Changes in the conventional re/insurance market have turned the spotlight onto different forms of risk financing.

In the aftermath of the September 11 disaster and the accumulated underwriting ills of the property/casualty insurance industry, commercial insurance buyers experienced radical increases in prices and reductions in both coverage and available limits. For many, this reaction was both excessive and irrational, and they have actively sought alternatives to conventional insurance.

One group, the Air Transport Association of America, representing 22 major US airlines, formed a new group captive insurance company in Vermont named Equitime to provide terrorism coverage to its members, who have each contributed $50m to capitalise the new venture. It is offering up to $300m in protection, with $2bn of excess support provided by the US government.

How did the commercial insurance industry react to this commendable effort? Maurice R (Hank) Greenberg, the chairman of the American International Group (AIG), suggested that the government end its reinsurance support of the new company, and let market forces work. Just a few months earlier, alongside fellow CEOs he had lobbied in Washington for a government reinsurance of the entire industry to the tune of 90% of all terrorism losses over $10bn and a smaller percentage of the losses under $10bn.

As its option, AIG proposed to the airlines a terrorism insurance rate of $1.00 to $1.50 per passenger. Mr Greenberg argued that any cost would be "passed through to the consumer and is hardly more than the cost of a soda". At over 100 million passengers per year, the airlines' cost would be well over $100m, radically higher than what they propose to charge themselves through the captive - an amount which represents a pretty impressive soda. Chris Duncan, the Chief Risk Officer (CRO) of Delta Airlines and the principal architect of Equitime, responded to the Greenberg comment with: "It is enough to say that we have a difference of opinion of what a real, functioning marketplace is."

This kerfuffle reminds me of similar reactions in previous insurance `crises'. In the 1840s, when the underwriters at Lloyd's threatened New York shipowners with radically higher insurance rates, the owners responded by creating their own marine insurance company, known as Atlantic Mutual - a company that evolved into a standard insurer and continues to this day. In the late 1800s, factory owners bristled when insurance companies would not give them credit for the newly-developed automatic sprinkler systems. They formed their own `factory mutuals', now merged into FM Global. In 1929, the Protestant Episcopal Church in the US established the Church Insurance Co to underwrite its churches and related properties in the face of unrealistic premiums. Beginning in the late 1960s, many governmental entities created their own risk-sharing pools in response to distinct non-interest by regular insurers. I remember the agonized complaints of commercial insurers when a group of Connecticut municipalities formed the Connecticut Interlocal Risk Management Agency. They moaned that CIRMA was under-funded, would attract only the worst towns and would be bust within a few years. Today it is the largest underwriter of governmental entities in the state. In the mid-1970s, when commercial insurers dumped their medical malpractice customers or offered exorbitant rates (in one instance I know, an insurance company offered to provide $1m in aggregate protection in one year for $1.3m), hospitals and doctors joined to create new captive insurance companies, derisively nicknamed `bedpan mutuals' by their commercial competitors. In the last insurance crisis of the mid-1980s, corporations, educational institutions and even non-profits pooled their resources to build new insurers such as ACE, XL, SCUUL and YMCA Mutual. All of these responses to unsettled times served their owners well, and most continue operating today.

Tony Bridger, the risk manager of the Bank of Montreal, summarised the situation succinctly when he concluded: "Volatility can be managed; overreaction cannot." Captive insurers have consistently brought new capital, innovative ideas and fresh underwriting expertise to an industry that needs periodic external rejuvenation. Captives, in that sense, have been an important part of the functioning marketplace for more than 150 years.

What are captive insurance companies? How have they developed over the past 30-plus years? Do they really serve a legitimate purpose in today's economy? To answer these questions, I researched my own personal work with captives, drawing on four published articles.

In 1968, the captive idea was in its infancy. I wrote a paper that year for Business Insurance entitled `Putting the captive company in perspective'. I counted 200-300 captives owned by US parents, operating in the US and on offshore islands, with premiums in the vicinity of $400m-$500m. Most were single-parent entities, owned by a non-insurance corporation and underwriting only their parents' risks. A few were group captives, serving related organisations, such as the Belk Stores. Premiums paid to captives then were fully deductible. Most parent companies used their captives to fund higher property insurance deductibles and to create what were effectively tax-deferral internal reserves. They were, I wrote, "the ultimate in self-insurance technique". I warned, however, that "tax regulations could easily change", and that contending that a captive could produce a profit was "sheer wishful thinking". I was entranced by the potential of this new medium.


