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Captives, reinsurance and the renaissance risk manager.

The increasing use of captive insurance companies as a risk management technique has transformed and enhanced the role of the risk manager within the parent organization. As a repository of assets and liabilities, captives may become a significant part of the parent's financial structure and contribute substantially to the corporation's capital needs. The presence of a captive creates an opportunity for the development of flexible and responsive risk transfer programs that reflect areas of exposure particular to the parent company's operations. As the number and sophistication of risk management challenges have grown over the past 25 years, so have the opportunities for the risk manager to contribute significantly to the viability and profitability of his or her company. In many ways, risk managers with captives must meet many of the challenges faced by the executive management of insurance companies. Against this backdrop, it is not surprising that during this same period of time, relationships between risk managers and professional reinsurers have flourished.

Impetuses for the creation of captive insurance companies have varied over the years. In the early days of the captive movement, the quest for tax advantages led to the creation of many single-parent captives, particularly in offshore domiciles. As scrutiny increased and regulations tightened, many captive owners began to assume unrelated business to bolster the perception of their captive as a bona fide insurance company and to facilitate the tax deductibility of premiums paid by the parent to the captive. For many companies, this strategy backfired, with unrelated business creating exposure and losses greatly out of proportion to the benefits of potential tax deductibility of their premiums.

The insurance market cycle has also contributed to the need for captive insurers. Wild swings in pricing and capacity have been common for major corporations with difficult exposures. Often, an insured's own experience or exposure had little to do with the cost of insurance, as it was priced by a market driven primanly by supply and demand. Coverage forms and contracts tended to reflect industry standards or underwriter's concerns, rather than provide protection for exposures that threatened the insured. It became increasingly possible that substantial premiums could be paid to an insurer over a period of years, only to find that company insolvent when the time came to fulfill its obligations.

Over time, the nature of relationships between insurers and insureds began to deteriorate, driven by the legal climate in the United States. An explosion in the concepts of negligence, liability and appropriate compensation has revolutionized the nature of virtually every relationship in this country, and imposed, sometimes retroactively, new duties, obligations and standards. Asbestos, environmental impairment, products liability, workers' compensation and employers' liability have been the causes of huge, mostly unforeseeable costs of compensation and litigation created by the expanding concepts of liability. With economic survival sometimes at risk, disputes between insurers and insureds began to magnify and multiply.

The absolute cost of risk transfer and related services through traditional insurer and brokerage relationships began to bear more scrutiny. Risk managers began searching for ways to deliver more of the premium dollar as claim payments, and sought to gain more influence over the cost and quality of key services such as loss prevention and claims payments. Unbundling of services and risk transfer became common.

Captives became a key tool for risk managers to influence and control insurance issues affecting their companies. The captive provides a vehicle for the structuring of price, capacity, coverage and security necessary for risk transfer transactions. A risk manager can mitigate the impact of the insurance market cycle by expanding the use of a captive during a hard market.


This evolving landscape has had a profound effect on the roll of a risk manager within the progressive corporation. In the past, risk managers were expected to be narrow specialists, charged with administering and purchasing insurance for non-business risks. Today's risk manager must be a true Renaissance Man or Woman, with a broad grasp of the issues or challenges facing the corporation.

Responsibility for a captive demands a working knowledge of finance, accounting, insurance and reinsurance. Risk management responsibilities add additional requirements for knowledge of operations, safety, technology, regulatory climate, environmental issues, management techniques, law, economics, actuarial science and much, much more. The nature of these issues for a major corporation demands specialized and sophisticated experrise in each area. For the Renaissance Risk Manager, the challenge becomes the successful integration of specialized expertise on the issues facing the corporation, and identification of gaps and new areas of exposure.

To meet this challenge, the risk manager must enlist a cadre of supporters from inside and outside the company. Internally, relationships with executives, operations, financial and legal management are critical. Increasingly, rapport and involvement with human resources and environmental management are also necessary. Formal and informal channels of communication must be created and maintained.

There are many areas of corporate activity where the involvement and impact of the Renaissance Risk Manager can be critical. Ideally, the risk manager becomes a key member of ad hoc or formal teams working within spheres of activity inside and outside the parent company.

From an executive management perspective, the risk manager should be in touch with the corporation's strategic direction and be aware of significant initiatives contemplated during the planning cycle. Acquisitions, divestitures, new markets, new products, expansion and downsizing all present risk management challenges with substantial financial implications. A risk manager able to be proactive, not reactive, to the environment of change present in dynamic companies is in position to highlight areas of exposure and deal with them effectively.


Operational challenges often involve the most significant asset of any corporation: its people. Issues relating to health, safety, financial security and workplace environment are critical to employee morale and efficiency. Operational activities also intimately affect client relationships and attendant concerns of reliability, efficiency and cost. To be effective, safety practices and procedures must often be implemented and supported by operations management. Disaster recovery planning, business interruption exposure and liability issues demand a detailed understanding of operations on the part of the risk manager.

Linkage with the general counsel's office provides the risk manager with information relating to the contractual relationships of the corporation. Ideally, the risk manager becomes involved before a contract is signed - providing an opportunity for negotiation or drafting of an agreement that eliminates unnecessary exposures. Interaction with outside counsel is also needed from a dairns perspective.

Environmental issues often transcend traditional corporate organizational structures. Given the involvement of operational, legal and financial issues, risk managers can be a catalyst for the creation of strategies dealing with environmental problems, with particular emphasis on new technologies, insurance carrier relationships and regulatory compliance.

