Amy Dadarria discusses self-insurance options and the use of captives

The phrase 'Alternative risk transfer' (ART) is somewhat of a misnomer. Many ART options embrace a significant element of self-insurance and therefore 'risk transfer' misrepresents a large portion of the choice available in the market. However, ART has become the common term for referring to those options and products which fall outside the practice of paying a premium to insurers in exchange for an indemnification of contingent liabilities resulting from losses of insured perils.

ART solutions are not new. However, the hard insurance market has heightened risk managers' interest in learning about their applicability to their organisation's particular risk profile and risk appetite.

What options are available for protecting your company's balance sheet and earnings in the most cost effective manner? Before exploring ART solutions, it is important to consider the issue of self-insurance. Increasing the company's exposure to potential losses, whether by choice or because of lack of capacity, is the first step in moving toward ART solutions.

There are many reasons why self-insurance may be part of the overall risk financing strategy. These include:

  • a limited or non-existent conventional insurance market
  • an expensive conventional insurance market in relation to one's own loss experience (ie underwriters making money on the company's account)
  • a conventional market that does not provide good value, with too much of the original premium evaporating in acquisition costs, frictional costs and other overheads
  • the cycles occurring in the conventional market – premiums rates often rise and fall according to industry conditions, not because the underlying risk has changed
  • unattractive terms offered by the conventional market (for example exclusions or insufficient limits).

    The level at which self-insured exposure is set is driven by an entity's ability to withstand potential self-insured losses, its cultural tolerance to potential self-insured losses, the options available, and market conditions. In today's market, self-insurance is often being imposed by insurers increasing the level and structure of deductibles and excluding certain risks. Exposure to self-insured risk is mitigated if the company has a good loss history and sound risk management practices.

    Once the risk manager has established what level of self-insurance he has elected (or has been forced) to assume, he should explore ways in which to treat the resulting exposure.

    It is important to note that the company is not indemnified by a third party for losses that occur within the levels of self-insurance assumed. For self-insured exposure that is unpredictable, or where there is exposure to large-scale single incidents, the company is at risk of increasing the volatility of its earnings if losses are unexpectedly high in any given year. While it is not the only motivation, ART products are often useful for balance sheet or income smoothing that enables the company to reflect an even level of losses in the company's financial accounts, even though actual losses may fluctuate from year to year.

    Self-insured retentions can be dealt with on a stand-alone basis, or be combined with an element of risk transfer. The structure of the solution will affect the ultimate choice of ART options.

    Where self-insured retentions are dealt with on a stand-alone basis, there are three basic methods for financing self-retained risk, with permutations on each. They are:

  • expensing basis – suffering losses as they fall
  • setting aside a fund out of which losses can be paid until the fund is exhausted (worst case) or topped up over a period (best case)
  • creating a formal self-owned insurance vehicle, for example a captive, a protected cell company, or a cell within a protected cell company.

    Expensing basis
    While the expensing basis is not considered an ART solution, it is one of the range of options available when dealing with self-insured retentions. This approach means paying self-insured losses from cash flow as they occur – the simplest form of self-insurance.

    The advantage of this approach is that money that would otherwise be paid out in premiums is retained and is available to spend elsewhere. Claims are paid when settled, which can be several years after they are first notified. The main disadvantage is that unpredictable losses make the income and cash flow budgeting process difficult. Any reserves made against claims notified are not usually tax deductible.

    Virtual captive
    The virtual captive can be interesting for companies with a decentralised group structure, or for any entity wanting to create a real cash fund that is used only to pay insurance losses. Contributions ('premiums') are collected and are set aside in a reserve, or contingency, fund for the payment of retained losses. This involves pre-loss financing (as distinct from the expensing basis mentioned above) and can be a suitable method of financing higher levels of retained risk.

    The main advantage of a virtual captive is that it provides the opportunity to enhance control of the risk management strategy. By centralising and benchmarking loss experience across the company, poor loss experience can be highlighted, and attention focused on where better risk control measures should be put in place. Premiums paid by each operating company can be adjusted to reflect poor or good loss experience in order to encourage them to improve their loss experience.

    A virtual captive can sometimes improve leverage over insurers. As the virtual captive matures and its fund capital grows, it justifies the retention of greater portions of the parent's risk. This in turn diminishes the dependence on commercial insurance and can improve the bargaining position when purchasing commercial insurance. However, this advantage is more relevant in a buyer's market than in the current hard market conditions.

    A virtual captive is an internal structure, and thus avoids the formalities and costs associated with the establishment and operation of an insurance subsidiary. A key drawback is that the fund created to pay losses is often raided for other purposes. Also, there is no benefit of income smoothing at the consolidated group level, although individual operating companies will replace losses with insurance premium and thus benefit from known expense level. Premiums paid to the virtual captive and any claims reserves made by it are not generally tax deductible.

