Background on: Captives and other risk-financing options

 

The topic

The insurance marketplace has a number of ways to transfer risk, used mainly in commercial insurance. These include captives, risk retention groups, large deductible plans, catastrophe bonds, weather-based derivatives, sidecars and collateralized reinsurance. These mechanisms account for between 25 percent and 35 percent of the U.S. commercial market.

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.

A May 2017 study on the global commercial insurance market by Swiss Re put global commercial insurance premiums at about $720 billion in 2016. An October 2012 study estimated that traditional commercial insurers accounted for 90 percent of the market, with 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.

 

Recent developments

• 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.
• There were 214 risk retention groups (RRGs) at the end of 2020, according to the Risk Retention Reporter. RRG premium increased from $2,536.5 million in 2010 to $3,574.7 in 2019.
• There were 1,024 purchasing groups (PGs) at the end of 2020.
• According to Artemis, catastrophe bond and other insurance linked-securities issuance rose to $16.4 billion in 2020, up from $11.1 billion in 2019. In 2020, capital outstanding stood at $46.4 billion, compared with $40.7 billion in 2019. The breakdown of issuance by type of transaction is $11.0 billion for property catastrophe bonds (67 percent of total issuance in 2020), $4.3 billion for mortgage ILS deals (26 percent) and $1.1 billion for other types of ILS including specialty, life, mortality and private deals (7 percent).

 

Background

I. Captives

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 many states and overseas jurisdictions have emerged as popular domiciles for captives. There are currently 5,985 captives worldwide, according to Business Insurance.

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.  Companies may also form a joint arrangement of multiple companies (group captive). According to an April 2021 white paper published by the Triple-I, A Comprehensive Evaluation of the Member-Owned Group Captive Option, group captives have become an attractive risk management option for a growing number and type of companies.

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) 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.

II. Self-insurance

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. They are also known as insurance-linked securities, often abbreviated as ILS.

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.

VII. Sidecars

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.

VIII. Collateralized reinsurance

Collateralized reinsurance refers to a treaty in which a nontraditional reinsurer places in escrow the entire amount of the coverage it is offering. If a treaty offers $30 million in protection, for example, the reinsurer escrows $30 million for the life of the contract. Provided the escrowed funds are invested safely, as in a Treasury note, there is little doubt the reinsurer will have funds to pay any claim.

Though they invest conservatively, traditional reinsurers rarely escrow funds specifically for a contract. This seldom becomes a critical issue; reinsurers rarely fail to fulfill their obligations. Regulators and private third-party analysts like Standard & Poor’s and A.M. Best monitor traditional reinsurers’ financial health and claims-paying ability.

Hedge funds, in particular, have launched their own companies to write collateralized reinsurance, usually via Bermuda-based companies that get underwriting guidance from traditional reinsurers. Collateralized reinsurance began to grow around 2010, as investors began to believe they could achieve an attractive rate of return on insurance. In addition, insurance risks like catastrophes are not correlated to traditional market risks, a circumstance that helps investors construct a more robust portfolio.

Additional resources:

• 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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