External support must come from a variety of sources, induding: insurance brokers, actuaries, accounting firms, third-party administrators, legal counsel, consultants, insurers and, increasingly, reinsurers. Through knowledge of his or her company and the universe of service providers, the risk manager can select and implement the best expertise available for the challenges.

For risk managers with captives, a professional reinsurance company is often the best choice for risk transfer issues involving or affecting the captive. The affinity between risk managers and reinsurers is real and natural, as it results from the needs of captives and risk managers that closely resemble issues facing insurers. As large corporations have taken on the financial and administrative characteristics of insurers, they have developed needs that reinsurers have built themselves to satisfy over decades of evolution. Amongst the largest reinsurers, there is substantial capacity, a track record of stability and, generally, excellent security. Reinsurers are comfortable with large, sophisticated transactions and have the people necessary to implement and maintain them successfully. Unique, one-of-a-kind programs are ideally suited to the flexible approaches available to professional reinsurers.

Captive reinsurance programs are designed to respond to dual concerns: the insurance needs of the parent and the financial goals of the captive. A successful program satisfactorily addresses each concern through a complete market cycle. Insurance issues of coverage, price and capacity may be managed completely within the captive or in the broader context of developing excess capacity from the market. Appropriate reinsurance protection for the captive ensures acceptable variances in the balance sheet and income statement entries, assisting in the achievement of the captive's financial objectives.

Captive reinsurance program structures are limited only by the imagination of risk managers, their brokers and reinsurers. Despite their flexibility and variety, these programs are built upon one of two basic structural foundations: guaranteed cost or adjustably rated. Each platform can accommodate a great deal of customization to respond to a captive's objectives.

Guaranteed cost programs provide the risk manager with a stability and certainty of cost that is desirable in many circumstances Budgeting processes make guaranteed cost programs desirable to utilities, public entities, contractors and others who need to cost their products and services precisely for external scrutiny. They deliver a fixed amount of expense that is easily apportionable amongst profit centers based upon objective criteria. Due to the risk to the underwriter, these programs can be expensive in the long run, as risk loads and capacity charges accrue.

Guaranteed cost programs can be used to generate capacity or to stabilize the financial performance of the captive. A captive's own capacity, supplemented by reinsurance, may be used to obtain adequate and appropriate coverage for the parent's exposure. By retaining predictable losses within the captive, a risk manager can often negotiate broader coverage than would otherwise be available from excess underwriters. Manuscript wording is developed to reflect the unique exposures inherent in the parent company operations, providing a predictable response to loss events. Then, either proportionable or excess coverage for the captive is negotiated with a reinsurer. Additional capacity is generated in the open market, as needed.

Excess of aggregate or stop-loss reinsurance is often utilized to stabilize the effects of captive retentions over time. Unexpected frequency or severity may provide the captive with more losses than it can comfortably manage in a given time frame. Stop loss reinsurance transfers this risk, within defined parameters, to the reinsurer. The presence of stopdoss reinsurance can enhance the ability of a captive to retain per-risk or peroccurrence amounts needed to fill out capacity requirements. Stop-loss reinsurance can also assist in the development of an optimal set point in the risk transfer/risk retention equation from a cost perspective. Retentions can be finetuned to reflect income statement and balance sheet objectives, corporate tolerance for variation in results, the underwriting and economic characteristics of the business retained and operational issues such as claims settlement practices.

Adjustably rated programs provide the captive with a stake in the ultimate performance of the reinsurance program. The cost of reinsurance protection is adjusted upon an agreed-upon set of parameters. These types of structures include the familiar paid and incurred loss retrospectively rated programs, as well as treaty and finite risk covers. An underwriting precept is that the captive will pay all of its losses, plus a margin to the reinsurer, ff the program performs within negotiated parameters.

From the captive's perspective, adjustable structures are desirable for a number of reasons. They provide the captive with the ability to directly benefit from the implementation of safety and loss prevention measures that may result in improved loss experience. A better than average risk can benefit from that status direct and without having to generate consensus with an underwriter. Over time, a reinsurer may charge a lower risk load to reflect the more predictable performance of the program. Finite risk programs have the additional benefit of recognizing the time value of money in the pricing and structures of the cover.

As with guaranteed cost programs, adjustably rated covers may be structured on a per-occurrence basis. With both, utilization of program features affecting the limit such as deductibles and reinstatement provisions can further enhance the flexibility of a program.

In addition to risk-taking capabilities, a number of reinsurers have heavily invested in expertise and services valuable to the risk manager. Due to the complexity of their business, some professional reinsurers have retained the services of individuals with great expertise in claims, finance, actuarial science, management information systems, regulation, environmental issues and disaster recovery. Underwriters possess the experience and knowledge to deal with difficult or unusual exposures.

Current trends in the insurance industry continue to present challenges and opportunities to the risk manager with vision. Virtually every corporation must respond to an increasingly competitive business environment, emphasizing effidency, flexibility, responsiveness and nimble reflexes. The pace of change is quickening, bringing new and different risk management issues. Epochal shifts are taking place in such areas as health care delivery, corporate structure, global markets, information technology and finance. The insurance industry has responded to these changes by downsizing and consolidating, limiting the array of quality choices and capacity to the risk manager. At the same time, federal regulation may allow large commercial risks, insurers and reinsurers to interact with a latitude not possible in the current state-based system. In this environment, the relationship between risk managers and reinsurers will continue to flourish, and the influence of Renaissance Risk Managers on their corporations will increase.
COPYRIGHT 1993 Risk Management Society Publishing, Inc.
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Author:LeStrange, Kenneth J.
Publication:Risk Management
Article Type:Cover Story
Date:Aug 1, 1993
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