PowerPoint Slides for Professors Spring 2010 Version PowerPoint Slides for Professors Spring 2010 Version This file as well as all other PowerPoint files for the book, “Risk Management and Insurance: Perspectives in a Global Economy” authored by Skipper and Kwon and published by Blackwell (2007), has been created solely for classes where the book is used as a text. Use or reproduction of the file for any other purposes, known or to be known, is prohibited without prior written permission by the authors. Visit the following site for updates: To change the slide design/background, [View]  [Slide Master] W. Jean Kwon, Ph.D., CPCU School of Risk Management, St. John’s University 101 Murray Street New York, NY 10007, USA Phone: +1 (212)

Risk Management and Insurance: Perspectives in a Global Economy 13. Internal Loss Financing Arrangements Click Here to Add Professor and Course Information There are two sections which add discussions (or figures) to the book. One is about rent-a-captive and protected cell company. The other is about contingent capital as an ART technique. There are two sections which add discussions (or figures) to the book. One is about rent-a-captive and protected cell company. The other is about contingent capital as an ART technique.

Study Points  Motivations for internal loss financing  Self-insurance  Captive insurance companies  Other ART techniques 3

Internal Loss Financing Arrangements  Unplanned The firm is unaware of the loss exposure.  Planned Informal The firm makes no special arrangements to finance losses (internally) Formal Self-insurance Captive insurance 4 We cover mainly self-insurance and captive insurance in this chapter.

Motivations for Internal Loss Financing 5

Motivations  Stronger control of risk management program Even when transferring residual risks to an insurance company, the firm may benefit from: Greater bargaining Broader and more uniform coverage Less problems of coverage availability/affordability  Lower firm’s cost of risk Lower administrative expenses Avoid subsidizing others Provide access to reinsurance Grain tax advantages 6

Motivations  Better cash flow control  Capture investment income When facing long-term loss exposures When using a captive  Avoid inefficiencies with traditional insurance Counterparty risk Subsidizing poor risks Information asymmetry 7

Self-insurance 8

 Individual self-insurance  Group self-insurance 9

Risk Analysis  The self-insured borrows several key techniques used by insurers.  But, self-insurance is not a solution to every risk. Candidate risks may include: Exposures exhibiting both low frequency and severity Exposures reasonably expected to exhibit high frequency and low severity  A large number of exposure units is desirable A self-insured firm still faces the problem of possible correlation among loss exposures. 10

Risk Analysis – Reliability Analysis  Case A manufacturer examines its exposure to workplace injuries. The number of injuries has been 10 percent of the number of employee years. Willing to self-insure these injuries, if a minimum of 95% of the injuries does not exceed 125% of the expected value. Workplace injuries commonly follow a pattern typified by a Poisson distribution Using the central limit theorem, we approximate the Poisson distribution via a normal distribution. Hence, using a 95% confidence interval, we get 433 as the number of full-time employees during a year – the number the firm needs for self-insurance. 11 Pages

Risk Analysis – Setting Reserves  Maintaining financial solvency is critical even in self- insurance  Factors to be examines Loss development factor Exposure factor Trending factor  Table You may not agree with these factor classifications.

Estimation of Loss Reserves (Table 13.1) 13

Use of Self-insurance – the U.S.  Commercial liability risks  Group health plans  Workers’ compensation benefits 14

Third Party Administrator (TPA) (Figure 13.1) 15

The Future of Self-insurance (Table 13.2) 16

Captive Insurance 17

Background  Captives are not new to risk management and insurance professionals. However, not until the 1960s did several pioneers flight the resistance of established commercial insurers and persuade many U.S. corporations to create their own insurers.  Captive insurance has become a significant market force internationally More than 90 percent of the top 500 U.S. firms own a captive. The share of the global captive insurance market by 2,500 world’s largest firms was 80% in

Background  Captive insurance use is not limited to the private sector.  Captives exert a disproportionate influence on the commercial insurance market.  Captives also are a result of the growing instability and unpredictability of modern economic activities. 19

