Expert Commentary

What's in Store for 2004 for Alternative Risk?

This month's captives risk management column looks at how the 2003 predictions made here fared and comments on what is predicted for the upcoming year.

January 2004

At the beginning of a new year for capital and surplus and reserves and underwriters and executives, it behooves me to offer some thoughts on what may well be in store in the peculiar area of captives and alternative risk mechanisms. To put some of this in perspective, let me take score of what I predicted last year at this same time, and offer my hindsight criticism for your benefit and amusement.

The commercial property-casualty market will not see reduced pricing or increased availability of coverage and limits in 2003. I feel confident in that statement.

This prediction proved to be on target. I am tempted to repeat the prediction for 2004, but I feel that some areas will see increased availability of coverage, but it will be limited. Pricing will not show any meaningful reduction for companies that would traditionally consider a captive as an alternative. The medical profession will continue to face some tough choices, and it will share the pain with regulators, legislators, and others. In a major election year, I fear that some quick and easy—though conceptually flawed—solutions will be put forth. In the heat of promoting perceived action by their elected officials, I doubt if serious time will be devoted to thoughtful reform of the system.

Risk retention groups will get more attention as risk sharing/fronting partners are all but universally opposed to getting involved with medical malpractice and other professional lines of coverage.

Risk retention groups (RRGs) will receive a great deal of deserved and undeserved attention. RRGs are a terrific alternative risk finance mechanism, but they have limitations. The Risk Retention Act limits coverage to selected liability coverages, specifically excluding workers compensation and private automobile lines. Also, property lines are not included.

Regulators and the aforementioned public officials are currently examining the Act to determine if expansion, particularly for property lines, is appropriate. Already much of the debate is out of focus due to the well-publicized collapse of a large auto warranty RRG, domiciled offshore under a grandfather provision of the original 1981 Act. This failure, while unfortunate, owes little if anything to the Act and risk retention group structure or regulation. Poor management is lamentable but should not wrongly taint the entire industry, which was in no way involved.

The new record-keeping and reporting requirements both onshore and offshore will cause many deals to be deferred or canceled as there will not be enough time or people or systems to comply. Without adequate resources and facing low returns, insurers will renew a few accounts and take a pass on most new submissions.

This did not develop. To the credit of regulators, underwriters, and all involved, extra time was taken, and in my experience few deals were deferred or canceled due to new requirements or regulations. Any rejection of new submissions was essentially for sound underwriting reasons, or the slow realization of the proposed captive owner that a captive may not be the solution originally hoped for. I trust that this will remain the case in the coming year.

The risk sharing partner community is changing, and not necessarily for the positive for captive owners. The remaining partners must become more selective in putting forth their paper, and they will do so. Their shareholders will demand it. They will want to see larger deals, with great loss pictures and substantial financial resources put at risk.

Consolidation and mergers in the industry have continued involving major insurers to a degree unimagined a year ago when the above prediction was made. I suspect that the coming year will see a continuation of the trend. Many observers acknowledge the weakness of some large, key insurers. Any pressure to make their unknown liabilities for asbestos shown on balance sheets could be the death knell. Thus, this observation remains valid for the coming year.

A backdrop for the coming year is the ongoing challenge to the regulatory system. When risk sharing firms review their successes and failures from last year and opportunities for the coming year, they will be watchful of the changes that may arise from regulatory change. As the National Association of Insurance Commissioners (NAIC) presses its member state Directors of Insurance harder for reform to fend off the mounting call for federal regulation, it will have to step up in making the call about unrecognized asbestos liabilities. The loser could be a major insurer.

As I have urged elsewhere, regulators and lenders are going to have to reconsider their requirements for the ratings of insurers. This is also a discussion for another day, but I will continue to call for action in this area.

This point, which remains an open discussion, is closely related to the above comments about state regulation. As some openly urge substitute federal regulation, others are questioning the wisdom of unregulated, privately-held rating bureaus to kill an insurer by dropping a rating a small degree. I await a clear explanation of the difference in ultimate security between an A.M. Best rating of A- and one of B++. And why does a lender demand evidence that it does not clearly understand. Acceptance of B paper by regulators and lenders would materially ease the tightness in the marketplace.

As a proponent of alternative risk financing, it behooves me to say that not everyone should be in a captive. Your best bet may be to pay the premium, if you can get a quote. ... Alternative risk finance has always meant that you pay your own way. Inherently, that means that you must have the resources to do so. Increasingly as the market withdraws, limits coverage, and raises retentions, the alternative participant will be required to put in more resources, to the point that the deal may not make sense.

While this is not an answer, or prediction, it is a fact that is as important in the coming year as it was in the last. Paying a tax deductible (probably) premium may always be your best option. Captives are not the answer to every premium/deductible/increase or coverage restriction. They should investigated, but with a sensible eye to the true costs of risk transfer.

While the commercial property/casualty industry is enjoying good profits, it is a very long way from restoring adequate surplus. It may be 5 years before adequate capital and surplus are restored to pay claims that exist today. Each time an insurer goes by the boards, it leaves more claims to be parceled out to the survivors.

Since a year has passed following that statement, one could conclude that we have but 4 years remaining until the next downturn in rates and premiums. In fact, with the shifting tides of asbestos reserves, professional liability claims increases, challenges to the regulatory system, and consolidations, I feel far less comfortable in making a prediction this year. The discomfort does not reside in fearing a quick return to soft pricing; I don’t see that occurring for some years.

My discomfort is based on the number, variety, and scope of challenges facing the industry. Captives, et al., will remain a popular, sensible choice for the informed risk manager. Indeed, their number and uses will grow in the coming year, at least to the degree that we saw in 2003. But the larger industry faces some interesting times. Stay tuned.

The author has an ownership position in three captive management companies, but is not in a captive management position.

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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