Leading through innovation
Steve Jobs once said that innovation distinguishes a leader from a follower. It is true in technology, and it is also true in captive insurance. This case study examines how a captive achieved outsized profits through innovative and evolving use of reinsurance arrangements and in the process has become a leader in its market sector.
With few exceptions, most captives are constrained by their parent companies who provide them with limited resources but challenge them to do more with less.
Typically, there are limitations in capital contribution, coverage capacity and manpower in administration. Then there are concurrent objectives to retain underwriting profits, obtain catastrophe protection and grow premium volume.
Reinsurance can be an effective tool to balance these two competing pressures. Used effectively, reinsurance can maximise a captive’s profits while managing its risks.
Although a captive could be either the primary insurer or the reinsurer, this case study illustrates the typical scenario where the captive is the primary insurer, or the cedant, with one or more insurers as the captive’s reinsurers.
Table 1 shows the two general classifications of reinsurance.
The International Risk Management Institute defines these terms as follows:
- Treaty reinsurance is a form of reinsurance in which the ceding company makes an agreement to cede certain classes of business to a reinsurer. The reinsurer, in turn, agrees to accept all business qualifying under the agreement, known as the “treaty”. Under a reinsurance treaty, the ceding company is assured that all of its risks falling within the terms of the treaty will be reinsured in accordance with treaty terms.
- Facultative reinsurance is a form of reinsurance whereby each exposure the ceding company wishes to reinsure is offered to the reinsurer and is contained in a single transaction. The submission, acceptance, and resulting agreement is required on each individual risk that the ceding company seeks to reinsure. That is, the ceding company negotiates an individual reinsurance agreement for every policy it will reinsure. However, the reinsurer is not obliged to accept every or any submission.
- Quota share reinsurance is a form of reinsurance in which the ceding insurer cedes an agreed-on percentage of every risk it insures that falls within a class or classes of business subject to a reinsurance treaty.
- Excess of loss reinsurance is a form of reinsurance that indemnifies the ceding company for the portion of a loss that exceeds its own retention. It is generally used in casualty lines.
Captives using reinsurance tend to implement one of these four options at formation and then, even though the strategy and surplus may change in the future, the reinsurance arrangement remains static.
Case study
When one of our captive clients commenced business in 2004, it was capitalised with $1 million in policyholders’ surplus. This level of surplus was totally inadequate to support the limits the captive was authorised to write, which were up to $2 million per occurrence in most cases and up to $15 million per occurrence for insureds with higher risk profiles.
In order to achieve these limits, the captive structured a quota share treaty and ceded over 90 percent of its risks to reinsurers. This alleviated the captive’s capital solvency pressure during its initial growth phase. The captive’s owners implemented an aggressive risk management programme and successfully kept the captive’s loss ratio under 25 percent for its initial three policy terms.
However, as it ceded over 90 percent of the risks, it also ceded over 90 percent of the underwriting profit. Its limited profitability was unable to offset its operating expenses, resulting in a successful underwriting captive operating at a loss.
To recapture additional underwriting profits, the captive restructured its reinsurance to an excess of loss treaty in the fourth policy year. Unfortunately, they then experienced the worst losses in the captive’s short history.
The relatively low attachment point cushioned the blow. Nevertheless, the captive realised that something had to be done to enable it to keep as much underwriting profit as possible while simultaneously shielding it from catastrophic losses and capital solvency pressure.
Following an extensive review, a decision was made to structure the captive’s reinsurance into two layers.
A. Purchase treaty reinsurance for limits up to $2 million per occurrence, accounting for the vast majority of its insureds. Using the captive’s cumulative loss ratio as a benchmark, the captive structured a sliding scale ceding commission rate table with its reinsurers:
a. When the captive keeps its loss ratio for the current policy year at or under its prior year’s cumulative loss ratio, subject to a maximum, the captive is paid a 40 percent ceding commission. The 40 percent was later increased to 60 percent as the captive managed to consistently lower its cumulative loss ratio year after year, benefiting from the owners’ aggressive loss control programme.
b. A formula was developed where each incremental increase in the captive’s loss ratio reduced its ceding commission income proportionately.
c. When the captive’s loss ratios increased to 75 percent, later lowered to 70 percent, the captive only gets 20 percent back in ceding commission income.
B. Apply facultative reinsurance for limits exceeding $2 million per occurrence. The removal of catastrophic risk eliminated uncertainty for the captive and kept capitalisation pressure off the captive.
Figure 1 demonstrates how the sliding scale has worked in the most recent four policy years.
The calculation is complex but the result is simple: the lower its loss ratio in the x axis, the higher the income the captive will receive from its reinsurers in the y axis. It is important to note that reinsurers would not have agreed to such an arrangement if the captive’s loss ratio had not been so stellar. It is also important to note that we have camouflaged a couple of identifiable characteristics to protect the captive’s confidentiality.
Because the captive bifurcated its reinsurance in year 6, it went from consistent operating loss to almost break even in year 7 and it has remained profitable ever since (Figure 2).
The net income shown in Figure 2 is after the captive distributed dividends in each of its recent policy years. In other words, the captive’s profit margin would have been even higher had it not declared dividends year after year.
Before the captive started writing business 16 years ago, its owner insureds selected a few successful captives as its peers and strived to emulate their best practices. They even visited some of these peers.
The peers were chosen for their size, maturity, solvency, industry homogeneity, and profitability. None of them has changed its reinsurance arrangements over the years.
While most of these peers have remained stable, our captive has risen above the rest by the yardstick that regulators most often use to measure a captive’s strength: risk-based capital (RBC) ratio (Figure 3).
Had the captive left its initial reinsurance structure unchanged, it would most likely have kept incurring operating losses each year and driven its RBC ratio under the regulatory threshold.
The captive was formed 16 years ago during an insurance crisis. With the help of its service providers including Advantage Insurance, the captive has magnified its profitability while minimising its risk exposures. In the process, it has become the leader in its industry.
Christina Kindstedt is managing director at Advantage Insurance Management. She can be contacted at: c.kindstedt@aihusa.com
