The most common reinsurance relationship is the one between a direct writing insurance company (the "reinsured" or "cedent") and its third-party reinsurers. A typical insurance company may write various types of insurance policies for several types of risks and generally will keep skin in the game by retaining portions of the risks it assumes through the insurance policies it issues to its policyholders. The reinsurer may reinsure all or part of these policies or just a certain line of business as specified clearly in the reinsurance contract. All of this, of course, is at arm's length.
Direct writing insurance companies, however, are not the only entities that issue insurance policies or similar evidence of coverage. Many other risk-bearing entities issue coverage, including captive insurance companies, government-related risk pools, risk retention groups, and other types of pools or risk-sharing entities. These entities are formed for various reasons, often relevant to taxes, the cost of purchasing insurance in the open market, the availability of insurance on the open market for government-related and other hard-to-place risks, and the belief that the risks can be managed better internally.
What distinguishes these risk-sharing entities from a "typical" insurance company is that the coverage they issue is limited to either one insured (or an affiliated group of insureds) or to the members of the pool or entity. Generally, there is a close affiliation or relationship between the entity issuing the coverage and the entities being covered.
For example, a captive insurer for a manufacturer will only issue policies to the manufacturer and its affiliates. The captive insurer is most likely a subsidiary of one of the companies in the manufacturer's corporate structure. Management of the captive may be closely tied to the manufacturer's risk management operations.
For a government or municipal risk pool, the pool will issue coverage to only the members of the pool. The pool will be governed by a board of directors that consists of directors who are representatives of each of the individual pool members. For example, if the government risk pool covers six sanitation districts in a particular county, the governing board of directors will include one representative from each of the sanitation districts. Most likely, the directors will be part of each sanitation district's risk management team or senior officials of those districts. Under this scenario, the insureds are managing the entity that is issuing coverage to them.
This commentary will not cover the regulatory issues associated with these risk-sharing entities—which are many—but will focus on the issues arising from reinsurance coverage provided by third-party reinsurers to these entities.
Coverage Grants and Risk Structures for Captives and Pools
Captives, risk pools, and similar entities may be structured in a wide variety of ways. For example, they may issue coverage with minimal limits and then purchase excess insurance to cover the maximum amount of liability they wish to insure. Alternatively, they may issue coverage with the maximum limit they are prepared (or allowed) to issue and then reinsure most of the limit while retaining a minimum amount.
These structures can be more complicated when affiliated or captive reinsurers are in the mix and the risk is shared among them and perhaps a third-party reinsurer covering the excess limits for a more catastrophic loss. Some structures may involve a fronting company issuing policies and reinsuring 100 percent with the captive, which then retrocedes a portion or most of the risk to the third-party retrocessionaire.
However, risk structures are just part of the administration of these entities. How these entities manage claims may differ drastically. For example, a captive or pool might have its own claims administration staff just like a direct-writing insurance company. Alternatively, the captive or pool may engage a third-party administrator to manage the claims. In some structures, the reinsurer will have claims handling responsibility, especially if they are assuming most of the risk. How claims are administered and paid are key elements that help determine the correct reinsurance structure used to support the captive or pool.
From the third-party reinsurer perspective, reinsuring a captive, pool, or similar entity raises the typical underwriting issues faced when considering a proposal to reinsure a typical direct writing insurance company. But these risk-sharing entities also raise all sorts of other issues that typically do not exist when reinsuring a direct-writing insurance company.
For example, whether the captive or pool has the personnel, knowledge, and administrative structure necessary to issue coverage and manage any claims that might arise are essential criteria that the reinsurer needs to know. Without the right personnel, the wrong coverage could be issued, and claims may be mismanaged. Just assuming that the managers of the proposed reinsured entity understand their obligations to administer coverage grants and to manage claims in a professional manner is dangerous. Some of these entities, especially small municipal risk pools, are thinly managed and may have very little experience in adjusting claims. They may rely on defense counsel to lead them instead of professionally managing the claims.
