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The emergence of financial reinsurance.

For more than two decades, risk management professionals have sought more creative ways to handle the retention of risk. Their methods have run the gamut from centuries-old self-insurance and simple deductibles to more sophisticated cash-flow programs, which are a fairly recent phenomena.

It is not uncommon today to find major organizations using a combination of retention vehicles to handle the same exposure. For example, consider the corporation that employs a self-insured retention before ceding a major portion of its auto liability premium to its wholly-owned captive. A variety of other combinations, including deductibles, compensating balance programs and incurred and paid loss retros, might also be found, depending on the exposures and objectives of the risk management program. Regardless of the particular techniques and their relative benefits, the decision of which method(s) to employ should follow a determination of how much risk an organization is able and willing to absorb. An organization's appetite for risk and its financial capacity to pay losses are key factors in setting retention levels.

Typically, an analysis of alternative retention levels recognizes that losses fall into at least two categories. The first consists of losses marked by high frequency, low severity and a high degree of predictability. Even the novice risk manager recognizes that purchasing coverage for these claims results in the classic "swapping of dollars" with insurance companies, thus creating an economic disadvantage to the insured. Barring extreme aberrations in the marketplace, losses falling into this layer clearly should be retained. The second layer of losses is characterized by low frequency and high severity. These losses, if and when they do occur, could threaten an organization's solvency. Therefore, an organization usually seeks to transfer this risk in the insurance marketplace.

A Simplistic Approach

The obvious problem in relegating risk to two categories is that it is too simplistic in today's world. The real difficulty comes in attempting to wed an organization's risk-taking level to the attachment point at which insurance markets will provide pure risk transfer. With the development of more unpredictable long-tail exposures, the gap between these two points is widening, creating a third layer of exposure that must be addressed by the risk management community. Asbestos, pollution, AIDS liability, medical malpractice and occupational disease are a few examples of these kinds of exposures. They create payouts that often fall somewhere between an appropriate or affordable level of risk retention and the market-driven points of risk transfer. These exposures produce losses of moderate frequency, but also result in costs that can range from nuisance to catastrophic levels. They may have some degree of predictability over time or no predictability at all.

From year to year, it may be unclear whether insurance or self-insurance is the best available option or, indeed, whether there is any option. When real insurance is available, the attachment points for even insurer-controlled excess markets are frequently far from desired levels of risk retention. Although the problem is shared by industries as different as health care and oil and gas, risk managers face a common challenge. They must guide their organizations in assuming higher levels of risk, with the knowledge that the possibility that one or more claims in this new area of retention will seriously threaten the cash position of the organization. Attention must turn from traditional analyses of alternative structures for primary, excess and umbrella programs to a more immediate financial imperative: protecting the balance sheet from an unquantifiable but potentially catastrophic exposure.

A Potential Solution

Although many employers would turn to the banking industry, financial reinsurance markets might provide a more advantageous solution to the risk retention problem. Through creative use of financial reinsurance concepts, it is possible for an organization to spread sizable claims payments over long periods of time, enhancing its capacity for long-term financial planning. Typically, the parties to a financial reinsurance contract are insurance companies. Usually, the reinsured party is an established insurance company or a captive or rent-a-captive operation. However, many of the concepts typically associated with financial reinsurance can also be used in contracts between non-insurance operations and insurance companies.

For our purposes, financial reinsurance can be defined as any reinsurance arrangement in which the limits of coverage, time period and premium being paid (ceded) acknowledge investment income or the time value of money as one of the key components. Often, the ultimate risk ceded to the reinsurer is capped at some level which is expected to match premium plus investment income earned over the contract period. In other words, underwriting risk is frequently avoided, and the risk often assumed by the reinsurer is limited to the credit risk of the ceding company and/or the timing risk. An example would be the risk that claims will be paid out quicker than expected and for amounts that exceed premiums collected.

Often used as a generic term for "time and distance" coverages, financial reinsurance products can vary widely in purpose and structure. The range of applications seems to be limited only by the imaginations of those involved, and the products can typically be modified to address the particular problems of specific companies. All of the products, however, have the common objective of achieving some form of chronological stabilization.

