Sue Copeman looks at those areas of alternative risk financing where companies can derive real value

While a number of innovative and often complex alternative risk financing deals have been discussed recently, relatively few have actually come into being. For most European companies, the more usual alternatives to insuring in the traditional market are establishing their own captive insurance companies and, in some sectors, participating in a mutual.

A collective approach

The problems that can arise in getting a number of competitive companies to agree to underwrite each others' losses have been well aired. And mutuals can often lose their attractiveness in a soft insurance market. However, they do seem to have the potential to work well in those industries that underwriters, perhaps unfairly, view as high risk.

One of the best examples of this is the energy companies' mutual, Bermuda-based Oil Insurance Limited (OIL). This started on 1 January 1972 with 16 shareholders and has grown substantially since. For example, 22 new members joined in 2002 and 10 in 2003, bringing the total number of shareholders at 1 January 2004 to 81.

Since then, OIL has gained another three new members - Electricite de France (EDF), the government owned-electric utility, Yara International ASA, Norway, and XTO Energy Incorporated of Dallas, Texas. In the words of Jack L Wesley, president and chief executive officer of OIL, "For 32 years OIL has provided one of the largest blocks of catastrophe property damage and pollution liability insurance capacity available, enabling international energy companies to utilise their OIL entry as the cornerstone of their overall insurance programme."

OIL provides a broad form of coverage and insures both property and some liability risks. Slightly more limited in its scope, and very much the new kid on the Bermuda block, is Pharmaceutical Insurance Ltd (PhIL), which provides excess property damage and business interruption insurance for the pharmaceutical and medical products companies that own it. Formed with assistance from Willis Group Holdings - the company is managed by Willis Management (Bermuda) Ltd - PhIL opened for business on 1 July last year.

Why did the pharmaceutical companies decide to set PhIL up? Neil Campbell, director, risk and insurance, of AstraZeneca plc, one of the founder members of PhIL says: "When we first looked at the concept, the prevalent property damage and business interruption premium rates and coverage restrictions did not reflect the excellent claims experience or superior risk management of the industry. In short we believed we were subsidising other industries.

Capacity had also become a problem, particularly for natural perils."

Other founding members of the new mutual include the parent or captive insurance subsidiary of the following companies: Aventis SA; Baxter International Inc.; Becton Dickinson and Company; Bristol-Myers Squibb Company; GlaxoSmithKline plc, and Sanofi-Synthelabo. It seems likely that other pharma companies will apply to join in the future. Eligibility depends on having:

- Annual revenue or turnover of at least US $1bn, with at least 75% of sales being pharmaceutical and/or medical products-related

- Rateable assets of at least US $1bn. (These are defined as the sum of inventory and plant, property (excluding land) and equipment, all before depreciation, in accordance with US GAAP or equivalent)

- An active and formal loss prevention programme.

Campbell believes that PhIL offers some significant benefits to its members.

"It reduces the cost of risk substantially through lower premiums, broader coverage, ability to access the reinsurance market as a collective, and introducing competition."

At the moment PhIL insures property damage and business interruption risks. Campbell says there are no plans for it to evolve into a liability insurer.

Turning to captives

For most European companies, however, mutuals are not a feasible option, and it is the captive insurance route that holds the greatest attractions.

Despite legislation that has largely removed the tax advantages of setting up a captive offshore, having a captive is still an attractive proposition for larger corporations. Even in the recent soft insurance market, captive formations continued.

Typically, it is well established companies which set up captives, although they are not necessarily multinational corporates, says Oisin Ryan of Interpolis Captive Management Services Ltd, Dublin. "The set up costs involved mean that most interest comes from mature companies, rather than those that have just been going for a few years. Having said that, much depends on the growth of the company. Probably some of the companies that were launched two or three years ago set up captives very quickly because they had lots of cash right from the start - but that's not the norm."