    Captive companies
    A captive insurance company is an entity formed primarily to insure or reinsure the risks of its sponsor. Captives are most frequently owned by a single legal entity, although there are a number of captives owned by consortia and associations, which mutualise or pool the risks of each participant.

    Captive insurance companies are usually formed in domiciles that recognise the unique characteristics and objectives of captives and regulate them accordingly. The number of captive formations continues to grow, with the rate accelerating in hard markets.

    Captives are either wholly-owned, rent-a-captives or protected/segregated cell companies. A captive can make good financial sense if its premium income will be sizeable enough to justify the additional expense of setting it up and if its business is expected to be profitable.

    Captives are a popular method of maximising the benefits of self-insurance. They can provide both financial and insurance benefits. However, they do have some disadvantages.

  • Capital commitment: The parent company must contribute capital as required by the applicable domicile's insurance regulations to underwrite the risks that are assumed by the captive.
  • Operating costs: The formation and operation of a captive entails various expenses, including organisational costs, management fees, legal and auditing fees and insurance premium tax (IPT). In addition a captive may require a commitment of the company's time and some travel costs. The extent of these costs will depend on the type of captive structure utilised.
  • Fronting costs and capacity: Captives in most domiciles cannot write statutory insurances directly, such as motor third party liability and employers liability. Dublin and Gibraltar allow direct writing in other EU member states, but for reasons of market security, a front may nonetheless be required. Fronting insurance companies are sometimes required for credit security reasons, when a third party is reliant on captive payments and, in such cases, the cost may be up to 10% of captive premiums. And as fewer companies are willing to front now, there may be only limited opportunity to write these risks through a captive.
    Captives and other forms of self-insurance have been around for a long time and now barely justify the tag 'alternative'. There are, in addition, numerous other and newer forms of ART products. All forms of ART and, in particular, captive-type self- insurance structures are attracting greater interest as a result of the prevailing market conditions.

    Amy Dadarria is managing director, Ark Consulting (London) Ltd, the London-based consulting arm of the Heritage Group, Tel: 020 7621 3701, E-mail:

    Captive benefits
    Financial Captive insurance companies offer the potential to:

  • smooth the impact of actual losses. A fixed annual captive premium expense replaces the periodic and probably uneven recording of losses as they occur
  • efficiently finance loss reserves. Captive premiums paid to the captive by a company or partnership are tax deductible. Premiums remain in the captive and earn investment income in a low tax environment until required to pay claims
  • participate in the underwriting profits of the sponsor's own account
  • stabilise insurance pricing. Insurance is a normal cost of business, but premiums fluctuate according to market conditions. Captive premiums can be set at a level that is relevant to the underlying risk profile, and not subject to the rate swings of the general insurance market.

    Insurance In addition to enhancing the focus on risk management and the leverage over insurers, as is the case with a virtual captive, an insurance subsidiary offers the potential to:

  • provide insurance capacity to the sponsor. A captive can accept risks that under normal circumstances would not be available in the commercial market
  • provide more beneficial wording. The regulation of captive domiciles usually allows more broadly worded insurance and reinsurance contracts. However, where the captive layer underpins a succession of conventional excess layers, underwriters of the excess layers will wish to ensure that a broadly worded captive primary layer does not erode more quickly than a conventionally worded policy. On the other hand, claims that would not erode the excess layer, known as 'non-ranking', can still be dealt with by a captive policy.

    ART products
    In addition to captives, there is a wide range of ART products that can be tailored to specific needs. They include the following.

  • Multi-year and multi-line policies (MMP) – purchased by an insurer and allowing it to benefit from reduced pricing gained from pooling uncorrelated risks and/or guaranteeing a premium to the insurer over a number of years, irrespective of the actual loss experience. However, in today's hard market, insurers are less willing to enter into these contracts.
  • Multi-trigger policies (MTP) – combining two separate events and only paying out when the second insured loss event occurs. The second trigger is normally pegged to an index out of the insured's control. Examples of the indexed triggers are commodity prices or interest rates. The insured has the advantage of beneficial rates where the insurer deems that the underlying triggers are uncorrelated, together with indemnity against severe financial loss when a traditionally insurable loss is coupled with an adverse economic development.
  • Contingent capital – connecting insurance and capital markets. Here a counterparty (which could be a bank as well as an insurance company) gives a contractual commitment to provide capital in the event of a pre-determined loss event. The insured can access the capital committed at a price that is less than it might be if the insured attempted to raise capital after the loss event.
  • Credit enhancement products – these take many forms and include collateralised debt obligations and credit default swaps.
  • Insurance linked securities – enabling the transfer of traditional insurable risk to the capital markets to increase insurance capacity, and mostly achieved using catastrophe bonds or life bonds.