Guide to Captives and Alternative Risk Financing

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Chapter 1: Overview

Risk Financing Options

All but the very smallest organizations devote significant financial resources to managing their event risks. These include the costs associated with removing risks from the balance sheet, the costs of loss prevention and claims management, and the costs of retained risk. As we discussed in the introduction, financing event risk involves three components: risk transfer capacity, the cost of that capacity, and the amount of retained risk.

With the exception of simple guaranteed cost insurance, every risk financing strategy includes all three of these components. Moreover, these three components are bound together; a change in one usually causes a change in one or both of the other two. These three building blocks comprise the risk financing strategy. This is important because it allows us to conceptualize the risk financing strategy for what it really is: an investment.

If our risk financing strategy is viewed as an investment, then we must be able to apply the same financial discipline to this as we do to any other investment. The challenge, of course, is devising metrics that accurately reflect the value of one risk financing strategy versus another.

One of the most important concepts inherent in this approach is the way in which we view retained risk. This includes all deductibles and self-insured retentions for which there is no formal funding vehicle. For middle-market companies, those with roughly $250 million to $500 million in annual sales, the aggregate amount of retained event risk can be (and often is) at least seven, and often eight, figures.

If we view our risk financing strategy as an investment, then we must understand that retained risk places a burden on our company’s capital. Every major investment involves capital, and every chief financial officer (CFO) knows how to evaluate an investment’s impact on the company’s capital.

So, as with any significant strategic decision requiring a capital investment, our goal is to be able to answer this question: How will our risk financing strategy affect shareholder value?

Shareholder value encompasses the spectrum of quantitative indicators used to measure the impact of strategic decisions. We believe that an organization’s risk financing strategy should be subjected to rigorous financial analysis similar to that used for any other strategic decision. This means that the risk manager, broker, reinsurer, or trusted advisor must be able to describe the relative value (or lack thereof) of any risk financing strategy in financial terms.

The standard method of illustrating the degrees of risk inherent in each class of risk financing techniques is a straight line—from simple guaranteed cost to sophisticated self-insurance. In lieu of expressing the spectrum of risk financing options along a single line, we illustrate relative levels of risk in a bar graph. This provides a more meaningful illustration of the relationship between the financing technique and the four major sources of risk (underwriting, pricing, regulatory, and financial).

Risks Defined

Underwriting Risk

This describes the degree to which the organization is subjected to adverse insurable losses. Guaranteed cost plans theoretically have no underwriting risk aside from that included in any mandatory deductible. In programs where the organization assumes a significant degree of actuarially predictable loss, the funding usually approximates the actuary’s 50 or 55 percent confidence level. In these situations there is a reasonable amount of underwriting risk. Underwriting risk is also known as basis risk. Basis risk is the risk that something other than the expected outcome will occur. When we invest, for example, in an index fund such as the Standard & Poor’s 500, the chance that our results will not mirror the overall fund’s results is known as basis risk. Ultimately, underwriting risk is a function of the loss exposure’s volatility.

Pricing Risk

Pricing risk exists in every risk financing technique; it is the risk that the hard costs will not reflect the value received. Hard costs are out-of-pocket expenditures that the organization will never recoup.

Regulatory Risk

This comprises the panoply of uncertainties visited upon every organization by the Internal Revenue Service (IRS), the Financial Accounting Standards Board (FASB), state departments of insurance, and each captive domicile’s regulatory protocols.

Financial Risk

This category includes investment and counterparty (credit) risks. Programs that assume significant underwriting risk include, as one of their benefits, investment income earned on the loss reserve fund. Credit risk, while not as pronounced as investment risk, is the risk that the organization will contract with a less-than-creditworthy risk-taking counterparty.

Formal Risk Financing Strategies

Guaranteed Cost Plans

Guaranteed cost insurance carries an incidental amount of underwriting risk, primarily created by mandatory deductibles. Conversely, pricing risk is moderately significant because of the relative lack of pricing transparency in guaranteed cost programs. But since the vast majority of the risk is transferred off the balance sheet, a certain degree of pricing risk is expected. Regulatory risk in guaranteed cost plans is negligible. Finally, the degree of financial risk reflects the potential credit risk or counterpart risk associated with the insurer’s financial strength.

Retrospectively Rated Plans

Underwriting risk is moderate. It is defined within the plan’s minimum and maximum premium factors and the chosen loss limit. Pricing risk is moderate-to-high because most insurers do not provide clients with a breakdown of the costs that are included in the basic premium. Regulatory risk is moderate because the premium tax deductibility issues, especially in incurred loss retros, are unsettled. In incurred loss programs the insured pays the full amount of the annual premium during the policy year with the expectation of potential return premiums based on loss activity. Financial risk in a retro is limited to the company’s investment decisions relative to the return premiums and to a slight degree of credit risk.

