Fall 2008 Version Professor Dan C. Jones FINA 4355 Handout

Risk Management and Insurance: Perspectives in a Global Economy 13. Internal Loss Financing Arrangements Professor Dan C. Jones FINA 4355 Handout

3 Note to the Professor 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.

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

5 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 We cover mainly self- insurance and captive insurance in this chapter.

Motivations for Internal Loss Financing

7 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

8 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

Self-insurance

10 Self-insurance Individual self-insurance Group self-insurance

11 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.

12 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. Pages

13 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 13.1 You may not agree with these factor classifications.

14 Estimation of Loss Reserves (Table 13.1)

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

16 Third Party Administrator (Figure 13.1)

17 The Future of Self-insurance (Table 13.2)

Captive Insurance

19 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 2001

20 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.

21 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)

22 Single-parent Captive (Figure 13.2)

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

24 Group Captive (Figure 13.3)

25 Rent-a-Captive Fronting InsurerClient 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)

26 Protected Cell Company Arrangement Fronting InsurerClient 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)

27 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

28 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

29 Captive Feasibility Study (Figure 13.4) 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.

30 Captive Feasibility Study (Figure 13.4) Turnover greater than £50 million? Ye s 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? Ye s Is involving a financial officer possible? Ye s 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? Ye s No Conventional Insurance Market oror If premium or retention amount exceeds £250,000 in any line, will you consider a cell captive in a protected cell company? Ye s No Is involving financial officer possible? Ye s 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? Ye s Continue Feasibility Study No

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

32 Captive in a Fronting Arrangement (Figure 13.5)

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

34 10 Largest Captive Management Firms (Table 13.5 ) (updated) Business Insurance (March 3, 2008)

35 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

36 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.

37 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.

Other ART Techniques: Contingent Capital Not in the book!

39 Fundamentals Contingent capital Simply, an option to issue a corporate security Contingent capital facility Right to issue new debt, equity or structured security During a specified period At a predefined issue price On the occurrence of a triggering event Unexpected & substantial loss by the right holder High correlation between the loss exposure and the price of the security

40 Contingent Capital - Elements Underlying Debt, equity or hybrid security defined at the beginning of the option period; that is, before the security is issued Tends to be deeply subordinated debt or preferred stock Tenor Limited duration; for example, right to issue five-year, fixed rate subordinate debt at any time during the next three months

41 Contingent Capital - Elements Intrinsic value (strike price) Usually at-the-money at inception; that is, Price set prior to loss realization Value tied to the price of the underlying on the date of contingent capital negotiation Cost-of-capital difference between [1]One under the arrangement and [2]The other in the open market at the time of exercise No option exercise if [1] > [2]

42 Contingent Capital - Elements Exercisability – dual triggers The underlying with a greater-than-market value and an objectively defined loss event First trigger usually American, thus giving the right holder to issue the securities at any time during the tenor period Instead of loss, the second occasionally tied to a variable beyond the firm’s influence, thus minimizing problems of moral hazard Linking the firm’s negative earnings shock to the average industry earnings, for example

43 Contingent Capital - Elements Placement Commonly a private placement with a (lead) option writer Until exercise, the writer collects a periodic commitment (premium) until the facility is exercised On exercise and in case of a put option, the writer gets a security in return for the (cash) payment to the owner of the facility  Compare it with an insurance contract!

44 Committed Capital Facility Example Insurer Purchase the option, pay the premium until exercise SPV Prior to exercise, holds capital, say, commercial papers On exercise by the insurer, liquidate its own securities to purchase, say, preferred stock issued by the insurer Investors Put Option Commitment Fee/Premium Cash Issue Securities w/ Collateral Investment Coupon + Premium Trust

Discussion Questions

46 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?

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

48 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?

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

50 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?