Some common financial reinsurance uses include surplus relief portfolio transfers, retrospective aggregates, prospective aggregates and catastrophic covers. Surplus relief, also referred to as quota share financing, involves contracts ceding a percentage of a company's entire risk or book of business to the reinsurer. The arrangements are frequently used to enable the ceding company to comply with statutory surplus requirements. Through portfolio transfers, reserves on known losses are transferred to a reinsurer in exchange for premiums equal to the discounted value (or net present value) of the ultimate claim payout. The transaction allows the ceding company to realize a profit from, for example, the difference between the book value of reserves and the premium paid to the reinsurer. Consequently, it will improve the surplus position of the company. Similar to portfolio transfers, through retrospective aggregates, reserves on both known and incurred but not reported losses are ceded to the reinsurer. Unlike the portfolio transfer, however, estimated loss reserves have a greater degree of uncertainty. The premium represents the discounted value of these reserves, and the difference between premium and book value is recognized as profit in the current year.

Prospective aggregates are typically used when dealing with unpredictable long-tail exposures. A reinsurance premium is paid prospectively in exchange for commitments from the reinsurer to pay losses in the future. The maximum exposure to the reinsurer is usually limited, and any underwriting income will be returned to the ceding company; only investment and fee income are retained by the reinsurer. In effect, this arrangement creates current capacity for the reinsured party by borrowing against future income. Catastrophic covers can be used to spread potentially ruinous loss payments over a period of years. The exposure may involve high levels of uncertainty or fairly predictable losses.

All these concepts can be combined or modified to address the problem described previously. The following case study, although presented hypothetically, typifies the ways financial reinsurance arrangements can be used to the insured's advantage.

A Case Study

Assume that Cure-All Inc. is a national, multifaceted health care system consisting of several large metropolitan hospitals, rehabilitation centers and strategically located blood bank operations. In the mid-1970s, Cure-All's risk management department established an offshore captive insurance company to cope with the medical malpractice insurance crisis. The conservatively managed captive benefits from prudent underwriting and has garnered a strong surplus position. Currently, the captive provides $1 million of general liability and medical malpractice coverage to all its operating units. In the most recent soft market, excess and umbrella limits reached $50 million.

On Jan. 1, 1985, all reinsurers, in addition to converting their policies from occurrence to claims-made forms, excluded all coverage for liability associated with Acquired Immune Deficiency Syndrome (AIDS). The uncertainty surrounding AIDS and the related liability exposure for health care operations rendered markets for insurance coverage almost non-existent. The risk manager quickly began formulating a strategy to cushion Cure-All from the potentially disastrous impact of future AIDS claims. Because Cure-All enjoyed full occurrence coverage for the AIDS risk prior to the first year, and given that AIDS is usually a long-tail exposure, the risk manager recognized time as a valuable ally and acted appropriately.

In the first year, the risk manager and the chief financial officer determined that CureAll's annual risk-bearing capacity for the AIDS exposure was approximately $2 million. It was also determined that the captive's capital and surplus position allowed payment of the first $1 million of AIDS claims without threatening its solvency ratios. Contingency reserves were established by Cure-All, the captive's parent, to handle the remaining $1 million of risk retention. In each of the five years, the captive issued a separate policy with an annual aggregate limit of $1 million for AIDS liability. Currently, at the end of the fifth year, the contingency reserve has accumulated funds totaling $5 million. The organization knows of only 10 reported claims from occurrences dated before the loss of coverage in the first year. All of these claims are in early discovery and no reasonable estimate of reserve values has yet been made.

During the past year, the risk manager has become aware of two excess facilities that can now provide coverage for the AIDS exposure. Each market has capacity to provide limits of $25 million, however, neither will attach at points lower than that amount. With the prospect of securing this larger layer of protection against the catastrophic impact of AIDS, the question now becomes how to handle the unwanted middle layer of risk between the captive's $1 million policy and the $25 million attachment point. One answer is through use of financial reinsurance principles. It would be realistic to expect that effective marketing efforts would yield a policy providing the needed $24 million of protection for the middle layer. Using the same concepts applied in prospective aggregate and catastrophic coverage contracts, the full policy limits could be obtained at the beginning of the coverage period in exchange for transferring the contingency reserve monies as initiation of a long-term funding commitment by the insured. Specifically, the program might work in the following way.

Cure-All's captive would issue an AIDS liability insurance policy with aggregate limits of $25 million. The first $1 million of aggregate losses for the coverage period is retained by the captive, while the next $24 million is ceded to a reinsurance company. Terms of the reinsurance contract would set policy limits at a $24 million aggregate for the five-year policy period with a retroactive date beginning Jan. 1 of the first policy year. The deductible limit would be priced at $1 million per occurrence with a $1 million annual aggregate. The policy premium would be set at $5 million at the inception of coverage followed by 20 quarterly payments of $750,000. Basis of commutation of the policy would be $24 million, less claims costs at the end of the coverage period, and the policy could be cancelled for non-payment of premium, or at the insured's option.

