Captives and Other Risk-Financing Options
Traditionally, businesses and other organizations have handled risk by transferring it to an insurance company through the purchase of an insurance policy or,
alternatively, by retaining the risk and allocating funds to meet expected losses
through an arrangement known as “self insurance,” in which firms retain rather
than transfer risk.
During the liability crisis of the 1980s, when businesses had trouble obtaining some types of commercial insurance coverage, new mechanisms for transferring risk developed, facilitated by passage of the Product Liability Risk Retention
Act of 1981. These so-called alternative risk transfer (ART) arrangements blend
risk transfer and risk retention mechanisms and, together with self insurance,
form the alternative market.
Captives—a special type of insurance company set up by a parent company,
trade association or group of companies to insure the risks of its owner or owners—and risk-retention groups—in which entities in a common industry join
together to provide members with liability insurance—were the first mechanisms to appear. Other options, including risk retention pools and large deductible plans, a form of self insurance, followed.
ART products, such as catastrophe bonds, weather derivatives and microinsurance programs are also emerging as an alternative to traditional insurance
and reinsurance products.
Alternative Market Mechanisms
I. Captives
Wholly owned captives are companies set up by large corporations to finance or
administer their risk financing needs. If such a captive insures only the risks of
its parent or subsidiaries it is called a “pure” captive.
Captives may be established to provide insurance to more than one entity.
An association or group of companies may band together to form a captive to
provide insurance coverage. Professionals—doctors, lawyers, accountants—have
formed many captives over the years. Captives may, in turn, use a variety of
reinsurance mechanisms to provide the coverage. In particular, many offshore
captives use a “fronting” insurer to provide the basic insurance policy. Fronting
typically means that underwriting, claims and administrative functions are
handled in the United States by an experienced commercial insurance company,
since a captive generally will not want to get involved directly in running the
insurance operation. Also, fronting allows a company to show it has an insur-30 I.I.I. Insurance Handbook www.iii.org/insurancehandbook
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Captives and Other Risk-Financing Options
ance policy with a U.S.-licensed insurance company, which it may need to do
for legal and business reasons.
The rent-a-captive concept was introduced in Bermuda 20 years ago and
remains a popular alternative market mechanism. Rent-a-captives serve businesses that are unable to capitalize a captive but are willing to assume a portion
of their own risk and share in the underwriting profits and investment income.
Generally sponsored by insurers or reinsurers, which essentially “rent out” their
capital for a fee, the mechanism allows users to obtain some of the advantages
of a captive without having the expense of setting up a single parent captive
and meeting minimum capital and surplus requirements.
Captives have been expanding into the employee benefits arena since
2003, the year in which the Department of Labor gave final approval to Archer
Daniels Midland Co.’s plan to use its Vermont captive to reinsure group life
insurance benefits.
While the leading domicile for captives in the U.S. is Vermont, offshore
captives covering U.S. risks are predominantly located in Bermuda, where
they enjoy tax advantages and relative freedom from regulation. The Cayman
Islands, Guernsey, the British Virgin Islands, Luxembourg and Barbados are also
significant centers for captives. Vermont is the leading domicile for captives in
the United States.
II. Self Insurance
Self insurance can be undertaken by single companies wishing to retain risk or
by entities in similar industries or geographic locations that pool resources to
insure each other’s risks.
The use of higher retentions/deductibles is increasing in most lines of insurance. In workers compensation many companies are opting to retain a larger
portion of their exposure through policies with large deductible amounts of
$100,000 or higher. Large deductible programs, which were first introduced in
1989, now account for a sizable portion of the market.
III. Risk Retention Groups
A risk retention group (RRG) is a corporation owned and operated by its members. It must be chartered and licensed as a liability insurance company under
the laws of at least one state. The group can then write insurance in all other
states. It need not obtain a license in a state other than its chartering states. Insurance Topics Updates at www.iii.org/issues_updates
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Captives and Other Risk-Financing Options
IV. Risk Purchasing Groups
Like risk retention groups (RRGs), purchasing groups must be made up of persons or entities with like exposures and in a common business. However, whereas RRGs are liability insurance companies owned by their members, purchasing
groups purchase liability coverage for their members from admitted insurers,
surplus lines carriers or RRGs. Laws in some states prohibit insurers from giving groups formed to purchase insurance advantages over individuals. However,
purchasing groups are not subject to so-called “fictitious group” laws, which
require a group to have been in existence for a certain period of time or require
a group to have a certain minimum number of members. The Risk Retention
Act of 1986 specifically provided for purchasing groups to be created to purchase liability insurance for members of the sponsoring groups.
V. Catastrophe Bonds and other Alternative Risk Transfer (ART) Products
A number of alternative risk transfer (ART) products, such as insurance-linked
securities and weather derivatives have developed to meet the financial risk
transfer needs of businesses. One such product, catastrophe (cat) bonds, riskbased securities sold via the capital markets, developed in the wake of hurricanes Andrew and Iniki in 1992 and the Northridge earthquake in 1994—megacatastrophes that resulted in a global shortage of reinsurance (insurance for
insurers) for such disasters. Tapping into the capital markets allowed insurers
to diversify their risk and expand the amount of insurance available in catastrophe-prone areas. Zurich Financial’s Kamp Re was the first major catastrophe
bond to be triggered. The $190 million bond was triggered by 2005’s Hurricane
Katrina, and resulted in a total loss of principal. Catastrophe bonds are now a
multibillion dollar industry.
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