Captives A Work Of ART In Hard Market

There are reasons why coverages against earthquake and flood damage are not written as a matter of course. Underwriting is intended to bring some discipline to bear in the assumption of risk so that a reasonable estimate of expected losses can be made in terms of the premium to charge.

Accurate pricing of the catastrophic exposure from earthquakes or, say, tsunamis, would likely prove an exercise in futility. With this type of risk exposure, the risk-to-reward ratio is skewed in terms of pricing for traditional products.

Providing the protection by using a vehicle dedicated to securitizing the particular exposure makes more sense.

The property-casualty insurance industry has traditionally functioned in a series of repetitive cycles–a hard market, followed by a soft market, followed by a hard market.

Hard markets generally are viewed as good for the industry and soft markets are not. The most recent prevailing soft insurance market extended several years beyond the normal market cycle, driving prices and profitability down.

Early in 2001, the market began to exhibit signs that long-suffering bottom lines might finally be shored up. The market was finally hardening, premiums were increasing, and access to reinsurance markets was tightening.

If the past is a prologue, a hardening market is the harbinger of an increase in captive insurance company formations.

The updated Risk Retention Act has been used to launch numerous industry-specific commercial liability captives. The captive laws of several U.S. jurisdictions make specific provision for risk retention group captives.

Coverages for workers' compensation, property, catastrophe and other non-liability coverages cannot be written in captives formed under the Risk Retention Act, but are suitable to captive programs nonetheless.

Explosive growth in the formation of captives and other special-purpose insurance companies usually follows a predictable pattern.

While the hardening of the liability insurance market, rising premiums and lack of capacity fueled the initial growth of captives, the use of captives has spread far beyond those initial applications into areas such as health coverage, benefits and overall risk management strategy.

Many of the U.S. captive jurisdictions have made their captive laws more flexible to accommodate non-traditional captive structures, and several provide platforms for securitization of risk–a practice that is much more widespread in Europe than it is in the United States.

A logical consequence of constricted reinsurance markets is the wider use of securitization-type vehicles for catastrophic exposure. Success, however, will ultimately depend upon a risk-and-reward analysis for players in this market.

In addition to fueling the growth in captive insurance company formations, the combination of the hard markets and fallout from Sept. 11 will likely pave the way for greater use of non-traditional reinsurance procedures such as finite-risk reinsurance, portfolio transfers and products that provide protection against defaults by reinsurers.

Many of these procedures are designed to provide the ceding company with balance sheet protection while permitting it to retain its funds on a funds-withheld basis.

Users of this type of reinsurance tend to view these devices as capital available to them for the contract period. Indications are that a number of foreign banks have focused greater efforts in the development of ART capabilities as a logical extension of the lending-credit function.

Consider for example, a finite-risk reinsurance arrangement that effectively finances the payment of losses over the course of 20 years.

For the reinsurer, the right investment strategy can make all the difference between managing the loss and losing money. This requires sophistication in the world financial markets focused on the effective management of assets and the hedging of expected payout patterns over the long term.

This would seem particularly well suited to fiscally-savvy international banks well schooled in the derivative markets and their offering.

This trend is likely to continue, as these banks are able to bring much needed capital relief to the reinsurance market.

While the growth of captives is a logical outcome of a hard market accelerated by the events of Sept. 11, regulators can be expected to take a very close look at existing capital and solvency margin requirements with a view towards strengthening them.

Loss of reinsurance capacity affects captive insurers, which generally have much lower capital requirements than licensed commercial insurers, as much as it does the traditional market.

Great care needs to be taken to avoid thinly capitalized captive insurers designed as an escape hatch from increasing prices or unavailable coverage.

The dynamics and timing are right and the synergies are in place to support the next phase in the growth of the alternative risk-transfer market. Proper marshaling of the forces will no doubt bring it to the next level.

Attorney Martin J. Nilsen is Counsel with the New York office of Edwards & Angell LLP (www.ealaw.com), an international law firm.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, March 4, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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