Market rate? What market rate?

In the past I have experienced competitive bids for national workers’ compensation accounts with significantly different fixed charges. This was due, I learned later, to competing fronting companies including or not including some of the estimated state assessments as well as their retention and reinsurance programme. We also know of the insurers’ application of an internal diversification credit.

This was illustrated for me clearly when I took some captive property portfolios including California earthquake risk to two Bermuda reinsurance markets, back in the early days. One, it turned out, already had a fair amount of California earthquake exposure in its portfolio. Adding this new business would have increased their overall risk, and therefore they were asking for a very high rate.

The other, just starting out, accepted the argument that adding a “bit” of California earthquake risk actually reduced their overall portfolio exposure, so they offered a lower rate. At least that’s the way the actuary in the second company explained it to me.

So the internal diversification credit is perceived differently according to fronters’ capital structure and business mix. This internal diversification credit allows insurers to load all the credit for reduced portfolio risk into the quote on a new (large) piece or book of business.

Normally, they would lower the risk-lowering effect on all existing business, and lower those rates across their portfolio, but they don’t usually do that. In a way, by leaving the existing small and medium-sized business untouched, these smaller accounts are subsidising the large accounts. That’s one argument against the true market rate.

Another is in areas where captive insurance is the norm, such as in medical malpractice liability or energy companies’ property programmes. I once served as expert witness for an energy company under attack by the Norwegian tax authorities for charging higher than market rates—incidentally, with a tax rate of 78 percent on excess profits it was understandable why they would go after every krone they could.

Anyway, we were able to demonstrate that all the E&P operators in the North Sea were using captive insurers in their property and business interruption programmes. Those who bought reinsurance other than from OIL (the companies’ group captive) went to brokers of Lloyd’s syndicates, where of course the reinsurance rates were lower than the captives’ primary rates.

In the trial proceedings there was a lot of argument about the erroneous concept of a “true” market rate. We won that case, but it took two appeals to win it.

Fixed or not

Consider the paradox of “the market rate” which implies something fixed and steady, and the existence of market cycles, during the peaks of which some liability rates double or triple.

What kind of market rate are we talking about? Yesterday’s? Tomorrow’s? I can just imagine the argument being made for a captive charging very high rates if they were to look back at the highest “market rate” charged in the recent past.

That vague language used by IFRS and the OECD about the rate a comparable insurer would be willing to charge for the risk has a time element in it, doesn’t it? The paradox of the market rate even runs to the location of the insurer and how much simple risk (homeowners’, automobile) they have in their portfolio, compared to the industrial risk, which is what captives usually write. The market rate for simple risks obviously shouldn’t apply to captives’ commercial risks.

Which brings me to one last observation. The smaller and simpler the portfolio, or individual insurance buyer, the more applicable the notion of “market” rate appears to be. For the larger, and more complicated exposures and portfolios, the notion of market rate is just that: a notion without definition.

There is a necessary ambiguity in trying to define the “right” rate for any insurable risk. I think the owners and tax collectors need to keep talking about that ambiguity to permit each side to work out individual interpretations.

It will depend on the skill of the analysts to make convincing arguments about the rates the captive is using. Which then could become the “market rate”. For a while, at least.

Hugh Rosenbaum is an honorary member of the Vermont Captive Insurance Association. He can be contacted at:  hughro2@gmail.com