Strength in numbers - risk pooling
Risk-pooling builds upon the fundamental insurance principle of risk-sharing and by partnering with a recognised reinsurance company with unrivalled experience, established contracts and mechanisms, captives can transfer their own exposures to third parties, and in return receive a share of a much larger pool of similar risks. The pooling of risks facilitates a smoothing effect on captive operation, created by the ‘law of large numbers’.
How does it work?
Captives reinsure their primary casualty risks up to pre-agreed limits per occurrence and in aggregate to a risk-pooling company such as Nexus Re. The premium is based on expected loss projections only, with no increases for expenses or profit margins, as would apply in a typical commercial reinsurance scenario. Nexus Re then receives the premium and reimburses claims as paid by the captive. The objective is for the pool to break even, and therefore ultimately claims paid to the captive should equate to premiums— in other words, 100 percent loss ratio. The aggregate limit is 135 percent of premiums, which protects the experience of the pool overall.
The risks Nexus Re assumes from all participating captives are then aggregated and retroceded back to the captives (acting as retrocessionaires of Nexus Re) in proportion to their share of the total premium for each year. Assuming a simple example of 10 participants, each with expected loss projections and premiums of $10 million, each would receive 10 percent of the pool premium and pay 10 percent of the pool losses. The risks received would be 10 percent of their own risk and 90 percent of unrelated risk, or those risks of other participants.
Should a captive pool risk?
"The pooling of risks facilitates a smoothing effect on captive operation, created by the 'law of large numbers'."
The writing of third party business by captives, and their qualification as an insurance company with the tax treatment benefit this may entail, will generally be a significant advantage for participants. Captives and their parents should take a medium to long-term view when entering a pool. There should be a history of stable loss experience at the selected loss limit to ensure a reasonable chance of projecting ultimate losses as accurately as possible. Captives need to accept that pooling is a risk-taking endeavour, premiums are determined in advance and actual losses incurred will invariably be higher or lower than the premium charged by Nexus Re. Equally, as a retrocessionaire, the actual losses reimbursed to Nexus Re may be higher or lower than the retrocession premium received.
What risks can the captive pool?
Pooling is suitable for high frequency, stable, primary casualty risks. Typically workers’ compensation is the main class ceded, however Nexus Re will also accept Federal Employer’s Liability Act (FELA) liability, auto liability, general liability and products’ liability, either in addition to workers’ compensation or separately. The per occurrence loss limit varies by participant depending upon the historical loss experience and the level at which losses are predictable. While a number of participants cede the first $250,000 to Nexus Re, there is capacity for limits up to $1.5 million if such losses are sufficiently stable and predictable.
Risk pooling mechanism
Setting the premium
While Nexus Re has independent actuaries who undertake reserve analysis for each participant and for the pool overall, the premium setting is a function of the underwriter, albeit based on actuarial principles. At least five years of historical loss experience is required, but the underwriter also works closely with the captive and its parent to understand the underlying risks and take account of information presented. The captive or parent will often be willing to share its own actuarial projections with Nexus Re and these will also form part of the decision process. Ultimately the premium will be negotiated and agreed between Nexus Re and the reinsured captive on an annual basis.
Handling the cash
There is quarterly settlement of premiums and claims between the captives and Nexus Re. All transactions are directly made between captives and Nexus Re’s bank account. Captives will retain the retrocession premiums to reimburse retrocession losses, and therefore the funds can be invested long-term by the captives until pool losses are settled.
Costs of Nexus Re
Nexus Re charges a fee based on premium income and claims paid, which is entirely separate from the risk-based reinsurance premium. Generally, the overall fee for participation is equivalent to 2 percent or less of premiums.
How can a captive join?
Nexus Re will ensure a full understanding of the agreements and mechanics with any potential participants prior to joining the pool. Loss and exposure data will be collected and analysed and a number of discussions will take place between Nexus Re underwriters and the captive and parent, usually involving risk management, accounting and tax personnel from the parent. Nexus Re does not interfere with any of the existing captive arrangements and provides reinsurance to the captive based on existing renewal dates and programmes. There will be no impact on any fronting insurers, third party administrators or direct issued captive policies. The captive will enter into a reinsurance agreement to cede risks to Nexus Re, and a separate retrocession treaty agreement will handle the business reinsured back from Nexus Re to its pooling retrocessionaires.
What security does Nexus Re provide?
Each captive retrocessionaire of Nexus Re is required to provide collateral to secure its obligation to the Nexus pool. Therefore in the event of the failure of a captive, or its parent, the outstanding losses of the pool are protected, minimising the credit risk of participation.
How can participation be terminated?
Although Nexus Re always recommends that captives and their parents take a long-term view, there is an appreciation that circumstances, risk management approach and the financial position of the parent company can change, resulting in a decision to cease participation. The Nexus Re contracts are annual and therefore need not be renewed if they no longer meet the client’s needs. As all obligations have already been secured, there is no concern for Nexus Re or other participants of a captive leaving and being unable to meet future claim payments.
How has Nexus Re performed?
Compared to the break-even goal, the Nexus pool has achieved a loss ratio of 98 percent since inception for all years combined. There are fluctuations by year and between captives, but our long-term objective is being achieved and those captives that have participated and continue to do so, will benefit from this long-term result.
To summarise, Nexus Re is a long-established Cayman Islands domiciled and regulated reinsurance company providing a pooling mechanism which enables captives to underwrite third party risk in a controlled environment.
Helen Stephenson is vice president and senior underwriter at Nexus Re. She can be contacted at: email@example.com
United in Cayman
Cayman has long been associated with captives—particularly healthcare captives, and more recently with catastrophe bonds—but perhaps it is less well known as the home of United Insurance Company (United), a unique reinsurance company providing innovative reinsurance capacity to captives, wherever they are domiciled. United was established as the first true reinsurance company in Cayman in 1975 and has been successfully supporting captives since then. The uniqueness of United relates to its ownership by captives of leading US, Canadian and European multinationals, many of which are household names. However, unlike a mutual, United is not limited to reinsuring its members, but provides insurance and reinsurance solutions to a wide range of captives. United holds an AM Best rating of A- (Excellent). United contracts professional management of its operations to Aon Insurance Managers (Cayman) where a dedicated team perform underwriting, claims and accounting functions on behalf of the company, all under direction of the board of directors who represent the company’s shareholders. In addition to providing traditional property, marine and casualty reinsurance to captives, United has specialised in risk-pooling for more than 30 years. Pooling enables for-profit captives of US parents to share their risks in a controlled environment, benefit from greater stability when it comes to losses and potentially qualify as a ‘true’ insurance company by means of the third party business they reinsure from the pool.
Nexus Reinsurance Company (Nexus Re) was established in 1998 as a wholly owned subsidiary of United to act as a dedicated risk-pooling entity. Nexus Re is domiciled and regulated in Cayman, but has taken a Section 953(d) tax election under the IRS code. For tax purposes, Nexus Re is a US taxpayer which eliminates the Federal Excise Tax which would otherwise be payable when captives cede and retrocede risks with a non-US reinsurer.