Large Deductible/Self-Insured Retention Plans

These programs permit the insured to pay for losses up to a per-occurrence limit and often an annual aggregate limit. Above these limits, risk is transferred to an insurer. Underwriting risk, similar to retros, is moderate based on the amount of retained risk. In these programs, the insured assumes the majority of what is defined as burning layer losses. The burning layer is the primary layer of coverage that funds the majority of losses. Depending on the line of business, these losses may be actuarially predictable, producing a fairly low amount of underwriting risk. Workers compensation is one of these lines.

Conversely, losses within a $1 million directors and officers self-insured retention (SIR) plan are anything but predictable and represent significant underwriting risk. Pricing risk in these programs mirrors that of retros in that the insurer’s premium reflects the risk transfer excess of the deductible or retention, and insurers rarely if ever divulge the expense components in their pricing.

Regulatory risk is low in these programs, as losses within the deductible or SIR are tax deductible when they are actually paid. Financial risk is commensurate with how the insured manages the loss payments within the deductible or SIR. [See the discussion on passive self-insurance for a detailed explanation of this important issue.]

Group Captives/Risk Retention Groups/Pools/Rent-a-Captives/Cell Captives

Group programs tend to retain risk commensurate with deductibles and SIR plans, but some divide the retention into that which is paid by the individual member and that which is paid by the group (shared). Sometimes the costs of excess premiums and risk management services can be driven down by virtue of the economies of scale created by the group. Regulatory risk for a group program, depending on the structure, can be significant. Members expect that their premiums will be deductible from their federal income taxes, as they are in their existing programs.

The risk here is that if the program does not meet the IRS and FASB minimum tests, the program may not be deemed a bona fide insurer, thus ineligible for premium deductibility and insurance accounting. The financial risk in a group captive is somewhat higher than that in retros and deductible/SIR plans because no single member controls the investment of funds; this is done by an asset manager hired by the group.

Pure (Single-Parent) Captives

Similar to each of the self-insured components of the previous techniques, single-parent captives have underwriting risk commensurate with the captive’s retentions. Single-parent captives, however, tend to hold more risk than the typical (start-up) group plan. This is partially because the parent company is large enough to qualify for its own captive, and its losses have significant actuarial credibility.

Large single-parents appear to be more comfortable assuming, say, a $500,000 per occurrence retention in their own captive the first year than are members of a group. Pricing risk tends to be somewhat lower for pure captives than for group programs based primarily on program size. Regulatory risk, however, in the form of IRS and FASB rules, is far greater in a pure captive than in a group captive.

One of the basic tenets of qualifying as a real insurer is the notion that the risk is distributed among a number of unrelated policyholders. Pure captives, by definition, have no unrelated policyholders with which they can share risk, so they technically cannot employ insurance accounting. Because pure captives tend to assume more risk than their group brethren, the financial risk is likewise increased.

Self-Insurance (Trusts, Qualified SI, Passive SI)

There are two broad methods of self-insuring any loss exposure:

1.  Create a fund from which losses are paid; or

2.  Eschew a fund and pay losses from cash flows or cash reserves.

Underwriting risk mirrors the others assuming the retentions are similar.

Pricing risk is reduced, however, because excess insurance, for workers compensation for example, is almost a commodity, with little price variations between and among the small number of insurers and reinsurers that provide the coverage. Aside from the possibility that the insured would do something to jeopardize its qualified self-insured status, regulatory risk is negligible. Financial risk is similar to that of pure captives.

Exotic Risk Financing Techniques

These techniques include finite risk insurance, structured insurance, cell captive usage, contingent capital arrangements, and other capital markets applications. Each of the four main categories of risk are maximized for every one of these techniques for one important reason: the benefits of these deals usually far outweigh the risks, so if the deal manages to navigate successfully through the treacherous shallows, the down-stream benefits can be significant.

Chapter 2: Passive Self-Insurance versus Active Self-Insurance

Passive versus active—these are the fundamental choices for dealing with risk. When we passively assume risk we decide not to arrange any special funding. We think that, for whatever reason, retaining risk in the absence of dedicated funds is more efficient than the alternatives. It is likely, however, that our decision to passively retain risk has been made for us by circumstances or perhaps an insurance company.

Active self-insurance, to which the majority of this book is devoted, is defined as any risk financing strategy for which you purposefully provide funds. Purchasing insurance is an active measure, as is forming a captive.

