Captives Endure Market Challenges

Most of us are aware that about half of the reinsurance contracts were renewed around Jan. 1. The remainder, other than a large group around June 30, are scattered throughout the year.

I am advised that the year-end contracts are all renewed, and in force. The yet-to-be finalized or even discussed contracts, meanwhile, are now creating a situation that is difficult to predict or negotiate in confidence.

This chronological spread of contracts has created interesting situations in which a few carriers are still offering terrorism, mold and similar coverages, even though they believe that those features will not be in their renewal terms.

Others are carefully watching the competition for a lead as to whether they should abandon a particular line of business or take advantage of a competitors strategic waffling.

Regulators are also evaluating the impact of the reinsurance market on their approved lines of coverage and rates. Some statesmost, in facthave provided some form of terrorism exclusion in commercial lines.

Virtually none are willing to extend those exclusions to personal lines. Toxic mold issues are gaining much time and attention at the regulatory level as everyone struggles to understand the exposure and how best to address it.

Most reinsurers are not paying heed to the regulators, however, and are proceeding with their own business goals foremost. Whether or not terrorism is excluded by a regulator has nothing to do with whether it is offered or included in the reinsurance.

The trend making the most noise is that of pricing. Reinsurance premiums have climbed above historic levels in almost every line of coverage.

Horror stories of price increases are abundant throughout the industry, and captives are no exception. We are aware of captives being asked to pay increases of 500 percent in some excess coverages, such as workers' compensation. Entire layers of reinsurance have evaporated. In these cases, the captive elects to take more risk in-house.

This increased unavailability and cost of reinsurance has caused captives to play a greater role than originally intended in accepting risk for their parent companies. Since this is the most widely accepted role for captives, it comes as no surprise.

Validation of this use of captives is in fact good news. The other news is that some parent companies have "requested" loans and other cash payments to the parent to help with the huge increases in premiums outside the captive.

In some cases, the captive is asked to fill in coverage for increased retentions and differing attachment points. Those captives that serve many different policyholders are asked to provide stability at lower levels than were intended at the formation of the captive.

Since the captive is controlled, it can provide coverage at lower costs than the commercial market, and is increasingly being asked to do so.

This situation has the potential to come to the attention of actuaries and regulators. The cash drain, combined with lowered retentions and reduced reinsurance commissions, could impact the capital and surplus of the captive.

The prudent owner-operator is aware of this, and monitors the ratios closely. But the increased exposures could materially affect the original actuarial assumptions in the feasibility study that was accepted by the regulator. In such cases, proactivity in discussing the changes in business plans could prevent some embarrassing moments later on.

As to captive formation, I suspect that it is also at an all-time high. I am not aware of a well-funded captive that has not proceeded to formation due to reinsurance or other coverage issues.

Quite the contrary. Captives are the flavor of the year. A company with financial resources and organizational ability has no real reason not to proceed. There are, in fact, many more reasons to move forward.

A captive recognized as a non-admitted reinsurer in order to provide premium stability and coverage availability has more of a need to redress that issue in this market than in almost all previous hard markets.

There are domiciles in which a captive can provide direct coverage, upon payment of surplus line taxes. Some lines of business do not require certification by an admitted, A.M. Best-rated carrier. In these situations, a captive can write business directly, thereby saving frictional costs and adding to the overall industry pool of risk transfer capacity.

There is evidence of industry groups and individual organizations that have to this point been satisfied with alternatives in the traditional market, that are vigorously investigating the potential of forming a captive.

For example, any risk that contains the word "medical," or any form of the word, will encounter scarcity in the professional liability, directors and officers liability, and workers' comp markets. This trend has not been so extreme in decades.

The use of captives by medical-related organizations is not new, but the recent increase in inquiries regarding captive formation is noteworthy because many in the industry felt that the field of medical malpractice captives was already "plowed ground." All things considered, it is a good time to consider, or reconsider captives.

Michael Mead is chairman of Minneapolis-based Captive Insurance Companies Association. He is president of M.R. Mead & Company in Chicago.

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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