When Is Reinsurance Not Reinsurance?
April 2005
Reinsurance is a widely accepted and practiced
structure allowing primary insurers to manage their portfolios of risk. Excess
insurance does much the same, but there are critical differences to the captive
owner. Both forms are insurance of insurance, in a manner of speaking. They
are critically important to the overall success of the insurance industry.
by Michael
R. Mead
M.R. Mead &
Company, LLC
A captive owner rarely plans to retain 100 percent of all the risk to be
financed through the captive or risk retention structure. The actuarial analysis
and careful planning will suggest the level above which the owner will want
to seek finance from third parties. The form and structure of the reinsurance
product deserve and will require a great deal of the captive owner's attention.
Programs such as specific excess and aggregate excess with reinstatements are
available, but suit different purposes.
Some Caveats
The first caveat to the captive owner is to recognize that there is little
to no regulation or standardization in reinsurance. The use of a knowledgeable,
qualified partner is very important. Reviews of policy language and contracts
are essential to assure success. Terms, conditions, and exclusions can vary
widely from insurer to insurer, and from policy to policy. Increasingly we find
that elimination of coverage and restrictive terms have become hidden rate increases.
The second distinction to bear in mind is that reinsurance and excess insurance
are not necessarily the same thing. Reinsurance of a captive sits above and
behind the captive's layer, and can in many circumstances be called upon in
the event that the captive does not or cannot respond to a claim.
Excess insurance, in general, does not always respond to a claim below its
attachment point, regardless of other issues. This form is referred to as Straight
Excess. Because of the feature of not responding below their attachment point,
known as dropping down, straight excess policies can be less expensive to purchase.
This position can, and has been, changed in litigation, causing some excess
writers to be very cautious in application of the straight excess policy.
Tax Issues
Beyond the premium however is the issue of taxes paid by the captive. If
the captive is purchasing reinsurance of itself, and showing limits beyond its
own financing limits, then it will be responsible for taxes on the full amount.
If the captive is purchasing excess insurance above its limits, then the taxes
may not be applicable.
An example would a policy with a limit of $1 million, in which a policy issuing
insurer writes the policy, and cedes $250,000 to the captive, along with the
premium. The policy issuing insurer may then offer risk transfer above and behind
the captive, aggregating losses at $250,000 annually. The captive would pay,
if required by its domicile, a tax on the premium for the $250,000.
In the example, if the captive were to write a $1 million policy either with
no admitted policy issuing insurer, directly, or reinsure the policy issuing
carrier 100 percent and then itself purchase reinsurance, it would then owe
taxes to its domicile on the entire premium. To reduce domicile taxes, the insured
could purchase excess coverage, over and behind the captive, thereby shifting
or eliminating some taxes.
Much more is required in the analysis of the structure of reinsurance, but
one advantage of a captive is to control your own costs. Close scrutiny of structures
may help in reducing taxes. When it is your money, any part of the expense load
in the transaction is worth investigating, in my view.
Other Concerns
The most recent Fronting/Risk Sharing Survey conducted by the Captive Insurance
Companies Association (CICA) indicates that concerns about reinsurance now top
concerns about availability of fronting partners. This indication is borne out
anecdotally in the many stories about downgrading of reinsurers. Captive owners
should carefully study the financial strength of their reinsurers. Choices may
not abound, particularly for healthcare and construction owners, but one should
not take the first offer.
A form of reinsurance/excess which is currently under scrutiny is the finite
policy. Simply put, a finite policy is limited in paying losses to the funds
on hand, and when the policy expires, the premiums may be returned to the policyholder,
sometimes with interest. Current investigations center on the validity of risk
transfer in these transactions. One must bear in mind that these policies can
be structured to meet all regulations and guidelines, and that much care must
be used when doing so. If done properly, a finite policy can be a useful application
of reinsurance. Done improperly, it can jeopardize the entire captive and its
use of tax deductions. The fines and penalties can be significant and commercially
terminal.
Students of the game will wonder about the difference between a finite policy
and a retrospectively rated program with the losses projected to ultimately
being fully secured with an irrevocable evergreen letter of credit. In many
ways, they are similar, but retrospectively rated programs are not being challenged.
Perhaps they will make a comeback.
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