Theory of Passive Self-Insurance

Almost all organizations retain some amount of event risk in the absence of any formal financing arrangements. There are three fundamental reasons for retaining risk. First, losses are predictable and small enough such that the organization simply pays the loss rather than paying an insurance company to pay them—the don’t trade dollars with an insurer rationale. Second, we retain event risk because the insurance industry demands it. We usually cannot purchase a directors and officers liability policy without a significant deductible or self-insured retention. Third, first-dollar insurance may be too expensive given the (low) probabilities of loss.

Just to be clear: passive self-insurance is not the same as being oblivious to the exposure. Even though the approach is passive, it is a recognized form of self-insurance.

Regardless of the reason for retaining risk, an organization must know how these losses will be paid. Passive self-insurance affects a company’s financial statements in two distinct ways. First, self-insured losses, regardless of size, must be paid from either a company’s cash flows or from its cash reserves (retained earnings). This affects the company’s cash flow and/or income statements, as self-insured losses reduce expected cash flows or earnings. Second, when a company agrees to assume risk, for example, a $1 million retention on directors and officers coverage, the decision has an effect on its balance sheet. Why? The retention represents a potential loss of capital. Put another way, the company’s capital now has another burden to bear, regardless of whether the loss actually occurs.

Unfunded event risk places a burden on a company’s capital similar to that created by market risk and the other financial risks recognized in the firm’s weighted average cost of capital (WACC). Every risk formulated into the WACC represents a potential reduction of value—shareholder value. The company must compensate its shareholders for its financial risks and earnings volatility, and should do the same for its event risks.

Considering these arguments, why should a company actively self-insure?

•  For loss exposures with little frequency and high catastrophic potential, passively retaining $500,000 or more of the primary layer risk may be a better strategy than funding some calculation of expected losses (the aggregate amount of loss, each claim capped at $500,000), in an active financing structure, especially if insurance accounting, discussed in this book in detail), is not achievable.

•  Actuarially expected losses (primary level) should be considered budgeted expenses similar to insurance premiums and for which no active funding vehicle is necessary.

•  Active risk funding vehicles require a company to fund capital. The company employs capital based on its return requirements. For any strategic decision involving the use of capital, if the hurdle rate (or WACC) cannot be met, the venture should not be pursued. Should the same logic apply to capital devoted to financing risk?

•  Formal risk funding requires frictional costs (expenses) above and beyond that needed to pay for losses, so creating a cost center to manage event risk may be considered a poor allocation of resources.

The Fundamental Question – to Fund or Not to Fund

Assume that expected losses within the first $500,000 risk layer equal $200,000, meaning that the actuary thinks that aggregate losses capped at $500,000 will amount to no more than $200,000. The organization could fund that $200,000 with a formal risk financing vehicle along with the attendant frictional costs or it could simply retain the risk passively. Which is the better course of action?

On one hand we can simply retain the $500,000 risk, paying any and all losses that fall within the retention, understanding that the probability of loss is relatively low. On the other hand we can choose to fund the risk, albeit at a cost that must be paid in advance of any loss.

So, what are the critical variables in determining the more effective course of action?

•  Availability of Funds

•  Likelihood of Loss

•  Impact on Capital

Availability of Funds

The organization must be able to afford to pay claims. This is the first threshold question: Can the organization pay for uninsured event risk losses? The financial statements provide answers to key questions:

1.  Does the company have sufficient retained earnings to withstand a significant loss (whatever the company’s definition of significant loss)?

2.  What are the company’s cash management objectives, and how could a major loss affect those objectives?

3.  Does the company have lines of credit that may be tapped in the event of a large retained loss?

One way to start the conversation with the CFO is to ask this open-ended question: If we discovered that we had to pay a $5 million loss, in a lump sum, next week, from where would the funds come?

Likelihood of Loss

The likelihood of loss question is contentious. It goes to the heart of the organization’s so-called appetite for risk and its risk-taking (or risk-avoiding) culture.

The likelihood of loss also plays a crucial role in the results of the availability of funds analysis because (theoretically) the higher the retained loss, the less likely it is to occur. Low-level, frequency-prone losses should be retained, and, therefore, funds must be made available to pay these claims. Higher-level retained losses with small probabilities of occurrence are meaningful only in a worst-case scenario. We caution against using statistical methodology to calculate a so-called probability of loss excess of the primary, expected layer, to determine whether to purchase off-balance sheet risk transfer and how much to purchase. Statistical analysis works fine when determining non-survival-threatening outcomes. But when it comes to withstanding a one-in-twenty-year catastrophic event, a company most likely employs the concept of minimax: it’ll do anything to minimize the maximum possible loss.