Pre-underwriting audits and periodic audits during the life of the reinsurance relationship (and runoff) are essential to a reinsurer's understanding of its counterparty. Relying on brokers or agents is not the optimal way of making sure that a captive or risk-sharing pool is a risk worth underwriting.
A reinsurer needs to consider the amount of risk being retained by the reinsured entity compared to the amount of risk the reinsurer is assuming. If the reinsurer is assuming most of the risk, the structure of the reinsurance contract should be different from a reinsurance contract where the reinsured entity is retaining a substantial amount of the risk. This is especially true if there is any question about the entity's ability to supervise and adjust claims.
Another issue that may arise is whether the entity's management understands the relationship between a reinsured and its reinsurer. A professionally managed captive or pool will understand that they must operate just like an insurance company. This means they must handle claims in a good faith manner without consideration of reinsurance. This includes having the personnel and systems in place to set reserves (again, without consideration of reinsurance), monitor outside counsel, create and maintain a claims file, and independently analyze the claim as the loss develops for purposes of setting reserves and adjusting the claim, including settlement.
Where an entity is not professionally managed and has extremely close ties to its insureds, improper consideration of reinsurance in the claims handling process may occur. This is especially true where the reinsurer is assuming the bulk of the risk. For example, the sanitation districts mentioned above are issued coverage limits of $5 million by the risk pool. The pool cedes all but $100,000 of the limits to its reinsurers. This creates a situation where there is less incentive for the risk pool to defend a case through trial. The reinsurer needs to be vigilant under this scenario to avoid a situation where the riskpool is relying on the reinsurer's assets to settle a claim that otherwise has legitimate defenses.
Where the risk-sharing entity is undercapitalized, the incentive to rely on the reinsurer's capital is more pronounced. An aggressive claimant's lawyer who makes settlement demands well above the coverage limit may cause an inexperienced risk-sharing entity to consider settlement within the reinsurer's coverage to avoid what it perceives as a possibility of an excess of limits verdict at trial.
Using the example above, one of the sanitation districts is sued when a pedestrian suffers a catastrophic injury after being hit by one of the garbage trucks. The pedestrian has an aggressive lawyer who demands multiples of the $5 million coverage limit to settle the case. An unsophisticated or inexperienced pool board may consider settlement up to the full $5 million limits as the best way to avoid the possibility of an excess of limits verdict, which would require the sanitation district to issue bonds to pay for any excess amount over the coverage limits.Using the example above, one of the sanitation districts is sued when a pedestrian suffers a catastrophic injury after being hit by one of the garbage trucks. The pedestrian has an aggressive lawyer who demands multiples of the $5 million coverage limit to settle the case. An unsophisticated or inexperienced pool board may consider settlement up to the full $5 million limits as the best way to avoid the possibility of an excess of limits verdict, which would require the sanitation district to issue bonds to pay for any excess amount over the coverage limits.
If in this scenario there are legitimate defenses to liability, but the pool board ignores those defenses and focuses instead on the availability of the nearly $5 million of reinsurance limits as its golden ticket, the reinsurer will find itself in an untenable position.
Another essential item to consider is the reinsurance contract wording. With a risk-sharing entity, there may be a need for claims cooperation, claims control, and other provisions that give a reinsurer active involvement in the management of claims to help mitigate the scenario discussed above. The more sophisticated and professionally managed the captive or risk-sharing entity is, the less concern should there be about day-to-day monitoring and management of claims. In those situations, the contract wording should be closer to the wordings used in "typical" reinsurance relationships.
Follow-the-fortunes and follow-the-settlements provisions need to be carefully considered when reinsuring a captive or risk-sharing entity. Many reinsurers try to write these out of traditional reinsurance contracts, and the incentive to do so with a smaller government or municipal risk pool is even greater.
These are some of the more important issues in reinsuring a captive or risk-sharing pool, but there certainly are others. Captives and risk-sharing pools, especially smaller governmental or municipal pools, raise myriad issues that go beyond the typical reinsurance underwriting of a direct writing insurance company. These entities provide a fertile source of business for reinsurers, but care must be taken in entering into these relationships to avoid unnecessary surprises.
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