Eleven years later, doubts crept into my thinking. In `Captives in quandary' from the Proceedings of the Third International Captive Insurance Co Conference - Bermuda (March 1979), I reported that the US Internal Revenue Service (IRS) ruled that premiums paid to single parent captives were no longer deductible (Revenue Ruling 77-316). The IRS promptly won a pivotal lawsuit against the Carnation Co in December 1978. European tax authorities began to consider their own constricting rules. Wherever possible, other regulators threw up roadblocks. The rush of captives to Bermuda had also created a strain on its infrastructure; captives reportedly accounted for 14% of the island's GNP. Yet interest continued. I counted almost 1,000 captives worldwide, with $4bn to $5bn in premiums alone for the US-owned companies. The exploding medical malpractice crisis in the US spawned numerous hospital and doctor-owned insurers, which, as a group, underwrote almost 20% of all US hospital beds. I concluded: "The future of captives lies largely in the degree to which they can convince tax and regulatory authorities of their legitimacy, avoid ill-advised underwritings, create a firmer financial base, and complement the conventional world insurance market."

After another nine years, I reviewed the captive scene again in Business Insurance, this time more optimistically (`Captives' role in industry to increase'). The count had more than doubled, to over 2,500 companies throughout the world. Captives were now a global phenomenon. By 1987, we were plunging down again in another market cycle in which insurers irrationally increased rates and withheld protection. I commented then that everything was in flux: the commercial marketplace, regulation, taxation and the law. I forecast, wrongly as it turned out, that in five years we would have fewer but substantially stronger captives. I also forecast, more correctly, that Bermuda would become a `third market', that captives would expand to cover `unfundable' loss exposures such as environmental, earthquake and political risks, and that they would create liaisons with other financial markets. We needed, I suggested, new global regulations covering both captives and other insurance companies. This, unfortunately, has not happened, despite the Basel Committee's promising new guidelines for financial institution capital sufficiency.

In my next commentary on captives, `Captive insurers in the key of `C'', in Risk Management, the total count had grown to 3,350 with an estimated $10bn in capital and surplus. Captives continued to be formed, even in the midst of a renewed `soft' market, and owners and prospective owners still believed that they met the five criteria of cost savings, coverage, cash flow, capacity and control. Yet I questioned their utility. Too many single parent captives were operated as `corporate toys', insurance playthings that `piddled with trivial (financial) issues'. I argued that most failed "to respond to the real economic and risk challenges confronting their parent companies." They fell into the same trap that entangled commercial insurers: irrelevancy.

Today, ten years later, 4,500 plus captive insurers operate around the world. They account for $50bn in annual premiums, $202bn in capital and surplus, and $230bn in investable assets. The crunch of a market out of control contributes to fresh consideration of self-insurance, single parent captives, and especially group captives, such as Equitime and sEnergy, a business interruption and property pool created by 12 energy companies from the US, Canada, South Africa, Denmark and Norway. Yet, despite the pressures of the times and the continuing enthusiasm for captives, more observers question their effectiveness.

Hugh Rosenbaum, the editor emeritus of Captive Insurance Company Reports, wrote recently: "For each argument in favour of a captive, there is a counter-argument for a better alternative." He suggested a new metric for assessing the relative value of a captive: comparison to the true alternative: full insurance and non-insurance.

His qualms are echoed in an academic study, `Do insurance captives enhance shareholders' value?' by Mike Adams and David Hillier. Although their data are out of date (they use 1997 figures), their conclusions merit thought. They write: "The empirical evidence suggests that an investment in a captive insurance subsidiary is likely to turn out a zero-sum game for many public corporations, with managers winning at shareholders' expense. Insurance captives are often sold to corporate managers as risk management solutions without an in-depth and crucial appraisal of how such solutions are expected to add value for shareholders. Widely-held shareholders are likely to be better off in diversifying their risks by holding better balanced portfolios of investments rather than establishing a captive insurance company. Changes in the taxation code in many jurisdictions, including the US and UK, have also reduced the financial flexibility and efficiency of the captive insurance concept as a risk management vehicle."

