Captive Reinsurance Causes ConfusionPart of the problem is that captives function as bothsellers and buyers

With the recent announcement of results from the CaptiveInsurance Companies Association annual “Risk Sharing/FrontingSurvey,” questions have arisen about reinsurance that merit somediscussion.

The survey results, released at CICA's annual conference inMarch, revealed that for the first time, “fronting” was not theprimary issue among the captive-owner respondents.

In its place, of primary concern to respondents was reinsuranceits security, availability and affordability.

Since that revelation, several people have asked a questionalong the lines of, “If captives are in effect reinsurers andalways reinsure fronting carriers, how can captives be concernedabout reinsurance?”

The question is a good one in that terms are often tossed aboutas if everyone has the same understanding of their use, which oftenis not the case.

To clarify:

? A reinsurer accepts risk and premium from a primary carrier,which issues policies and offers other services. Increasingly thatreinsurer is a captive.

? However, the captive usually does not wish to accept 100percent of the risk, so other risk-transfer arrangements areinvestigated. These can be offered by the “front” as a package dealoften the most cost-effective route.

? Reinsurance is insurance of insurance, and is used to preservecapital and protect the balance sheets of insurers. Reinsurance hasbeen around for centuries and comes in many forms.

? It should be noted that, in general, reinsurance is neitherregulated nor standardized. Careful study of the reinsurancecontract is therefore important.

One attraction of setting up a captive is that as an insurer,the captive gains direct access to the reinsurance market notsomething traditional insureds have available to them. When usedthoughtfully, direct access can improve pricing, coverage andterms.

Reinsurance and excess insurance can be structured to protect acaptive from a single loss above its capacity, or from anaggregation of many losses in a policy period. These are oftencalled vertical and horizontal losses, or specific andaggregate.

A typical structure would occur when the “front” accepts littleor no risk, placing up to 100 percent of the exposure with others.The captive can then arrange reinsurance behind its limits, orobtain excess coverage over and around its limits.

This difference is all important. If reinsurance of the captiveis chosen, the costs to operate the captive can be increased as itwill be responsible for higher premium taxes (where they apply) andmay well face increased capital demands.

Regulators might question the captive's ability to acceptresponsibility for the limits if the reinsurer fails, as allexposure is on the captive's books.

For this reason, reinsurance of the captive is usually done asexcess of the captive's retention. This may reduce some costs,capital requirements and regulatory concerns.

An excess insurance policy can be written to not respond untilthe loss reaches beyond the attachment point of the captive knownas straight excess. Attachment points and actuarial projectionsbecome critical to the captive's acceptability and probability ofsuccess.

Concern expressed by this year's respondents to the CICA surveyseems to be focused on the security of reinsurers following a yearof expensive catastrophes.

In addition, the issue of price has returned for many captivesin regard to reinsurance. Some captive owners report a hidden costincrease by tightening terms and reducing coverage while the rateremains steady.

In the heat of battle, the terms “excess” and “reinsurance” havebecome synonymous, although in fact they are not. Shortcuts inspeech are hopefully corrected in the structure and documentationof a program.

Michael R. Mead, CPCU, is president of M.R. Mead & Companyin Chicago.

Reproduced from National Underwriter Edition, April 15, 2005.Copyright 2005 by The National Underwriter Company in the serialpublication. All rights reserved.Copyright in this article as anindependent work may be held by the author.