Hard Market Prompts Property Captives

Although property risks generally have not been widely coveredby a captive insurer, in this difficult insurance market there areboth “hard” and “soft” reasons for doing so, according to expertsat the Vermont Captive Insurance Association annual conference inBurlington last month.

“Hard” reasons for forming a captive include saving money bygetting an accelerated tax deduction, “and reducing the totalfrictional costs of an existing risk retention strategy,” said EdKoral, senior manager at Deloitte & Touche in New York. “Softreasons have to do with managerial comfort and happiness.”

A captive, he said, puts the profit and loss of the propertyprogram into a financial language “in a way that insurance lingocouldn't do.”

In the past, talk about property risk in a captive “used to killoff projects. You didn't want to attract a lot of frictional coststo the transaction, and there is not a lot to gain fromaccelerating a tax reduction for a property loss,” he said.

A property loss, Mr. Koral explained, “either happens or itdoesn't.” The loss generally is paid off in 24 months, which meansaccelerating the tax deduction for loss reserves “will not be wortha lot compared to the frictional costs, premium tax, [and costs of]operating and setting up the captive.”

However, setting up a captive for property losses can greatlybenefit a corporation with subsidiaries, he noted. If a corporationdecides to take “all property losses up to $5 million peroccurrence, that might not sell very well in Peoria,” he said,explaining that “people in the subsidiaries might fear a big losscould wipe out their bonus.”

Unbeknownst to the corporate risk management department, thesubsidiary might call a local insurance broker, “and you might finda fill-in policy that is on a subsidiary-specific basis for somepremium amount that will never be disclosed or discussed withcorporate,” he said. “Imagine an organization that has dozens ofsubsidiaries, and imagine that conversation taking place dozens oftimes.”

The captive serves as both a carrot and a stick forsubsidiaries, he said. “The stick is we'll make you take a bigdeductible,” while the carrot is, “we'll also sell you someinternal insurance that will allow you to deal with your own[profit and loss] issues” on a local basis.

Mr. Koral continued that a captive can also be used to manage alarge deductible, “particularly in a market where the deductible isgoing up faster than you can manage with your own subsidiary.”

Rather than simply “being a postman or a messenger,” if theinsurance market raises a deductible from $1 million to $5 million,for example, with a captive, “I have a chance to break that link,”he said.

The risk manager can deal with the insurance market anddetermine a “corporate deductible based upon what the overallcorporate risk retention need is,” Mr. Koral said. The risk managercan also work with the subsidiaries to help determine theirindividual risk retention needs. The captive, meanwhile, serves as“the shock absorber that sits in the middle,” he explained.

While the captive might not have an identifiable dollar value,it has managerial value to the extent that “you can avoid yoursubsidiaries wasting corporate money by dressing up their ownP&Ls and buying local insurance policies,” he emphasized.

Robert Storey, vice president at Munich-American RiskPartners inPrinceton, N.J., said that using a captive for property risks givesan organization direct access to reinsurance. “Historically,reinsurers haven't had much contact with insurance buyers,” hesaid. “To access us, you had to go through an insurance company.But with captives that has changed.”

What are the benefits of direct access to reinsurance? “We findthat captives are often asked by their owners to look and act likea big insurance company, even though they're not,” Mr. Storeyexplained. “Reinsurance can help you do that.”

Reinsurers can achieve this by helping increase large-linecapacity, increase premium capacity, stabilize loss experience, andreduce volatility “in the form of catastrophe relief for orderlywithdrawal of business.” They also provide underwriting expertise,he said.

Mr. Storey said that there normally are restrictions andregulations limiting the maximum amount of insurance a captive canwrite. The limit, he said, is typically 10 percent of surplus.

The captive's ability to write large accounts where the 10percent of surplus restriction applies, however, would limit themto small accounts or small shares of large accounts, he added.

There are also jurisdictional limits on the premium a captivecan write, he said. In meeting premium-to-surplus ratiorequirements, “the net premium is used in the calculation, meaningthat reinsurance would have the same benefit as the large-linecapacity,” Mr. Storey said.

Reproduced from National Underwriter Property &Casualty/Risk & Benefits Management Edition, September 16,2002. Copyright 2002 by The National Underwriter Company in theserial publication. All rights reserved.Copyright in this articleas an independent work may be held by the author.