Under this arrangement, the insured pays a total of $20 million over the five-year policy period into a premium fund held by the reinsurer. The terms of commutation indicate that if no claims are paid out over this same period, an amount equal to the policy limit will be returned to the insured. However, if claims and expenses are paid by the reinsurer, the amount returned at the point of commutation would be adjusted accordingly. For example, if the reinsurer had paid $5 million of claim expense during the policy period, the reinsurer would return $19 million to the insured. If requested, the reinsurer would provide a letter of credit as security against the premium fund. The letter of credit amount could be adjusted periodically to reflect the fund's changing value.

Other contract terms would be determined through further negotiation. For example, the reinsurer may be unwilling to take any timing risk and may request that any lost income be borne by the insured. In other words, if at any point claim payments exceed premiums plus investment income earned by the reinsurer, the insured would pay an additional premium that includes a borrowing charge for the cost of using the reinsurer's funds. In exchange for this feature, the reinsurer may allow the additional premium to be paid on a scheduled basis that extends beyond the coverage period.

Conversely, the reinsurer may willingly take the timing risk in exchange for concessions on the commutation amount. On the other hand, the reinsurer may be uncomfortable with guaranteeing a commutation amount and may, therefore, only agree to provide some previously defined rate of return on the premium fund. The return may be a relatively conservative fixed rate such as 5 percent, or it may be pegged to some mutually agreeable market index such as the prevailing Eurodollar or the Treasury Bill rate. In almost every case, however, the contract should provide the insured with the option of canceling it and settling accounts before the end of the contract period. Typically, the reinsurer would agree to this stipulation only if the reinsured is willing to properly reimburse any directly related lost investment income and additional transaction costs that would be needed to close accounts.

Certain advantages can be realized under the arrangement. For one, greater financial capacity results. To the extent that the reinsurer takes the timing risk, the insured's ability to pay AIDS claims has increased from only $6 million, from $5 million contingency reserve plus $1 million captive policy, to $25 million on the first day of the coverage period. Second, a contract is now in force which provides evidence of insurance through the issuance of certificates of insurance. The evidence provided by the underlying financial reinsurance contracts may reduce fear by excess markets that attachment points will be forced lower in future "after-the-fact" judiciary proceedings. Third, the insured has a greater capability to determine the timing of cash outlays based on a variety of options that might be provided by the reinsurance contract. Fourth, depending on negotiated terms, the cash flows regarding AIDS liability claim payments can be stabilized and more easily forecast over a five-year period or longer. In addition, when the captive's $1 million retention, $24 million financial reinsurance and $25 million excess program limits are added together, a $50 million program results, which dovetails nicely with the rest of the liability coverage.

Accounting and Taxes

An issue to consider is how to record reinsurance premiums for tax purposes and in preparation of audited financial statements. The question is whether the premium payments represent true expenses or whether they merely constitute deposits placed with a financial services institution. Hard-and-fast rules are difficult to employ because terms of financial reinsurance contracts can vary widely. However, a good principle to follow is substance over form. Generally, when the terms of a contract resemble a banking arrangement, it is likely that premiums paid to a reinsurer will be considered assets of the insured. Conversely, the higher the level of risk transfer, the greater the case for recording premiums as tax deductible expenses.

Given the Cure-All case study, suppose the contract terms required immediate payback by Cure-All of any shortfall in the premium fund held by the reinsurer. Under this scenario, it is highly unlikely that the contract would be considered real insurance by either independent auditors or tax authorities. The premiums would probably become tax deductible expenses only as claims are paid. However, assume that timing risk is introduced, policy limits are increased so they materially exceed commutation levels, and in order for the commutation formula to apply, claim experience during the contract period must not exceed 35 percent of policy limits. Under these circumstances, a different conclusion might be reached. The contract begins to adopt elements of a real risk transfer and increases the likelihood that premium payments will be deemed tax deductible expenses.

The upshot of this scenerio: The specific terms of a financial reinsurance contract should be reviewed with qualified tax or legal advisers before taking a tax position. Opportunities to use financial reinsurance concepts will grow as more exposures fall between acceptable retention levels and available risk transfer points. Using available brokering capabilities, marketing skills and a little imagination, the risk management community might soon recognize financial reinsurance as an instrumental part of effective risk funding programs.
COPYRIGHT 1990 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990 Gale, Cengage Learning. All rights reserved.

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Author:Daniels, Gregory L.
Publication:Risk Management
Date:Apr 1, 1990
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