Insurer Downgrades, Fronting Likely To Remain Key Issues In 2003

The reorganization of at least one major player, Kemper, is causing a serious disruption in what was already a difficult climate for risk-sharing partners, especially in the vital role of frontingan agreement by an insurer to issue a policy on behalf of a captive.

Even though some of these rating downgrades were foreseen, the extent and suddenness have been surprising.

As a veteran observer, I am struck by what has become the almost routine process of the decline and fall of an insurer.

Once upon a time, when certain actions by a carrier were observed, such as reducing claims adjusting staff or changing the organization from home office-oriented to field office-oriented, or vice versa, you could begin to see telltale signs a company was sliding toward the abyss. That process, however, was not inevitable or irreversible.

It was years of informal observing between the first signs of trouble at Reliance, for example, and its final close by regulators.

Today the availability and speed of information are such that the rating agency process and regulatory action are not far behind the advance rumor mill.

Instead of years, we are seeing months in the cycle between the chief executive officer quietly packing his parachute and regulators taking control. Along the way, the brokers and agents, in self defense as much as anything else, will have moved their business, and the valuable employees who know the business will go with them.

The downgrading of insurers has a particularly sharp affect on captives. Fewer and fewer risk-sharing partners remain, and the math tells you that the survivors cannot handle all the action. Sheer volume is overwhelming many underwriters today.

Most buyers of commercial property-casualty coverage will be affected by current market conditions, and they will seek alternatives in captives and risk retention groups. But they will not all be satisfied with the search. Just because there is a need for certain coverage or better rates does not mean that alternative risk finance is the answer.

For captives, I would expect to see increased curiosity and examination of the option, and more records in formation in most domiciles occurring despite the fronting scarcity. The risks of business have to be insured in some fashion, somewhere. I would expect that someone will step up to provide a fronting solution, and there are many possible sources.

Fronting, or risk certification, is very difficult in the first quarter, and will remain difficult for the remainder of 2003. As fewer carriers are willing to provide fronting, I would expect some captive formations to be shelved.

The captive industry will still continue to grow, however, as there are many buyers in search of a solution. As has often been said, captives are not for everyone, and the current forces in the market will reinforce that dictum.

Among the solutions is a change in regulatory stance to allow captives to write directly in more jurisdictions. There are several such discussions going on as this article is written.

To become widely useful, one state will have to give recognition to another domiciles accreditation and licensing process, so that a licensed captive in one state can write elsewhere.

Or perhaps the Risk Retention Act can be expanded to include workers' compensation. The solution to the current challenge will require innovation and new approaches not only by insureds and insurers, but also by regulators.

I would also expect to see some of the newer domiciles with staffing and budgets to greatly expand their base.

Arizona, while off to a slow start at midyear, is rapidly and quietly gaining interest as a domestic domicile.

South Carolina continues its torrid pace. With the retention of Ernie Csiszar, a veteran regulator, I would expect that the licensing pace in that state will continue to accelerate. Most other domiciles also reported record new captive formations last year, which should continue through this year.

Already there had been increased interest in forming property captives, and this will continue in 2003. While the cash flow advantages are not as appealing, as long as coverage is hard to find, more people are considering a captive for property coverage.

As more captives are considered, the cost structure will come under intensified scrutiny. There are only, really, 100 cents in the risk dollar. Yes, some additional funds can be generated in the tail and through interest, but now is not a good time to build your captive on that premise.

And services must be compensated. I suggest that an approach is that services will need to be more carefully defined and charged more accurately by all risk-sharing partners.

The standard percentages will have to be carefully re-examined and either reimbursed appropriately or eliminated. That would include certification, regulatory administration, risk transfer, claims management and so forth.

All sides must recognize that if somebody has to do the job, it is worth paying them adequately to perform it. Expertise will become more dear, which will put further pressure on the price structure. Programs which generate uncontrolled losses will lose out.

Some previously uninvolved carriers have recently begun to offer captive services. These are really deductible programs in which services are required to be purchased from the carrierwhich may or may not be the best choice for these services.

These requirements enable some carriers to cost shift and recover expenses imbedded in traditional programs that may not be delivering the requisite returns.

Today, despite all of the challenges, business moves ahead and will continue to do so. Commerce will prevail and solutions will come forward. All of these factors will give us yet another interesting year in alternative risk finance.

Michael Mead is past chairman of the Captive Insurance Companies Association and president of M.R. Mead & Company LLC, a consulting intermediary in Chicago.

Reproduced from National Underwriter Edition, March 10, 2003. Copyright 2003 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.