Definition and Classification  Definition A closely held corporation whose insurance business is supplied primarily by its owner(s) and in which the owners are the principal beneficiaries.  Differences from traditional insurer Ownership and management control Scope of operation  Classification Single-parent captive Group (association) captive Rent-a-captive Protected cell companies (sponsored captives) 20

Use of Captive Simplified Business Captive Insurer Reinsurer Purchase insurance 1)Retains all, or 2)Retains a small portion of the risk and purchase reinsurance

Single-parent Captive (Figure 13.2) 22

Benefits from Captive Operations  Alignment with corporate goals (ERM)  Tailored coverage  Control over claims  Direct access to the reinsurance market  Possible tax benefit Inclusive of concession tax benefit 23 Not in the Book!

Captives in New York (Selected)  First Mutual Transportation Assurance Company (Metropolitan Transportation Authority)  CM Insurance Company, Inc. (Columbus-McKinnon Inc.)  Moody’s Assurance Company Incorporated (Moody’s Corporation)  TSI Insurance Incorporated (Town Sports International)  Sammarnick Insurance Corporation (Viacom Inc.)  Haversine Insurance (Omnicom Group)  Customer Asset Protection Company (CAPCO Holdings) Owned equally by fourteen financial institutions  Bergstresser Insurance (Dow Jones & Company) 24

Group Captive  Organizations using it typically exhibit the following traits: Entities sharing common needs Capital constraints Business volume constraints 25

Rent-a-Captive  Characteristics Use by one firm of management, investment, and other services of an existing captive owned and operated by an unrelated firm, for a fee De facto, capital lease agreement Usually offshore created by insurance brokerage firms or institutional investors  Be careful! Responsible for underwriting results of its own Commingles assets (e.g., investment) of the sponsoring captive Possible high collateralization and usage cost Counterparty risk  Short-term solution 26

Rent-a-Captive 27 Fronting Insurer Client Firm B Client Firm A Client Firm C RAC Client Account A Client Account B Client Account C Premium/ Insurance Premium/ Reinsurance Segregated by contract and shareholders agreements Not in the book! An illustration involving a fronting company (see also Figure 13.5) Not in the book! An illustration involving a fronting company (see also Figure 13.5)

Protected Cell Company (PCC)  A.k.a. “sponsored captive” Creation of captive within a captive Only the sponsoring captive subject to regulatory compliance of its own and all sponsored captives Sponsored captives shielded from the operation of sponsoring captive At the underwriting level At the operational level Only limited jurisdictions permit PCCs 28

Protected Cell Company (PCC) Arrangement 29 Fronting Insurer Client Firm B Client Firm A Client Firm C PCC Cell A Cell B Cell C Premium/ Insurance Premium/ Reinsurance Segregated by statutes Not in the book! An illustration involving a fronting company (see also Figure 13.5) Not in the book! An illustration involving a fronting company (see also Figure 13.5)

Risk Retention Group (RRG)  A type of U.S. group captive created under The Product Liability Risk Retention Act of 1981 The Liability Risk Retention Act of 1986  Unlike typical insurers, they need to be licensed in a single state only – by default, their domiciliary state – but can operate in all U.S. states.  Declining RRG markets The restriction of business to liability lines and the unavailability of state insurance guarantee benefits to their insureds. A lack of uniform accounting standards, non-uniformity in RRG management standards 30

Use of Captive as a Risk Financing Technique  Capital commitment and expenses See Figure 13.4 See also Table 13.4  Risk of adverse results  Captive as a distraction 31

Captive Feasibility Study (Figure 13.4) 32 There are two typos in the figure (first printing of the book). The third box on the left has “exiting,” which should be “existing.” The fourth box on the left states “Is involving financial officer possible?” The correct one should be “Is involving a financial officer possible?” The corrected figure is made available in the next page.

