Guide to Captives and Alternative Risk Financing

Donald Riggin

• Publisher: The National Underwriter Company
• Year: 2013
• ISBN:
  9781939829115
• Topic: Business
• Subtopic: Insurance
• Index: Business

Master the What, Why, When and When Not of CaptivesThrough exclusive, expert analysis and an extensive use of in-depth case studies to illustrate real-world situations and applications, Guide to Captives and Alternative Risk Financing provides a practical guide to captives and other risk-financing techniques. For new professionals or those dealing with captives & alternative risk on a limited basis, it is essential learning. For more experienced professionals, it will provide essential information on established options and an entree to the latest concepts. It fully explains: » What a captive is» Why it is used» How it is created» Where it is created» When you should use a captive» When you should not use oneGuide to Captives and Alternative Risk Financing also employs charts and graphs to illustrate various risk-financing techniques and highlight their value. Case studies are designed to help you identify situations in which captives or other alternative risk-financing techniques will be useful.This brand-new resource is ideal for all organizations utilizing captives, including: » Closely Held For-Profit» Publicly Held For-Profit» Large Not-for-Profit» Large Multinational Companies and AssociationsCFOs, Treasurers, and anyone even tangentially involved in managing risk must have direct access to the information presented in this practical reference.This resource is also absolutely necessary for all insurance-industry practitioners: agents, brokers, consultants, attorneys, and CPAs.

Chapter 1: Overview

Risk Financing Options

All but the very smallest organizations devote significant financial resources to managing their event risks. These include the costs associated with removing risks from the balance sheet, the costs of loss prevention and claims management, and the costs of retained risk. As we discussed in the introduction, financing event risk involves three components: risk transfer capacity, the cost of that capacity, and the amount of retained risk.

With the exception of simple guaranteed cost insurance, every risk financing strategy includes all three of these components. Moreover, these three components are bound together; a change in one usually causes a change in one or both of the other two. These three building blocks comprise the risk financing strategy. This is important because it allows us to conceptualize the risk financing strategy for what it really is: an investment.

If our risk financing strategy is viewed as an investment, then we must be able to apply the same financial discipline to this as we do to any other investment. The challenge, of course, is devising metrics that accurately reflect the value of one risk financing strategy versus another.

One of the most important concepts inherent in this approach is the way in which we view retained risk. This includes all deductibles and self-insured retentions for which there is no formal funding vehicle. For middle-market companies, those with roughly $250 million to $500 million in annual sales, the aggregate amount of retained event risk can be (and often is) at least seven, and often eight, figures.

If we view our risk financing strategy as an investment, then we must understand that retained risk places a burden on our company’s capital. Every major investment involves capital, and every chief financial officer (CFO) knows how to evaluate an investment’s impact on the company’s capital.

So, as with any significant strategic decision requiring a capital investment, our goal is to be able to answer this question: How will our risk financing strategy affect shareholder value?

Shareholder value encompasses the spectrum of quantitative indicators used to measure the impact of strategic decisions. We believe that an organization’s risk financing strategy should be subjected to rigorous financial analysis similar to that used for any other strategic decision. This means that the risk manager, broker, reinsurer, or trusted advisor must be able to describe the relative value (or lack thereof) of any risk financing strategy in financial terms.

The standard method of illustrating the degrees of risk inherent in each class of risk financing techniques is a straight line—from simple guaranteed cost to sophisticated self-insurance. In lieu of expressing the spectrum of risk financing options along a single line, we illustrate relative levels of risk in a bar graph. This provides a more meaningful illustration of the relationship between the financing technique and the four major sources of risk (underwriting, pricing, regulatory, and financial).

Risks Defined

Underwriting Risk

This describes the degree to which the organization is subjected to adverse insurable losses. Guaranteed cost plans theoretically have no underwriting risk aside from that included in any mandatory deductible. In programs where the organization assumes a significant degree of actuarially predictable loss, the funding usually approximates the actuary’s 50 or 55 percent confidence level. In these situations there is a reasonable amount of underwriting risk. Underwriting risk is also known as basis risk. Basis risk is the risk that something other than the expected outcome will occur. When we invest, for example, in an index fund such as the Standard & Poor’s 500, the chance that our results will not mirror the overall fund’s results is known as basis risk. Ultimately, underwriting risk is a function of the loss exposure’s volatility.

