Delayed reaction: the alternative risk market made it through the 2005 U.S. hurricane season in relatively good shape, but the storms' real blow may be yet to come.

Most alternative risk vehicles breathed a sigh of relief after the devastating 2005 U.S. hurricane season came to an end. Substantial losses appeared to be limited to specific industries--transportation, health care, oil and energy, for example--but the greatest impact for the alternative risk market is likely to come later. Some experts predict growth for the market; others foresee a change in coverages written. The hit the reinsurance market took on the heels of the hurricanes likely will impact pricing and capacity--effects already being felt by some alternative risk vehicles.

The reason many alternative risk vehicles sustained little to no loss is that they do not write property coverage; therefore, they are largely insulated from catastrophic fluctuations, said Stephen Scammell, senior consultant for Towers Perrin and editor of its Captive Insurance Company Reports. Instead, alternative risk vehicles, which include wholly-owned pure captives; rent-a-captives, including protected cell captives; risk-retention groups; and other risk-financing arrangements that use elements of serf-insurance, generally concentrate on workers' compensation and liability coverages in the United States, he said.

The majority of captives that responded to a recent Pulse Survey conducted by Towers Perrin on the www.captive.com Web site said they suffered no losses as a result of the 2005 storms. Only four of the 30 respondents said they incurred more than $1 million in losses, and five cited losses between $100,000 and $1 million.

It appears that most captives were well positioned to weather the storms, said Thomas Stokes, regional partner, Captive, Actuarial and Pooling Solutions (CAPS) of Willis Group Holdings. "Most traditional captives don't insure catastrophic property risks, and those few that do, prepare for the catastrophic nature of such risks and capitalize their captives accordingly." He said he's aware of captives that have been impacted by the storms, but because of proper planning have survived intact.

That's eliminating the need for further recapitalization. "Most of the captive losses are within working layers that are easily funded through the existing capitalization of the captive," said Philip Barnes, managing director of Aon Insurance Managers [Bermuda] Ltd. "For instance, you wouldn't have catastrophe layer losses reinsured into a captive, or if they are in a captive, they are reinsured out. If you have a hit, the reinsurance market would kick in, so the captive itself would remain relatively solvent and additional recapitalization wouldn't be necessary."

Reinsurance Repercussions

"[Reinsurers'] capital base is much smaller than the traditional market, and they may be faced with having to finance hall" of the $55 billion in U.S. catastrophe losses in 2005, so that really impinges on their capital and surplus," said Towers Perrin's Scammell. As a result, terms and conditions will tighten, and pricing will rise, and some captives that buy reinsurance will feel the direct effects, he said.

That doesn't come as a surprise to some companies. Half of the respondents to the Towers Perrin Pulse Survey said they expect reinsurance pricing to increase as a result of the recent hurricanes, while more than 36% expect reinsurance capacity to shrink.

"Where we may see captives get more involved is in potentially fronting and providing policy to insureds and accessing those reinsurance markets that aren't going to be established in the United States to issue policies directly in the United States;' said Greg Myers, executive managing director of Beecher Carlson, an insurance brokerage and risk management consulting company. "Captives will do more fronting for either deductibles or to fill out cat layers and maybe act as an intermediary between an issuing carrier of one reinsurer where the issuing carrier doesn't accept reinsurance from that company."

The recent hurricane season also may change the way some reinsurers look at captives, said Scammell. "Because the U.S. reinsurance market has a smaller capital base of around $73 billion, compared with $413 billion in the U.S. commercial market, reinsurers will now want to make sure they're dealing with creditworthy insurers. So if they have limited capital to give, they'll give it to their traditional commercial markets, thus making less available for captives." He said credit issues also will become a greater concern among the reinsurance community. "Reinsurers will possibly look to financially-rated companies as good risks. There's only a couple of hundred financially-rated captives of the approximate 5,000 captives now in existence," he said.

Changes Ahead

Some industry experts believe growth in the alternative risk market may result from the fallout of the storms.

"What happens in a situation like this is that there's a knock on the market and rates tend to go up and risk managers start thinking about whether they should be taking more risk in house or retaining more risks as a corporation, and part of managing that risk is putting it into a captive," said Aon's Barnes. He said Jan. 1 reinsurance renewals already have created a flurry among some risk managers to consider using captives more or potentially set up such structures.

