The Cayman Islands hosts a wealth of management companies that will assist with the creation and management of a captive insurance company. The best managers follow these practices to ensure that the captive is a successful investment over the long term.
The Cayman Islands hosts a wealth of management companies that will assist with the creation and management of a captive insurance company. The best managers follow these practices to ensure that the captive is a successful investment over the long term.
Letters of credit
Security is essential in many business relationships, particularly when a Cayman Islands captive elects to conduct business with a US- or London-based issuing carrier. Most issuing carriers insist on security at inception, and at each renewal. The letter of credit (LOC) is widely used as security.
Planning in the early stages will enable the captive to make judicious use of LOC obligations. Initially, the language in a reinsurance agreement may seem innocuous:
“The Reinsurer shall post a Letter of Credit to the Company in an amount to be agreed by the parties. The Company shall release all or part of the Letter of Credit when it determines that the liabilities are no longer significant [sic].”
After all, the term of the contract is one year, and the liabilities will decrease over time, presumably resulting in a reduced LOC. Unfortunately, this language is one sided because it lacks criteria that requires the issuing carrier to lower the LOC. Practically speaking, the reinsurance agreement could renew for 10 or more years, with an equal increase in the LOC each year. The issuing carrier may hold
10 times the amount of the initial LOC before it decides that gradual reductions are in order.
A reinsurance agreement should contain language that protects both the issuing carrier and the reinsuring captive. The following satisfies the needs of both parties:
“The Reinsurer shall provide a Letter of Credit to the Company in the amount of the outstanding liabilities. The Company will periodically reduce the Letter of Credit. For the purpose of this Agreement the term ‘outstanding liabilities’ shall mean the sum of 1) the Company case reserves, plus 2) the Company Incurred But Not Reported Reserves, the latter to be calculated annually by an independent professional actuary [sic].”
These criteria will protect and preserve the liquid assets of the captive.
However, what if the reinsurance agreement does not contain any criteria? What does the captive do to avoid the ‘bottomless pit’ of quicksand that absorbs the LOCs?
The best approach is to give comfort to the issuing carrier that the captive presents no credit risk. Namely:
An “A-” or better credit rating from A.M. Best.
The ability of the captive to say, “we have always paid your cession statements promptly”.
When a cession statement or claim raises a question, the captive should look for a solution, not just the problem.
The captive should pay that part of the claim or cession statement that it owes, and write an explanation (with appropriate questions) targeting those amounts that are unclear.
The captive might even give benefit of the doubt to the ceding carrier and make the payment in conjunction with a letter to the ceding carrier that: (i) acknowledges that the captive relies on the issuing carrier to present a proper claim; (ii) identifies the issues/questions; (iii) requests that the ceding carrier provide answers to specific questions; and (iiii) acknowledges that the captive will make a payment in good faith to the ceding carrier. However, if the claim is not properly covered in the reinsurance agreement, the captive expects that the ceding carrier will subsequently allow a credit to the captive.
The last approach is low risk when:
The reinsurance agreement includes ‘correction/discovery of errors’ language that states that the parties will be returned to their original position upon discovery of an error, and an interim payment shall not prejudice either party; and
Significant future payments are expected against which the captive might take credit.
‘Good faith’ is a corner stone of the reinsurance relationship. Strong personal relationships are also critical.
Two other comments regarding the drawing of LOCs are worthy of note.
Practical features, such as the geographic location of the bank that posted the LOC, are important. A Cayman captive may hold an LOC placed by a New York bank on behalf of a US issuing carrier. If the Cayman captive petitions a New York bank to obtain the release of the funds, the captive may find itself traveling to New York and facing an injunction that the issuing carrier has filed to prevent the drawdown. While on paper the LOC would appear to provide excellent security, legal action in a US court may be necessary. Considering the ‘disinformation’ that such artistic masterpieces as The Firm have generated, the reliance on a decision by a US court is likely to generate at least mild anxiety for a Cayman-based company. After all, it is tough enough for US litigants to reasonably anticipate the outcome of decisions in US courts.
On the other hand, if an LOC is successfully drawn, there is no guarantee that the beneficiary can keep the money. If the LOC is drawn without cause, or based on error, a reinsurer could use the court system to show that the draw on the LOC was not warranted, and that the issuing carrier was ‘unjustly enriched’.
LOCs are best used to provide long term security, not as a short term ‘hammer’ to enforce a position. Clearly, LOCs do not eliminate a loss that arises from a poorly drawn contract, or an underwriting decision.
