Expert Commentary

The Economic Bailout and Its Unintended Consequences

Events are moving quickly in the insurance world and our little slice of it. It behooves one to keep up to the extent that you are able to do so.


Captives
April 2009

It is no longer conjecture that the federal government will be involved in the regulation of insurance; the only question now is how and when. Bills to regulate some or all insurers to varying degrees have been introduced. Whether or not they will pass this time around with all of the other issues confronting the Administration is problematic, but the probability is certainly greater than in years past. This is an issue which bears a close watch to determine the effect, if any, on captives, but it is not the subject of this article.

Beyond regulation, the "Law of Unintended Consequences" is now arriving on the captive scene in the form of fallout from bank failures and bank problems being addressed by the Troubled Asset Relief Program (TARP).

The "economic crisis" affecting much of the world is showing itself in surprising ways to captive owners and managers. If you have not yet encountered the issue, then this discussion may help you prepare.

Reinsurance and Collateral

Two strong influencers of captive success, reinsurance and collateral, are both being affected negatively, and the pain is spreading. Late last year, many captives began to find that the cost of letters of credit and other forms of collateral were getting more dear as the banking industry struggled with its problems, well discussed elsewhere [see Captives and Collateral (August 2007)]. Banks began to restrict the lines of credit, and/or negatively adjust the terms of letters of credit supporting the captive's collateral.

Collateral Alternatives

At the same time, many fronting companies were beginning to increase their collateral requirements, causing the captive owners and managers to consider alternatives. One of the alternatives was the purchase of reinsurance at lower attachment points. By reducing the limits written by their captives, they were able to obtain reinsurance at lower levels, thus reducing the amount of collateral needed to support their letters of credit, and reducing the letters of credit themselves.

This strategy is definitely a short-term solution based largely on then reasonable reinsurance terms. It made sense to take advantage of the market in the fourth quarter of 2008. In the first half of 2009, that position must be reconsidered.

Rising Reinsurance Rates

Coming into play now is the predicted rising rates for reinsurance. Some have observed that this may be in the category of a self-fulfilling prophecy, but the facts show that reinsurers had a tough year in 2008 not only from natural catastrophes but also investment losses, along with the rest of the world. These losses must be recouped, and there is only one way to do that—raise rates. The midyear renewals should see the first effects of this strategy and may well carry forward for quite some time.

Bank Problems

Intersecting the rising rates are the credit crunch and the troubles of banks. As captive owners evaluate their existing and proposed letters of credit, bank lines of credit, and the size of their deposits in the banks, fronting companies and reinsurers are considering their exposures to troubled banks. This is a very delicate situation that must be navigated with care and skill. Who is to judge the maximum amount of money to be deposited in major banks whose share prices have plunged and who may be hanging on to solvency by a federal thread? At what point are directors and officers of a captive exposed to the consequences of choosing a bank which defaults and ties up or destroys assets needed for claims and capital? What is the role of regulators in this process? Will they be state regulators or federal?

Some fronts and reinsurers have preempted the captive owners' analysis by restricting the overall exposure of the front/reinsurer to the banking exposure. In some cases, captives have been advised to find another bank to hold their deposits or to issue their collateral support. The fronts/reinsurers are seeing a genuine credit risk from some of the leading banks.

To the front/reinsurer now comes the same question being asked of the directors and officers of the captive posed above: When is the company at risk for using a "threatened financial institution"? The quite natural response is to limit exposure. Banks are being rejected as acceptable issuers of letters of credit or as acceptable depositories, even while the banks in question continue to be licensed and to operate.

What is now the process to select the financial institution for your captive if it is licensed, operating, but may have appeared on a fronting company/reinsurer's "do not use further" list? How do you renegotiate your attachment point as reinsurance rates rise and collateral becomes more sticky? How will you renegotiate collateral with a federal regulator, whether that regulator is an insurance authority or the overseer of a failed financial institution, be it bank or insurer?

Conclusion

I suggest for your consideration that, if you have not yet encountered these issues, you will before the year is done. In keeping with the purpose of captives as vehicles of control, it behooves the prudent owner/manager to be in early discussions with the fronts, reinsurers, and banks to be in agreement and to quickly put terms in place that will provide the captive the best opportunity to succeed.

There are no quick, easy answers for this unintended consequence, just as there none for the other parts of the current economic crisis. But early airing of the challenge, and prompt and frank discussion of alternatives, will serve us well going forward.


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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