John Copeland, head of Marsh Management Services' Guernsey office, says that a company needs to be able to pay about £500,000 of premiums into its captive, which generally means that it will have been paying premiums to the traditional insurance market of at least £1m. "You have to remember that the captive will only be retaining risk at the lower end of the scale and will need to buy catastrophe reinsurance. There are also the running costs, so that's the sort of level that makes it viable."

Benefits of captives

It is often insurance market conditions that encourage a company to look at this option. Not surprisingly, Ryan says that interest grew in the recent hard insurance market. "However, I believe that it is much better for a company to set up a captive in soft market conditions, because you should have the excess cash available in order to justify it to your boss when the market turns hard. That would be ideal. But people don't look at it like that."

Copeland's view is that companies that decide to establish a captive often do so because they feel they are being ripped off by the insurance market. "They are paying out money for premiums and they don't see it coming back as claims payments. So they decide that they are willing to take risk back onto their balance sheet in a controlled way."

As well as choosing an appropriate domicile, companies also need to decide what type of business to put into the captive. Ryan emphasises that it should be profitable. "If the captive is not in the black you have to fund it on an ongoing basis, which defeats the purpose. The ideal risks are high volume low value risks which are predictable, rather than the big exposures that could wipe out the captive's balance sheet.

Copeland says: "In the captives that we manage we see almost every line of business. There's no hard and fast rule, although most companies to begin with look at their property damage/business interruption risks or their liability exposures."

Many companies review the captive insurance strategies annually. Ryan believes that if the captive is writing the kind of business like directors and officers liability, where the traditional market approach can change significantly from year to year, companies have no choice but to review regularly, because the reinsurance market that they rely on for capacity to protect the captive is changing so much itself. "You have to move with the market," he says.

Copeland agrees that monitoring the traditional insurance market is key to deciding your captive insurance strategies. "If the insurance market premiums double, you might to decide to increase retentions in the captive to maximise savings. It's a matter of using the captive in combination with the traditional market. And captives' programmes can change significantly from one year to the next."

So what are the benefits? Copeland says: "The best captives work where you look at your risk management processes in parallel to starting the captive. It is a truism, but generally the long-term solution to paying high premiums is to reduce your losses. So if you can divert premiums to your captive and improve your claims experience, you are going to get a good result." Coupled with this, there is usually a greater board focus on risk management issues when a captive is in place. Copeland explains: "Instead of just looking at the expense of the premiums, the board are looking at the whole process. They want to see profits coming out of the captive."

Value in a hard market

Nigel Blore, group risk manager, Transport for London, gives a risk manager's view. "At the risk of stating the obvious, the captive does provide some stability at a time of great volatility in the insurance market. It represents a buffer against major price increases and restrictions in cover, as well as giving the market confidence that, as an insured, you are prepared to back your judgement with your own capital in terms of the retention that you keep.

"I would suggest that a captive has never been more valuable than during the current hard market. Certainly our captive has given us the flexibility to maintain insurance protection at an acceptable cost. In our case we are able to use our captive in the way it should be used, which is as a risk financing and risk management tool. As a non tax-paying entity, unlike most commercial companies with captives, tax issues do not get in the way of what should be the primary purpose of having a captive insurance company. Nevertheless, to ensure the highest standards of corporate governance, it is important that the captive maintains underwriting and management independence"

While the whole point of having captives is to reduce costs, overheads can be high - and of course there is no guarantee that the captive will produce a profit every year. Indeed, there have also been a few captive closures recently.

Ryan suggests that the finance director of a company that is going through a difficult period could view the captive as a 'pot of gold'. Closing it not only reduces overheads but also releases funds, representing a quick fix for the needy.

Copeland agrees that shutting down a captive is often a short term gain, although he understands why some large companies may consider closing a captive that insures purely short tail business. "They save the running costs, they don't have to pay insurance premium tax and, with the change in the CFC (controlled foreign companies) rules, the tax position generally is less attractive, with 90% of the captive's profits having to be transferred back to the parent as a taxable dividend."

Nonetheless, the trend continues to be growth in captive formations, proving that for most large companies they are offering a valuable alternative to the conventional market.