Lincoln Trimble outlines the role of captives in a hardening market.

A little over two years ago, we wrote an article relating to the use of non-traditional reinsurance for captives and other risk-sharing vehicles. We expressed with some surprise that despite the existence of a “...seemingly unending soft insurance cycle”, customers continued to pursue captives for a wide array of reasons. Since those days, there has been a dramatic shift in the primary casualty markets, particularly in the US. Terms and conditions are becoming considerably more favourable to insurers, and availability, particularly in certain troublesome classes, has become significantly curtailed.

In our day-to-day operations in Bermuda, we are seeing a dramatic influx of reinsurance business. Single parent captives are expanding the role of their already active captives, or resurrecting previously dormant ones. Associations and specialty MGAs are establishing captives or occupying rent-a-captive cells in order to take advantage of the perceived profit potential generated by a hardening market.

California dreaming
This is especially true for areas of the market that have become particularly dislocated. Without casting judgment on these sectors, we have seen waves of ostensibly distressed groups such as workers' compensation for professional employment organizations, California workers' compensation, general liability for California-based residential contractors, nursing home liability, transportation liability, auto extended warranty and the like looking at captive programs. In reality, these sectors may or may not be distressed, but there is clearly a thought by some that there is opportunity inherent in these market dislocations. As a result, numerous captives and risk retention groups have sprung up to respond to the demand.

A typical MGA-owned captive will contract with service providers such as a fronting company, a third party claims administrator, a premium finance company, and of course, reinsurers.

Every dollar of insurance that is written by the MGA owner is divided up between the sources of expense and a loss fund, or that amount left over after expenses with which to pay claims. The extent to which net retained losses exceed the loss fund available for such retained amount is the risk a captive bears.

This, of course, is where the reinsurer comes into play. The captive will normally reinsure the front company and retain a net amount per loss, for example, the first $250,000. Any amount in excess of that per loss net retention is ceded to an excess of loss reinsurer. Normally, the fronting company will also require the captive to purchase aggregate excess of loss reinsurance to protect against unanticipated frequency within the net retention per loss. The difference between the loss fund and the attachment point of the aggregate excess of loss reinsurance partially constitutes the downside financial risk of the captive owner.

From a reinsurer's perspective, this downside financial risk is a critical consideration in evaluating the confidence of the MGA in its own book of business. It is part of the reason that a number of reinsurers actively solicit captive business and it is the simple alignment of financial interests that ensures that the captive owner and reinsurer are working to attain similar goals – to make an underwriting profit.

Despite the attractiveness of captive business to some, reinsurance for this class is, indeed, hardening. Quotes that would have been deemed unacceptable just months ago are now attracting attention. We have seen a significant increase in submissions and a significant decrease in the numbers of interested reinsurers.

We do believe, however, that most reinsurance covers can be placed somewhere, except for the most shunned sectors. It may take significant work, and it may come down to the wire, but reinsurers are out there, though understandably in the current marketplace, they are generally stretched thin with too many submissions.

With the emergence of hardening insurance and reinsurance markets, brokers and reinsurance customers will have to become more and more resourceful and, in some cases, patient to accomplish their goals with regard to purchasing reinsurance for alternative risk vehicles. There are, though, reinsurance alternatives available, and within the scope of alternative risk reinsurance there are non-traditional structures that might assist in the purchasing process.

Finite risk
One way of defraying reinsurance costs in a hard market is, of course, larger net retained lines. With additional risk comes additional volatility. A potential remedy for this volatility is finite risk. Finite risk has been used since the mid-1980s as a tool to allow an insured or reinsured to smooth out the effects of various risk events, or to more actively participate in underwriting profits, or for a host of other risk management and financial reasons. Finite risk doesn't need to be an overly complex transaction, particularly when the underlying risk is not exceptionally large in size.

One such example is a real estate development company that ran its large property catastrophe insurance deductible through its captive.

While the company could comfortably handle the net retention, individual losses were charged back to the individual profit centres with disastrous effects. In order to spread out the effect of the deductible, the captive placed finite risk reinsurance that allowed it to pay reinsurance premiums over a multi-year period.

A property cat loss in the first year of the program meant the reinsurance company would pay the loss and ultimately be reimbursed by the end of the reinsurance agreement period. Subsequent property cat losses would be given more and more risk transfer. In the end, the captive attained more predictability, an element of risk transfer protection, and in this case, some tax advantages as well.

Finite risk can also be used to cover risks within the captive that might not have an active reinsurance market. For example, one financial institution wanted to cover multiple lines of business within its captive on a combined lines basis.

In addition, it wanted to introduce an element of finite risk coverage to fund traditionally uninsurable events, such as rogue traders and patent infringement.

One emerging – or re-emerging – area is discounted, prospective reinsurance. This is most commonly used for risks with larger, more predictable estimated losses. In these cases, a fronting carrier may offer a guaranteed cost cover to a customer with or without a single parent captive.

Let's assume that in this case the estimated ultimate net loss for general liability is $65m.

The fronting company may offer a guaranteed cost program for a premium of $70m, then will in turn offer a large portion of that premium to a finite risk reinsurer that will take the money and offer coverage out to the point at which it believes it can pay losses and still make a meaningful profit after investment income accruing to the ceded premium.

In this case, the finite reinsurer may take $65m of the $70m and cover out to $85m – to 120% of the cedent's gross premium. The fronting carrier then might buy additional limits from other, more traditional, reinsurers beyond the $85m protection, possibly to several standard deviations beyond expected levels.

This type of reinsurance allows the fronting carrier to use the leverage of the finite reinsurer to offer a very attractive guaranteed cost premium to its customer for very little downside risk.

Retroactive liability
This hardening market appears to be driven by shortages in profit, and as such, there will undoubtedly be insurers and reinsurers going into liquidation, many of which will be reinsurers to captives. Many more will suffer downgrades, and events such as these threaten the health of captives' reinsurance programs. Many captive owners focus such attention on reinsurance renewals that inspection of the stability of the reinsurance programs of the past, even the recent past, is often forgotten.

Obviously, this becomes a greater problem with longer tail business. Conducting a review of past reinsurers and their current financial condition may encourage a captive owner to place preventive retroactive reinsurance limits. For example, if a reinsurer was on a captive's workers' comp program for the years 1992 to 1995 and has since gone into liquidation, retroactive limits may be placed to shore up the program for those policy years.

If, however, a previous reinsurer is not in liquidation but the captive has concerns over future performance, retroactive liability can be sold on a contingent basis as well. The retroactive reinsurer supplies both risk credits and credits for the likelihood of the original reinsurer defaulting.The need for retroactive liability spotlights the importance of carefully selecting reinsurers in the first place. Finding quality paper in a hardening environment will become increasingly difficult.

All changing marketplaces lead to innovation, or creating opportunity out of chaos. While a hardening reinsurance market in the alternative risk sector will bring challenges, it may also lead to opportunities to place highly efficient, albeit non-traditional, solutions.