In order to encourage the reduction of an LOC when the reinsurance agreement does not contain criteria, the captive should rely on internal staff, or outside advisors, that have the experience with ceding carriers, and that can take advantage of long-term relationships. Other factors to consider are the pattern of prior LOC reductions by the issuing carrier on other programmes, an understanding of the reason why the ceding carrier insists on a high LOC, and a working knowledge of actual claims practices in the original jurisdiction. The combined skill sets that are required of point personnel include an accountant’s familiarity with the operation of an LOC, a ‘hands on’ understanding of claims practices, exposures and latent injury claims, and a familiarity with actuarial analysis.
A reserving philosophy
A reserve is a financial tool that fills a gap in the financial accounts of the company. Its life begins when the party at risk becomes aware of a specific exposure, and its life ends when the known exposure is paid. Operationally, it is the educated best estimate by presumably experienced claims or insurance specialists about the eventual cost of the claim. A property reserve typically has an abbreviated life, and may be paid in one or two years. Workers compensation, medical malpractice, product or general liability claims may be unresolved for many years or even decades—the so called ‘long tail’ legacy exposures. There is a greater risk to a risk bearer if the reserves on the ‘long tail’ claims are understated because the impact is more severe on a cumulative basis.
For our purpose, a reserve is not an evaluation of the exposure. The reserve should be established in the first month or quarter after the party at risk has notice of the loss. Notice often consists of a phone call, email or single-page report with ‘facts’ presented by one party. A reserve can be contrasted with a ‘settlement’ evaluation that takes place after all facts are available. This evaluation examines (or should examine) all coverage, liability and damage issues. The evaluation answers the question, ‘how much do we pay, if anything?’
An understanding of the function of a reserve is particularly important in regard to large ‘long tail’ exposures. A failure to maintain correct reserves is an impediment to the proper recognition of profit/loss of the company and the wealth (or lack thereof) of shareholders, and so not a good thing.
Within this article, a ‘reserve’ is differentiated from an IBNR reserve, or incurred but not reported reserve, that professional actuaries generate. The equation and standard terminology is: (paid loss + case reserve =) incurred loss + IBNR = ultimate expected loss.
Actuaries can generate IBNR using several different techniques. However, most rely on the case reserve as the foundation for their work.
There is trouble ahead for the risk bearer if different claim specialists (or even different service companies) fail to use a common objective in setting reserves.
There are two extremes in setting reserves:
‘Wait for the facts to become definitive’—this approach invites the dreaded ‘stair stepping’ on individual claims, and ‘deterioration’ of the overall book of business.
‘Ultimate possible cost’ (also known as ‘worst case basis’)—in the extreme, this invites reserving on a ‘limits’ basis. The problem here is that few cases will exhaust the limit of liability. By volume, the majority of casualty claims are resolved quickly, perhaps within several months or one year of the loss, even if most seasoned claims professionals recall the ‘bell ringer’—the settlement or verdict with many ‘$000s’.
‘Ultimate probable cost’ is the middle ground and the preferred approach. Because the exposure is new, all ‘facts’ are unlikely to be available, and it might take years before they are available. The approach requires a loss pick from the decision maker based on her/his experience about the likely exposure five or 10 or more years down the road. The decision maker is unlikely to be accurate in a high number of instances.
However, the objective is that the loss picks that are too high will offset the loss picks that are too low. That is: total reserves = total costs.
This reserve philosophy called ultimate probable cost is the essential first step, but the effort falls short if no one knows the objective, or if it is applied inconsistently. Therefore, the objective should be: (i) written; (ii) used consistently over time; and (iii) common to all parties that that have responsibility for establishing reserves. It should be a standard feature in claims manuals and claims service contracts, and recognised by the captive, the ceding company, and the claims contractor. Based on a consistent underlying reserving practice, the actuaries that project ultimate expected loss will be heroes. The underwriters that renew and write new business will have confidence in their existing experience when they ‘sharpen their pencil’. Importantly, the shareholders of the company will take comfort in the presumed wealth that they accumulate in their captive.
Reinsurance relationships
There were two captive insurance companies in Cayman—Integrity Captive Insurance Company and Haphazard Insurance Company (both are fictitious). Each captive: (i) was owned by a parent company headquartered in the US; (ii) had significant products liability exposure; (iii) (the parent of each captive) treated this exposure in the years before 2002, at least in part, by purchasing an umbrella liability policy with limits of $5 million X $1 million (primary layer to include a large deductible) from a large US-based carrier; and (iiii) created a captive in 2002 that issued a policy that replaced the $5 million layer issued by the umbrella carrier. The reinsurer of the captive $5 million X $1 million layer starting in 2002 was part of the family of companies that issued the umbrella policy before 2002.