Pricing Risk

Pricing risk exists in every risk financing technique; it is the risk that the hard costs will not reflect the value received. Hard costs are out-of-pocket expenditures that the organization will never recoup.

Regulatory Risk

This comprises the panoply of uncertainties visited upon every organization by the Internal Revenue Service (IRS), the Financial Accounting Standards Board (FASB), state departments of insurance, and each captive domicile’s regulatory protocols.

Financial Risk

This category includes investment and counterparty (credit) risks. Programs that assume significant underwriting risk include, as one of their benefits, investment income earned on the loss reserve fund. Credit risk, while not as pronounced as investment risk, is the risk that the organization will contract with a less-than-creditworthy risk-taking counterparty.

Formal Risk Financing Strategies

Guaranteed Cost Plans

Guaranteed cost insurance carries an incidental amount of underwriting risk, primarily created by mandatory deductibles. Conversely, pricing risk is moderately significant because of the relative lack of pricing transparency in guaranteed cost programs. But since the vast majority of the risk is transferred off the balance sheet, a certain degree of pricing risk is expected. Regulatory risk in guaranteed cost plans is negligible. Finally, the degree of financial risk reflects the potential credit risk or counterpart risk associated with the insurer’s financial strength.

Retrospectively Rated Plans

Underwriting risk is moderate. It is defined within the plan’s minimum and maximum premium factors and the chosen loss limit. Pricing risk is moderate-to-high because most insurers do not provide clients with a breakdown of the costs that are included in the basic premium. Regulatory risk is moderate because the premium tax deductibility issues, especially in incurred loss retros, are unsettled. In incurred loss programs the insured pays the full amount of the annual premium during the policy year with the expectation of potential return premiums based on loss activity. Financial risk in a retro is limited to the company’s investment decisions relative to the return premiums and to a slight degree of credit risk.

Large Deductible/Self-Insured Retention Plans

These programs permit the insured to pay for losses up to a per-occurrence limit and often an annual aggregate limit. Above these limits, risk is transferred to an insurer. Underwriting risk, similar to retros, is moderate based on the amount of retained risk. In these programs, the insured assumes the majority of what is defined as burning layer losses. The burning layer is the primary layer of coverage that funds the majority of losses. Depending on the line of business, these losses may be actuarially predictable, producing a fairly low amount of underwriting risk. Workers compensation is one of these lines.

Conversely, losses within a $1 million directors and officers self-insured retention (SIR) plan are anything but predictable and represent significant underwriting risk. Pricing risk in these programs mirrors that of retros in that the insurer’s premium reflects the risk transfer excess of the deductible or retention, and insurers rarely if ever divulge the expense components in their pricing.

Regulatory risk is low in these programs, as losses within the deductible or SIR are tax deductible when they are actually paid. Financial risk is commensurate with how the insured manages the loss payments within the deductible or SIR. [See the discussion on passive self-insurance for a detailed explanation of this important issue.]

Group Captives/Risk Retention Groups/Pools/Rent-a-Captives/Cell Captives

Group programs tend to retain risk commensurate with deductibles and SIR plans, but some divide the retention into that which is paid by the individual member and that which is paid by the group (shared). Sometimes the costs of excess premiums and risk management services can be driven down by virtue of the economies of scale created by the group. Regulatory risk for a group program, depending on the structure, can be significant. Members expect that their premiums will be deductible from their federal income taxes, as they are in their existing programs.

The risk here is that if the program does not meet the IRS and FASB minimum tests, the program may not be deemed a bona fide insurer, thus ineligible for premium deductibility and insurance accounting. The financial risk in a group captive is somewhat higher than that in retros and deductible/SIR plans because no single member controls the investment of funds; this is done by an asset manager hired by the group.

Pure (Single-Parent) Captives

Similar to each of the self-insured components of the previous techniques, single-parent captives have underwriting...