But those already established in the market likely won't make significant changes following the recent storms. Some may consider writing property insurance into their captives because of concerns over the commercial market and its pricing, terms and conditions, said Scammell. "But the flip side is that there are people who wrote the risk into their captive and got hit pretty badly and are now thinking that maybe this wasn't such a good idea. So now they're either going to buy more reinsurance or diversify back into the commercial market because self-insuring all the risk was more than they could tolerate."

It doesn't appear that such a wholesale movement of property risk into a captive will come anytime soon. Only one respondent to the Pulse Survey said it's considering using its captive to write property coverage.

Some organizations also may begin writing more property programs for organizations to fill out layers and provide some solutions such as fronting, said Myers. "Every time there's a dramatic change in insurance, companies use captives more to better manage their overall risks." He said softening--or at least stabilization--now on the casualty side may give way to growth in the program business and people using captives to support that business.

Today's risk managers are more proactive in their approach to risk retention analysis and have developed modeling techniques to help them balance retentions with commercially available products. "Risk managers are taking a closer look at their company balance sheets to evaluate the optimal amount of risk to retain without unduly impacting profitability," said Stokes. "On the other side of the coin, risk managers are making sure they are not buying too much insurance at a disadvantageous price. It's a classic risk versus reward exercise."

Stokes added, "Captives are a great funding vehicle for retentions, lessening the potential for negative impact on business cash flows that can hurt the bottom line in the event of losses, as was the case with the recent storms"

A Matter of Expectation

"The real question isn't whether captives were hit by the storm, but whether they were expecting to get hit," said Stephen Cross, chief executive officer of Aon Corp. Captives Services, based in Dublin, Ireland.

For many, he said, the answer was "yes." Most were expecting some type of hit and were structured and robust enough to absorb the losses, he said. "None of our captives suffered beyond any predicted estimates." He doesn't foresee a need for future recapitalization or a potential collapsing of captives as a result of the storms. "They took some licks, but all came through it fairly well,' Cross added.

A similar situation could happen again, said Cross. He said predictions for the 2006 hurricane season look equally or even more ominous than last year's devastating season. "So this could have a compounding effect;' he said. "The captive market generally doesn't follow the typical year-to-year market in the way most people purchase insurance. Rather, they look at items and risks over a longer period of time and plan out budgets for two to five years. If reserves get hammered each year and captives had massive losses in 2005 and likely again this year, it's more difficult to structure your risk management program."

The geographic spread of risk is important, but Cross said location isn't always the key to identifying risk. "There's reasonable expectation that larger global corporate accounts will stiffer some level of natural peril losses in any given year. If you expand that horizon over three to five years, it becomes less relevant where the event will happen but you can fairly certainly say events will occur."

The answer to helping identify risk, Cross said, likely will come from a stronger dependence by risk managers on the use of analytical tools, good actuarial and predictive signs and heavier reliance on reinsurance.

The hurricanes' minimal impact on the viability of captives points to the robust nature and viability of captives as solid risk funding vehicles, said Stokes. "If anything, these storms will further solidify the position of captives," he said. "With the new, more sophisticated approach to risk financing by risk managers and the inexorable drive by commercial insurers to force companies to retain more risk, especially in the catastrophic arena, the old view of captives being tied to the whims of a cyclical insurance industry is long gone."

The beauty of a captive is that it can react to situations such as this, said Aon's Barnes. "They can provide a buffer to the effects of market change, and wherever they may be domiciled, the continued use of captives in global programs can help buffer companies from the impact of changes in insurance market conditions following these types of catastrophic events."

Key Points

* While the traditional insurance and reinsurance markets were hit hard by the 2005 U.S. hurricane season, the alternative risk market was relatively unscathed.

* The hit by reinsurers as a result of the hurricanes likely will have some impact on pricing and capacity for alternative risk vehicles.

* Most alternative risk vehicles weathered the storm because they don't write property coverage and were well capitalized.

* Some industry experts believe the recent storms may give rise to growth in captives.

Hits And Misses

Although many alternative risk facilities avoided losses from the 2005 hurricane season, their counterparts in health care, retail, chemical, transportation and some household-name fast-food chains likely suffered a blow, some industry experts said.