While I emphatically disagree about the focus on only shareholders to the exclusion of other `investors', the Rosenbaum and Adams-Hillier reservations suggest that we should consider other options. Add to these doubts other disturbing factors. In the aftermath of the Enron collapse and the Tyco and Stanley Works disclosures, many governments question the use of offshore, tax shelter vehicles such as `special purpose entities' (SPEs) and captives. New regulations are inevitable. Adverse publicity continues. Captives also now cost considerably more, with the rise of reinsurance costs (captives remain capitalised at relatively low levels and require much reinsurance) and the explosion of annual `fronting' costs from around 5% to 15% or higher. Fronting is still necessary because of antiquated local regulations that require the use of admitted insurers, a form of protectionism that makes no sense in a global economy. Finally, add the flurry of news articles when Arthur Andersen's Bermuda captive announced that it would not cover a professional liability settlement because, as reported, the parent company had failed to pay its premiums.

If cracks now appear in the captive edifice, and the conventional market continues in erratic disarray, how can managers fund their risks? I offer six suggestions.

First, I suggest that the goal of risk financing must be to build and maintain reputation, the critical ingredient for organisational survival. Most quantifiable insurance `losses' seldom have a material effect on an organisation. The public perception of customers, employees, suppliers, regulators, lenders and communities carries far more weight than recovering some dollars for fire damage or the expenses of a lawsuit. So, first, risk financing must be flexible and liquid so that managers have the funds necessary to re-establish credibility. Flexibility and efficiency are the keystones, as confirmed by Adams and Hillier.

Second, the critical idea for the future is building reserves for contingencies. These reserves can be internal or external. They can be concrete (an internal fund or a line of credit) or qualitative (the willingness of shareholders and lenders to advance more funds in the event they are needed). They must also be flexible and easy to access. Slow recoveries or those restricted to certain contractual stipulations (see most insurance clauses) are useless.

Third, owners can and should consider radical increases in the capital of their captives if they are to serve real financial needs. BP's Jupiter, domiciled in Guernsey, is capitalised at £1bn ($1.6bn). Postcap, the Consignia (UK's ex-Royal Mail, soon to be Royal Mail again) captive, also in Guernsey, is capitalised at £100m, although only £1m is paid in. If a captive makes sense, why not put enough money into it to allow it to play a significant role in corporate affairs? Is this effective use of capital? If we measure results in terms of preservation of reputation following major contingencies, rather than looking more narrowly at return on equity, it probably is.

Fourth, regulations such as the US Risk Retention Act can and should be expanded to permit captives to underwrite not only liability but also property and other insurance, with a minimum of restrictive state regulations. It's time to remove, in both the US and elsewhere around the world, requirements that corporate insurance must be locally admitted. Here is where creation of global financial standards and regulations will spur more efficiency in risk financing.

Fifth, major corporations should use their lobbying power with governments to persuade them to permit new tax-deferred catastrophe reserves, reserves to which contributions are tax-deductible and in which earned investment income is credited with taxation. Individuals in the US are now permitted to build their pension funds in this fashion. These funds may also be used, in certain circumstances, to fund personal catastrophes. This idea would obviate the need for captives, onshore or offshore, since any corporation would have the same reserving capability of an insurance company. Michael Walters, a principal of Tillinghast-Towers Perrin, writes a challenging description of a `Tax-Deferred Catastrophe Account' in Emphasis, No 2, 2002. Although his brief supports such an account for an insurance company (in which I agree with him), it should be equally applicable to any non-insurance organisation. This idea comes laden with the tax implications - a one-time tax deduction - but its long-term implications for the sustainability of organisations argues for serious review. It's high time that we dropped this insane idea of managing only for the next quarter.

Finally, risk financing should look at all forms of funding, from charges to current operating income and internal reserves (tax deductible or not) to external pooling (group captives), lines of credit, equity financing and use of capital markets. The increasing use of catastrophe bonds presages an entirely new approach to funding major contingencies. As these capital markets become more liquid, their overhead costs will diminish and make them more competitive with other options. Remember that a cat bond is cash on hand. It must be invested and cannot be used until and unless the named contingency occurs, but it is immediately and fully available for use, in sharp distinction to most conventional insurance.

Hank Greenberg's characterisation of the cost of conventional insurance as being nothing more than the "cost of a soda" is incomplete and incorrect. Conventional insurance has lost its fizz. His comment, however, forces us to take a fresh look at how we finance risk, from reserves to captives to insurance. It's time to put the bubbles back in risk financing.

  • Felix Kloman has more than 30 years of distinguished experience in risk management consulting, publishing and teaching. He retired in 1993 as an officer and Principal of Tillinghast-Towers Perrin, and is editor of Risk Management Reports.