A lawsuit was filed in 2005 by 100 plaintiffs in the US State of Illinois, a jurisdiction with a reputation for large plaintiff verdicts. The suit alleged various exposures to the product of each company that resulted in lung, pulmonary and other latent injuries. The suit (as is typical) named 50 defendants, all product manufacturers, and alleged that the damages occurred over a long period of time, with exposure starting in 1980, and continuing through the filing of the lawsuit in 2005. In 2012, after significant discovery and the dismissal of most of the defendants, the jury awarded a verdict of $6 million (later settled in the same amount) against each (parent company) policyholder.
Integrity operated as an independent entity, establishing an arm’s length relationship with its parent company policyholder and its reinsurer. The chief risk officer, Bill Smith, was familiar not only with the terms of the umbrella policy that Integrity issues to the parent, but also the terms of the reinsurance agreement by which the reinsurer provided $5 million of support to Integrity. When the suit was filed in 2005, the Integrity policyholder sent the suit to all insurance carriers to include Integrity.
Integrity in turn, relying on good insurance and claim expertise, reported the loss to its reinsurer using standard protocol to include the reinsurance agreement reference numbers, and the dates of the agreements that potentially applied. The reinsurer acknowledged receipt of the original notice, and asked that Integrity keep the reinsurer advised. Integrity was keenly aware of the obligations and rights in the agreements to include the obligation to: (i) notify the reinsurer promptly of any event which might result in a claim against the reinsurer; (ii) allow the reinsurer to inspect all books, records and papers; and (iii) cooperate in every respect in the defence and control of any claim.
While the claim was pending, Integrity sent a letter to its reinsurer on six occasions, to include advice regarding the upcoming trial, the adverse verdict, and the planned settlement. The reinsurer made no specific recommendation about the termination of the exposure, but only asked that Integrity keep the reinsurer advised. Subsequently, Integrity provided to the reinsurer: (i) a copy of the release agreement: (ii) a timely proof of loss; and (iii) the ‘date certain’ that it would pay the $5 million. In conjunction with the payment date, the reinsurer wired its $5 million to Integrity, recognising the language in the reinsurance agreement:
“…[U]pon receipt by the reinsurer of satisfactory evidence of payment for which reinsurance is provided, the reinsurer will promptly reimburse the company for its share of the loss”
The president of the policyholder wrote to Bill Smith: “Regarding that unfortunate lawsuit that we resolved, and the involvement of Integrity—I love it when a plan comes together. Thanks.”
The claim for Haphazard took a different direction. The parent of Haphazard treated the captive as part of ‘one big happy family’. Bob Jones, the chief risk officer, was satisfied that Haphazard covered the product exposure, and that reinsurance was in place. To save expense dollars, the in-house claims staff at the parent company notified both the umbrella carrier (in the years before 2002), and the reinsurer of Haphazard (in the years of 2002 and after). The umbrella carrier and the reinsurer, both part of the same family of companies, also used the same group of claim professionals to monitor claims.
There was communication with the in-house claims staff, but because of the lack of detail in those communications, the reinsurer did not create a file until the verdict. The verdict arose as a result of damages that took place after 2002, thus implicating the $5 million cover of Haphazard. When the in-house claim staff approached the group of claim professionals about assistance to resolve the claim based on damages after 2002, the reinsurer asked, “What claim?” The reinsurer then discovered that it had no claim file and no reserve. It asked for prior notifications. There were none—not one letter from Haphazard to the reinsurer that identified the contracts that were exposed. The reinsurer claimed late notice, and denied the claim to Haphazard.
Haphazard hired a coverage law firm in New York that began discovery in the US and in Cayman. The reinsurance agreement allowed for London-based arbitrators, and the law firm began the arbitration process at the direction of Haphazard. Based on the argument that there was no prejudice to the reinsurer as a result of late notice, Haphazard eventually recovered most, but not all, of the $5 million through negotiation. The legal expenses of Haphazard totaled $450,000 (good lawyers operating in three different countries are expensive). Also, there was significant disruption to the cash flow position of Haphazard.
The president of the policyholder wrote to Bob Jones: “Regarding that unfortunate lawsuit and arbitration that we resolved, and the involvement of Haphazard, what happened?”
Bob Jones answered that the issue began with the treatment of Haphazard as part of ‘one big happy family’. It was not the type of response that he wanted to make. He subsequently took early retirement.
Unexpected challenges
Most, if not all captives in Cayman, face challenges regarding reserves, LOCs and reinsurance relationships. However, an individual captive may face an unexpected challenge involving: (i) the termination of a contract by mutual agreement in the form of a release, novation or commutation; or (ii) a unilateral attempt on the part of a reinsurer to terminate a relationship using a scheme of arrangement.
A discussion of these topics is beyond the realm of this article. But keep an eye on this space.