Captive Feasibility Study (Figure 13.4) 33 Turnover greater than £50 million? Yes Does the premium spending exceed £1 million for property, £500,000 for general liability, £1 million for motor liability, or £1 million for other liability? Does existing or planned risk retention exceed £1 million for property, £500,000 for general liability, or £1 million for motor liability? Yes Is involving a financial officer possible? Yes Single-parent Captive Can you accept the following indicative costs of £20,000 for feasibility study, £25,000 of annual operating cost, plus a minimum capitalization of £500,000? Yes No Conventional Insurance Market or If premium or retention amount exceeds £250,000 in any line, will you consider a cell captive in a protected cell company? Yes No Is involving financial officer possible? Yes Cell Captive Can you accept the following indicative costs of £20,000 for feasibility study, £25,000 of annual operating cost, but without capitalization commitment? Yes Continue Feasibility Study No

Captive Operational Issues  Underwriting  Direct insurance and reinsurance  Captive reinsurance and fronting arrangements  Captive management  Selection of captive domicile  Tax situation  Corporate governance 34

Considerations in Selecting a Domicile (Insight 13.1)  Quality of regulation and supervision  Investment restrictions  Minimum capitalization requirements  Premium and other taxes and expenses  Underwriting restrictions and reserve requirements  Reinsurance restrictions  Reporting requirements  Tax relationship of domicile with home country of the owner  Currency stability and convertibility  Quality of local infrastructure  Political and economic stability  Quality and ease of transportation and communications 35

The Tax Situation  Conditions for tax deductibility of premiums The captive assumes underwriting risk. Risk distribution is present. The captive operates according to accepted industry practices. 36

Captive – Corporate Governance  The Sarbanes-Oxley Act The captive must be managed based on a well-established code of ethics. The code governs the scope of responsibilities and authority of the board and its members. The board of the captive bears the responsibility for overseeing sound captive operations. The board bears the responsibility for financial reporting according to the laws governing the captive. The responsibility includes appointment of an auditor or an auditing committee as well as oversight of the auditing process. 37

Captive in a Fronting Arrangement (Figure 13.5) 38 Multinational Corporation in France U.S. Subsidiary Liability Exposure U.K. Subsidiary Liability Exposure France Subsidiary Liability Exposure Sweden Subsidiary Liability Exposure Japan Subsidiary Liability Exposure Fronting Insurer in the U.S. Fronting Insurer in the U.K. Fronting Insurer in Sweden Fronting Insurer in Japan Captive (Functioning as Reinsurer) Retrocession

Places of Domicile  Outside the Continent Bahamas Barbados Bermuda British Virgin Islands Cayman Islands Gibraltar Guam Guernsey Hong Kong Ireland Isle of Man Luxemburg Malta Panama Singapore States of Jersey St. Lucia Turks & Caicos US Virgin Islands  U.S. States Arizona Colorado Delaware Georgia Illinois Kansas Maine Montana Nevada New York Rhode Island South Carolina South Dakota Tennessee Vermont Virginia West Virginia 39 Red – Popular places

Number of Captives by Domicile (Table 13.3) (Updated) 40

10 Largest Captive Management Firms (Table 13.5 ) (updated) 41 Business Insurance (March 3, 2008)

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Discussion Questions 45

Discussion Question 1  Other than the involvement of a third party, can we argue that self-insurance and traditional insurance are virtually identical? What bases of arguments for or against this statement can you provide? 46

Discussion Question 2  Do you believe it is necessary for very large, well diversified MNCs to purchase excess insurance over their self- insurance limits? 47

Discussion Question 3  Why might a widely held corporation utilize a captive even though it would not purchase commercial insurance if it had no captive? 48

Discussion Question 4  What types of exposures might a firm specifically want to avoid writing in its captive and why? 49

Discussion Question 5  Do tax laws in your country discriminate for or against captives or are they neutral toward them vis-à-vis commercial insurers? Vis-à-vis non-captive self-retention? 50