes bonds have shown resiliency during the economic downturn. Issuance volume, based on number of deals and capital, was at the third-highest annual level since cat bonds were introduced in 1997.

VI. Microinsurance

 A number of insurance companies are seeking to tap markets in developing countries through "microinsurance" projects, which provide low cost insurance to individuals generally not covered by traditional insurance or government programs. This approach is an outgrowth of the microfinancing projects developed by Bangladeshi Nobel Prize-winning banker and economist Muhammad Yunus, which helped millions of low-income individuals in Asia and Africa to set up businesses and buy houses. Microinsurance products tend to be much less costly than traditional products, and thus, extend protection to a much wider market. The coverage is often geared to protection from natural disasters but can provide coverage for property and life/health risks as well.

American International Group Inc. (AIG) was one of the first companies to offer microinsurance and began selling policies in Uganda in 1997. Swiss Re, Munich Re and Zurich Financial Services have also entered the microinsurance arena. A 2008 study on the insurance sector of emerging market economies by Swiss Re reports that microinsurance is gaining popularity in Latin America, Africa and Asia.

In 2009, the International Labor Organization (ILO) announced that a third round of "innovation grants" would be awarded by its Microinsurance Innovation Facility (MIF) to foster creative microinsurance projects. The MIF was established in 2008 to support the extension of insurance to millions of low-income people in the developing world, with the overall aim of reducing their vulnerability to risk.