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When Is Reinsurance Not Reinsurance?

Michael Mead | April 1, 2005

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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.

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 insurer 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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