Captive boards and trading partners: communication is key
If you gave an essay test to your captive board, how would it respond to the following questions?...
If you gave an essay test to your captive board, how would it respond to the following questions?
I challenge you to try this test. While basic, it is an excellent tool to gauge if you have achieved a shared understanding, while also assessing if you are maximising the value of trading partner relationships.
The most successful captives have boards that have close and regular communication with all the parties involved in managing their insurance programme, including the broker, fronting carrier, excess carrier(s), outside counsel, independent auditors and actuaries, claims managers, domicile regulator(s) and investment manager.
You and your board should have face-to-face exchanges with these key partners at least once a year. These discussions give you the chance to explain, in person, your captive’s issues, goals and challenges, and assess how well the trading partners listen, confirm and respond.
Trading partners working in unison to create solutions can be extraordinarily powerful. Why would you rely on someone else to tell your captive’s story to key trading partners? Likewise, why wouldn’t you want your board members to see and evaluate those trading partners on their own? Let’s use three examples of topics for discussion to illustrate the benefits of working together:
Example one: collateral requirements
“Why do fronting carriers require the captive to provide collateral and is there any way to reduce the amount?”
To begin, think about re-employing the test. Hand out those blue books to the board. Remind them they have a fiduciary responsibility, and then ask:
Collateral seems to be a subject that remains shrouded in mystery. Most of the mystery stems from not having a clear understanding of the ‘why, how and who’ of it. Do board members understand that, in a fronting transaction, the carrier takes on a credit risk that may need to be supported by collateral? Do they realise that a carrier must allocate capital to support the fronting transaction’s impact on its credit, operational, regulatory, tax and legal risks? Also, regulatory conditions may require the carrier to hold collateral to support cessions to non-admitted reinsurers that result in potential capital costs (for example, the Schedule F penalty in the US).
Like any well-managed business, captives and their boards seek predictability, which yields stability. When collateral management seems mercurial, the issue becomes contentious. This is completely avoidable. Each party understanding the compliance and accounting issues establishes a foundation to jointly create solutions that meet the captive’s goals and avoid affecting the capital position of the fronting carrier.
We work with a range of captives requiring varied covers, including professional liability, first-party property, and many special coverage forms. Each captive has unique needs and challenges, and each seeks to minimise collateral.
Collateral determination is an analysis that must take into account:
The basics of collateral and fronting
National Association of Insurance Commissioners (NAIC) US statutory reinsurance accounting rules require commercial insurers to hold collateral for reinsurance cessions to “unauthorised” reinsurers in order for the carrier to receive credit for the reinsurance cession. No collateral means no credit for the reinsurance cession from fronting carrier to captive. Now, this would not be a good thing for a carrier. It would cause the oft-referenced Schedule F penalty. In effect, the fronting carrier would be retaining the risk and using capital as if it were insuring the risk, but for a fraction of the income, given that the consideration is a fronting fee rather than a risk transfer premium. That is a poor use of capital.
The NAIC requires that collateral take the form of a letter of credit, a “qualified” reinsurance trust (typically, a New York State Regulation 114 Trust), funds withheld or a combination thereof. No other forms qualify to offset a Schedule F penalty.
The amount of collateral is typically determined by a combination of factors:
Within each of the three broad categories described above (LOB, claim trigger and financial strength), there are variations on the theme. While the topic may be ‘collateral’, the programme structure, along with client’s needs versus wants, can have a great impact on collateral amounts. No two accounts have the same issues, and it is critical that the fronting carrier learns the issues first-hand from the captive board in a face-to-face, interactive exchange. Good communication yields good results. Not understanding can have long-term negative results.
Example two: understanding the symbiotic relationship of coverage and the effect of claim triggers when retaining risk through a captive and their impact on collateral
“I am paying too much for product liability. There is no need to transfer this risk, so let’s keep it. Find me a fronting carrier.”
We were recently approached regarding an account whose CFO was convinced that they were paying excessive premiums for their product liability. For the product involved and the limit provided, the premium seemed reasonable—to us. However, that is the view of an insurer, not an insured.
What really triggered the CFO’s ire was the fact they had never had a product liability claim. So paying almost anything was going to seem unreasonable. The CFO was determined to self-insure. Caution: retaining risk because no claims have ever manifested can be a dangerous, short-sighted decision.
In the ensuing discussions, it became apparent that the CFO had not made the paradigm shift from being an insurance buyer to running an insurer. When running an insurance operation, it is important to understand financial ‘tail’ commitments.
We discussed the claim trigger for the coverage. As an insurance buyer, the CFO had purchased an occurrence trigger, but even as an insurer, he still wanted occurrence. We were pretty certain that he did not understand the dynamics involved.
Given the semi-long life of the product insured (assume at least 10 to 15 years), we emphasised that with occurrence, collateral stacking would occur and it would quickly become a negative issue for the CFO.
We have often found that with occurrence triggers, the client’s motivation to continue with the terms currently in place is driven not by counterparty mandate, but by a thought process of “that’s the way it has always been”.
Using a claims made trigger can provide counterparties the protection that they seek, while allowing the captive predictability by ring-fencing open claims, allocated loss adjustment expense and incurred but not reported, thereby providing an element of control on the collateral amount held.
While we were willing to provide both options, we knew from experience that it is critical that the client understands the cause and effect relationship of key decisions. In the end, the CFO stayed insured another year by purchasing risk transfer.
Example three: utilising partners’ breadth of experience can provide surprising benefits to your captive
““This client’s lawsuits are costing us a fortune. Why was it a client in the first place—didn’t anyone check it out?””
Interactive communication between your captive board and your trading partners can add great value because of the networking that can occur and the broader perspectives brought to bear. Our industry is becoming increasingly specialised. Brokers, insurers and law firms are structured into practice groups.
On the one hand, this trend offers benefits. Because of increased loss exposures and the attendant compliance oversight, specialisation is practically mandatory.
But learning how others in a different industry/specialty recognise and manage certain risk management challenges may bring a new outlook to something with which you have been struggling.
As you are able to have trading partners that cross into many lines, you have a valuable resource at your disposal for brainstorming and creative problem solving.
For example, forensic claim reviews on loss causality stemming from inadequate healthcare patient intake/screening may have much in common with the client intake review process used by attorneys.
Experience shows us that costly medical malpractice cases and lawyers’ professional fees are related to the characteristics of client/patient intake.
It is only one piece of a comprehensive risk management, best-business practices discipline, but better management can reduce financial and reputational loss. Much can be learned from the experience of others with a slightly different view.
Communication enhances knowledge. It builds relationships and the opportunity to earn trust among all the key partners.
It stimulates proactive thinking, which can yield stable, predictable captive programmes that are flexible enough to nimbly respond to emergencies or the unexpected.
Consider testing your captive board to see if members share common understanding of the key tenets of your programme and its trading partners. If you are not doing so now, make certain to have face-to-face interaction between your board and the key trading partners of your programme. It will only benefit you. It’s true win-win.
