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Structured Insurance Programs

Donald Riggin | February 1, 2009

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Let's say that you're the risk manager for a large financial institution. Your directors and officers (D&O) liability insurance renews in a couple of months, and your broker is coming up dry. Nothing. Nada.

The current insurer has sent out notice of nonrenewal without the slightest interest in offering renewal terms at any reasonable retention, much less the expiring $5 million. Never fear, my desperate friend. There just might be a solution—a structured insurance program.

Structured insurance took its name from structured finance; that ingenious invention which allowed Wall Street to earn ungodly sums of money over the years and then promptly commits suicide. Aside from credit default swaps the most infamous example of structured finance is the collateralized debt obligation (CDO). This is the financial instrument that, fueled with subprime mortgages, managed to earn investment-grade ratings from the likes of Standard & Poor's. Alas, all good things must come to an end; too bad this party ended up destroying venerable old investment banking firms (Bear Stearns, Lehman Brothers), and crippling most of the others.

We, however, will not dwell on the current sadness. Structured insurance arrangements bear little resemblance to structured finance aside from the name. Now that structured finance is under a dark cloud, perhaps we should abandon the term "structured" altogether? But that's a topic for another day.

What Is Structured Insurance?

Structured insurance is a fancy name for a program with a significant amount of self-insurance—funded (not passive) self-insurance. Passive self-insurance is tantamount to a deductible or self-insured retention (SIR). Losses under passive self-insurance arrangements are paid from retained earnings or cash flow, not from any dedicated loss reserve fund. Before we finally decided on the term "structured," we used monikers such as "fully funded" and "finite risk." But, much to our collective dismay, these terms proved to be too straightforward, too obvious. Lots of people got into deep trouble using these terms, especially "finite." We needed another name. We needed a name that, as in the finance world, would sound very cool and at the same time provide the requisite amount of obfuscation. "Structured" seemed to fill the bill nicely.

Structured insurance converts passive retentions into a funded program—a loss reserve fund. Insurers that offer such programs do so in several formats, so we're going to focus on one popular variety: the cell captive approach.

A Structured Insurance Example

Now let's get back to your immediate problem—your D&O renewal (or lack thereof). The expiring program had a $5 million retention for Sides A&B separately. The premium was $1 million annually, but as Inspector Clouseau might say, "Not anymore." Now, to set up an effective structured deal, your company must be able to dedicate serious bucks to the endeavor. Let's assume that your firm is willing to allocate almost $20 million in a structured program. Here's how it might work.

Table 1. Sample Program Details
Coverage: Directors & Officers Liability (both sides or perhaps only Side A)
Insurance Limits (aggregate): $20 million
Policy Term: 3 Years
Policy Form: Standard Directors & Officers Liability
Coverage Vehicle: Excess and surplus lines policy written through L&M Insurance Company
Segregated Account: XYZ Insurance Company Ltd (a cell captive owned by L&M Insurance Company domiciled in Bermuda)
Structured Limit of Liability: $15 million
Excess of Structured Limit (provided by L&M or a reinsurer): $5 million

So far so good. Now let's have a look at how the financing might run.

Table 2. Sample Term Sheet
Gross Written Premium (cash): $8,478,500
Less Excess Insurance Premium: $2,500,000
Less LOC cost (about 54 bps): $45,000
Cash Ceded to Cell Captive: $5,933,500
Less Federal Excise Tax: $83,500
Less Ceding Commission: $750,000
Less Captive Management Fee: $100,000
Expected Losses Ceded to Cell Captive: $5,000,000
Cash Capital & Surplus: $1,700,000
Collateral (letter of credit): $8,300,000
Total Financial Commitment: $18,478,500
Excess Insurance Transferred to Reinsurer: $5,000,000
Total Policy Limit: $20,000,000

I know it looks confusing, but stay with me, and all will become clear. The best way to sort this out is to start from the bottom. Your goal was to structure a program that includes $20 million of insurance limits. Included in that $20 million is an excess layer of $5 million. So far so good.

Your total financial commitment of $18,478,500 is comprised of the following.

  1. Gross Written Premium, which includes expected losses, expenses, and the cost of the reinsurance layer ($8,478,500).
  2. Capital & Surplus ($1,700,000)
  3. Collateral ($8,300,000)

The ceding commission and captive management fee are paid to L&M Insurance Company, and the expected losses (as determined by an actuary on a prospective basis, not on a retrospective basis) are paid into the cell captive.

The reinsurance cost, $2,500,000, is of course paid to the reinsurer. So the captive's total funding, including expected losses, the capital & surplus, and the collateral is $15,000,000.

The collateral ($8,300,000) is, in this case, deposited into the cell captive in the form of a letter of credit to conserve cash. However, it certainly may take the form of cash. If anyone is confused at this point, please feel free to give me a call or write an email.

Tax and Accounting Issues

Far be it from me to dispense tax and accounting advice, so the following comments are for educational purposes only. From an accounting standpoint, FAS 113 provides the guidance, which states, among other things, that a reinsurance transaction must include a reasonable chance of a significant loss. This applies to Generally Accepted Accounting Principles (GAAP). For statutory accounting purposes (that which is used by insurance companies), the governing standard is the National Association of Insurance Commissioners (NAIC) SSAP 62. FAS 113 and SSAP 62 are virtually the same.

In our example, we have to look at two things: (1) the risk transfer percentage, and (2) the rate-on-line for the reinsurance layer.

In our case, the risk transfer percentage is 25 percent ($5 million divided by $20 million). Over the years, many practitioners applied what was called the "10/10 Rule." This meant a 10 percent chance of a 10 percent loss was thought to satisfy the reasonable chance of a significant loss mandate. Since the dust-up over certain finite reinsurance arrangements, few people use this rule anymore because there's not enough chance of a significant loss. Our example can be said to satisfy a "25/25 percent rule" if such a thing existed. If we hued to the old 10/10 Rule, our reinsurance layer would be only $2 million instead of $5 million.

Our rate-on-line is 50 percent ($2,500,000 premium divided by the $5,000,000). This is not a particularly low rate-on-line, but is probably low enough to constitute risk transfer as the present value of the premium will not come close to equaling the insured limit at the end of the 3-year policy term, especially at today's extremely low interest rates.

From a tax standpoint, the premium component ($8,433,000) might, I repeat might, be deductible from your U.S. federal income taxes. A prudent approach would be to deduct only the hard costs, e.g., the reinsurance premium, ceding commission, etc. None of the other expenditures would come close to qualifying for insurance treatment.

Capital and Surplus

Every insurance company, including cell captives, requires capital and surplus. As Bermuda's minimum premium-to-capital and surplus ratio is 5:1 on the first $6 million of premium, our capital and surplus ($1,700,000) represents roughly 20 percent of the premium.


So why would anyone opt to fund a structured program in lieu of just accepting a $20 million passive retention? I can think of two good reasons. First, in cases where a statutory or contractual need mandates evidence of insurance, structured programs provide first-dollar coverage. Certificates of insurance need not include a deductible or self-insured-retention. Second, using a structure can be an effective method of leveraging excess insurance capacity.

Through a single example, this article provides just a glimpse into the world of structured programsâ€"the tip of the iceberg, so to speak. Perhaps it has whetted your appetite for a deeper understanding of the subject. If so, contact me and I'll direct you to additional resources.

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