Theoretically, this means that the company will spend up to the perceived maximum loss to neutralize its effects. In reality, the company chooses a level of protection beyond which it assumes that it would be driven out of business (or close to it). Off-balance sheet risk transfer in excess of expected losses is known as precautionary protection. Regardless of the type of protection—insurance limits or some form of contingent capital—there is a point at which the company simply does not care how much the protection costs. This is minimax in action.

Put another way, the cost of the protection will always represent a fraction of the potential loss, so the question of whether to purchase it should be moot. Of course, the economics of the transaction work in concert with this strategy: the higher the level of protection, the less expensive it is.

Impact on Capital

This is the least understood aspect of self-insurance. Active self-insurance techniques require dedicated capital, so the impact is immediate and quantifiable. Passive self-insurance is altogether different. Small deductibles should have no material impact on the company’s capital. However, large unfunded retentions for such exposures as directors and officers liability can be quite significant. In the aggregate. Such a loss could have a serious impact on the company’s capital. The impact-on-capital argument has nothing to do with an actual loss, however, and everything to do with the additional burden the risk places on capital.

Chapter 3: Developing a Risk Financing Strategy

A risk financing strategy is the sum-total of the individual, tactical measures taken to finance risk as efficiently as possible. The following example illustrates the concept.

Example: ABC Company has a strategy for coping with, or taking advantage of, every contingency and opportunity. It has strategies for cash management, mergers and acquisitions, investments, and business in general. Does it have a risk financing strategy?

According to the risk manager, ABC Company retains a significant amount of risk, negotiates effectively for the best risk-transfer products at the best cost, and purchases high limits of excess insurance in case of catastrophic loss.

But is this really a strategy, or is it a reaction to the strategies of others? ABC Company’s risk financing strategy is a one-dimensional, non-financial, insurance-centric, response.

ABC Company has worked hard to reduce its risk transfer costs. These efforts help to conserve cash and increase the value of the purchased protection. Premiums are paid on a monthly basis, allowing ABC Company to budget the expense and maximize the value of the cash flow benefit.

When insurance markets are soft, ABC Company reduces its retentions and purchases additional insurance—timing the market, so to speak. What does this practice say about its risk management strategy? It says that ABC Company has no real strategy, unless that strategy is to transfer as much risk as possible off the balance sheet, with the only restriction being the cost of doing so. This is not what ABC Company intended, but what its actions lead to this conclusion.

If ABC Company’s definition of a successful risk financing strategy is measured by the size of its insurance premiums, then the risk manager has no real incentive to do the analysis to determine the optimal combination of retention and transfer costs. The risk manager just tries to get a continually lower premium. If that lower premium happens to require additional risk retention, so be it; the important cost (premium) is lower than last year’s. Without the risk strategy analysis, given ABC Company’s exposures to loss, loss history, and relative likelihood of loss, a higher premium (greater risk transfer) with a lower retention might prove to be a better option.

What Is a Risk Financing Strategy?

A risk financing strategy is any combination of risk transfer capacity (usually insurance limits), retained risk, and the costs associated with managing retained risk and transferring risk (the premium).

If a company employs these three components in its risk financing program, it already has a de facto risk finance strategy, but it must understand the unintended consequences.

There are two major unintended consequences associated with an insurance-centric risk financing strategy:

1.  The relationship among the components is out-of-balance because the analysis considers only retention. This results because the company cannot calculate the best, or optimal, combination among a theoretically infinite number of possibilities.

2.  The company neglects to calculate the impact of the strategy (the combination of components) on its cost of capital. Doing so not only enhances understanding of how risk affects the company, but it may also provide the ability, in conjunction with an active self-insurance program, to contribute to the company’s earnings.

Evaluating any one of the three risk financing components in isolation of one another provides an inaccurate picture of the impact of risk financing decisions on a company. For example, many risk managers focus primarily on determining the optimal retention level, believing that this is the only variable over which they have any real control. They use a variety of benchmarking data that suggest a range of potential retention options. Another problem is focusing primarily on the costs of risk transfer, mainly the premiums for excess insurance. This approach generally ignores the potential impact of retained losses on the balance sheet—the real impact on capital.

The main fallacy of such strategies is that the relationship between the three components is not linear. If it were, focusing on one variable would have a predictable and observable effect on the other two. Unfortunately, insurance and reinsurance pricing are subject to a wide variety of drivers, few of which are in the company’s control.

While a company can control the amount of retention it accepts and the amount of insurance limits it purchases, controlling their quantities is not the same as understanding their impact on capital and on the company’s balance sheet.

Chapter 4: Self-Insurance and Trusts

Qualified Self-Insurance

The decision to self-insure noncontrolled risks such as property and general liability require no special permission from state insurance regulators. However, controlled lines such as workers compensation and automobile liability require that the