* Emerald Assurance Cayman Ltd., the captive for CHRISTUS Health, a nonprofit Catholic health-care system with more than 40 hospitals and several health-care related organizations located primarily across Texas and Louisiana, took a hit from Hurricane Rita in September 2005. Four of CHRISTUS Health's hospitals and some ancillary organizations suffered about $65 million in losses resulting from the storm. "We were able to draw upon a property policy written through our captive company," said Gary D. Shope, risk finance director for the Irving, Texas-based corporation.

The health-care system's commercial property coverage kicks in for named storms at a $7.5 million deductible level. Shope said the saving grace came from the property deductible buy-back policy issued by CHRISTUS Health's captive several years ago. "That allowed the CHRISTUS Health System to absorb the $7.5 million deductible so that no individual facility in our system that sustained hurricane damage would have to pay the full $7.5 million deductible out of its own operating funds. Rather, each facility pays a small ($250,000) deductible and the captive pays the remaining deductible up to $7.5 million." He said that while the property policy provisions had been untested and theoretical for the past two years, their effectiveness was put to the test when Hurricane Rita hit. "Our captive was standing by to quickly pay out cash needed for mitigation and repairs, and it passed with flying colors. It's a perfect example of why you set up captives" he said.

* The American Road Insurance Co., a wholly-owned subsidiary of Ford Motor Credit, felt some effects from Hurricane Katrina. The company paid out more than $30 million in damages, net of salvage of about $15 million, caused from damage to about 35 Ford dealerships across the Southeastern United States and more than 2,700 vehicles, said Chairman James M. Moritz.

However, he credited the strength of the company and its product as helping to keep losses from financially impacting its 2005 results and balance sheet.

* Several other industries' alternative risk vehicles were more fortunate. For instance, Harrah's Entertainment Inc.'s captives got off relatively unscathed, despite damage to several of Harrah's casinos in Louisiana and Mississippi. "The policy between the captive and the subsidiary corporations has an exclusion for named windstorms in its property coverage. In our case, these losses were covered by our traditional excess policies," said Deborah Burd, director of financial services for the world's largest provider of branded casino entertainment, and incoming chairwoman of the Captive Insurance Companies Association.

* Two areas that weren't as fortunate were the oil and energy industries. Hurricane Katrina--the deadliest hurricane to hit the United States since 1928--crippled Gulf Coast pipelines, refineries, utilities and oil platforms. Soon after the storm, risk modeler Eqecat estimated insured losses to the Gulf offshore oil and gas industry could be between $5 billion and $8 billion.

For Oil Insurance Ltd., a Bermuda-based industry mutual that provides property damage coverages to the energy industry, the storms resulted in a first for the company. "It was the first time our event aggregate had ever been hit before, and it was hit twice in the course of a month," said George Hutchings, senior vice president and chief operating officer. OIL, which provides members with property damage insurance coverage with limits up to $250 million per occurrence, has a per event aggregate limit of $1 billion. "We suffered $2 billion in losses from hurricanes Katrina and Rita--S1 billion for each storm," he said. "It created a fairly significant increase in the premiums OIL charged its members because as losses are mutualized, everyone pays a portion of the losses as determined by their risk adjusted weighting in the pool:' While some members had losses and others didn't, and given the significant size of the losses, he said, the impact from the storms was a relatively important occurrence in the organization's history. It has fundamentally changed the way its members view exposure to such events, he said.

Who's Who In Captives?

Captive--An insurance company that primarily insures the risks of its owner and is actively managed by the owner and/or insureds. Assets of the captive are generally owned by the insured.

Association captive--A captive that underwrites the risks of members of an industry or trade association.

Rent-a-captive--A captive insurance company that provides access to captive facilities without the user needing to capitalize its own captive. The user pays a fee and must provide collateral.

Special-purpose vehicles for risk securitization--Reinsurance companies that issue reinsurance contracts to their parent and cede the risk to the capital markets by way of a bond issue.

Risk-retention group--An owner-controlled insurance company authorized by the Federal Liability Risk Retention Act of 1986. An RRG will allow members who engage in similar or related business or activities to write liability insurance for all or any portion of the exposures of group members, excluding first-party coverages such as property, workers' compensation and personal lines. The statute allows a group to be chartered in one state, but able to engage in the business of insurance in all states in which it registers.

Pure captive--Insures only the risk of the owner or the owner's subsidiaries.

Sources: South Carolina Department of Insurance, Vermont Department of Insurance, Illinois Captive & Alternative Risk Funding Insurance Association