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Chapter OutlineChapter Outline

11.1 Traditional Insurance ContractsBasis of CoverageDeductibles and Self-Insured RetentionsPolicy Limits, Excess Policies

Layering CoverageUmbrella Liability Coverage

11.2 Loss Sensitive ContractsExperience Rated PoliciesLarge Deductible Policies and Retrospectively Rated PoliciesRelated Loss Sensitive PlansLoss Portfolio TransfersFinite Risk Contracts

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Chapter OutlineChapter Outline

11.3 Captive Insurers

Motivations for Forming Captive Insurers

Tax and Regulatory Factors

Risk Reduction

Tax Treatment of Captive Transactions

General Legal Principles

Captives that Only “Insure” a Single Parent

Captives with Unrelated Business

Captives that Only Insure a Single Parent and Sister Corporations

Risk Retention Groups

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Chapter OutlineChapter Outline

11.4 Methods of Paying Retained Losses

Internal Funds

Cash Flows

Dedicated Assets

Lines of Credit

Issue New Securities

11.5 Trends and Innovations in Loss Financing

11.6 Summary

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Traditional Commercial Traditional Commercial Insurance PoliciesInsurance Policies

Basis of Coverage

– Occurrence coverage

insurer pays losses if they occurred during the policy period

– Claims-made coverage

insurer pays losses if the claim is made during the policy period and the loss occurred after the retro-active date

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Claims-Made versus Claims-Made versus Occurrence PoliciesOccurrence Policies

Compare risk bearing effects of a series of occurrence policies with a series of claims-made policies over 1995-1998 period

1995 1998

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Exposure Diagram with no InsuranceExposure Diagram with no Insurance

0

1

2

3

4

5

6

0 1 2 3 4 5 6

Loss Amount

Lo

ss P

aid

by

Fir

m

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Exposure Diagram with a Exposure Diagram with a DeductibleDeductible

Exposure Diagram with $1 million deductible (w and w/o premium)

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Types of DeductiblesTypes of Deductibles

Types of deductibles

– per _________ can use stop loss policy to limit aggregate loss

– aggregate– franchise

Deductibles versus self-insured retentions (SIR)

– Deductible: insurer pays losses and then is reimbursed– Letters of ______

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Exposure Diagram with a Exposure Diagram with a Policy LimitPolicy Limit

– Usually called excess policy: $3m excess of $1m

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Layering CoverageLayering Coverage

Purchase $3m excess of $1m SIR Purchase $5m excess of $4m

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Coverage for the World Trade Coverage for the World Trade CenterCenter

Retention $100,000 per claim

1st Layer $10 million from Am Home Assurance and Home Indemnity

2nd Layer $290 million from 11 companies

3rd Layer $100 million from 5 companies

4th Layer $100 million from 68 syndicates at Lloyd’s of London

5th Layer $100 million from 65 syndicates at Lloyd’s of London

(Source: Business Insurance, March 8, 1993)

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Umbrella Liability CoverageUmbrella Liability Coverage

– Coverage above _______ on other policies covering multiple exposures

– Example:

Commercial general liability policy limit = $20m Auto liability limit = $1m per occurrence Umbrella limit = $30m

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Loss Sensitive ContractsLoss Sensitive Contracts

Main feature:

– Policyholders’ payment depends on______during the policy period

usually requires a letter of credit

Examples:

– _________ rating

– Large deductible policies

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Retrospectively Rated PoliciesRetrospectively Rated Policies– Characteristics

minimum & maximum premium payment based on

– ________ losses

– paid losses

– Exposure diagram

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Why Use Loss Sensitive?Why Use Loss Sensitive?

– Want to retain risk but obtain

____________ of insurance

Purchase claims processing services

Satisfy __________ insurance laws

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Other Loss Sensitive PlansOther Loss Sensitive Plans

Can eliminate letter of credit by pre-funding losses

– Examples: _________ credit plans Premium financing plans

– ______ arbitrage

Loss Portfolio Transfers

– transfer ______ ________ to insurer– insurer takes on some __________ risk, but mostly

________ risk

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Finite Risk PlansFinite Risk Plans– Characteristics of finite risk plans (financial insurance)

Multi-period loss sensitive plans Example:

Cash Flows (in $thousands) from a Three-year Finite Risk Contract(Premium = $4 million, interest = 6% of beginning balance, $20 million aggregate limit)

Year 1 Year 2 Year 3At beginning of year:

Balance from previous year $0 $ $Premium 4,000 4,000 4,000Insurer’s fee -400 -400 -400Beginning balance

At end of year:Claim payments -2,000 -4,000 -5,000

Plus interest on beginning balance _____ _____ _____Ending balance

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Finite Risk PlansFinite Risk Plans

– Another example:

Cash Flows (in $thousands) from a Three-year Finite Risk Contract(Premium = $4 million, interest = 6% of beginning balance, $20 million aggregate limit)

Year 1 Year 2 Year 3At beginning of year:

Balance from previous year $0 $ $Premium 4,000 4,000 4,000Insurer’s fee -400 -400 -400Beginning balance

At end of year:Claim payments -1,000 -12,000 -1,000Plus interest on beginning balance _____ ______ _____Ending balance

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Smoothing Effect of Finite Risk PlansSmoothing Effect of Finite Risk Plans

$12

$6

years 1 2 3 4 5 6

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Captive InsurersCaptive Insurers A captive insurer is a ________ of a firm that

insures its parent.

Types of captives (use diagram)

– Pure captive ______ - _______ transactions may purchase reinsurance

– Captive with unrelated business insurance reinsurance

– Group captives

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Relationships with Captive Relationships with Captive InsurersInsurersParent

Corporation

Captive Insurer

Insurer A

Insurer B

Unrelated Non-Insurance Entity 2

Unrelated Non-Insurance Entity 1

Sister Subsidiary1

SisterSubsidiary 2

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Location of Captive InsurersLocation of Captive Insurers

Locations of Captive Insurers in 1996

Location Number of CaptivesBermuda 1,050Cayman Islands 373Guernsey 324Barbados 167Dublin 134Isle of Man 134Luxembourg 235Vermont 293

Source: Business Insurance, April 14, 1997.

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Motivations for CaptivesMotivations for Captives

– Tax

treat retention as ________ lower tax rates offshore

– Regulatory

want to ________ risk, but use a fronting insurer to

– _______ compulsory insurance laws– comply with restrictions on use of admitted insurers

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Motivations for CaptivesMotivations for Captives

– _____ ______ requirements

want to retain risk, but use a fronting insurer to meet third party requirements for certificate of insurance

– Reduce risk

______ exposures with

– unrelated business (primary or reinsurance)– other parents

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Tax Treatment of CaptivesTax Treatment of Captives

Tax Treatment

– General legal principles

risk ________ matters

_________ boundaries matter

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Tax Treatment of CaptivesTax Treatment of Captives

– General cases

_______ parent captive that only insures parent

_______ parent captive with unrelated business– Sears: 99% unrelated business

– Harper: 30% unrelated business

Single parent captive with _____-______ transactions– Humana

– Kidde

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Risk Retention GroupsRisk Retention Groups

Just like ______ _______

Pool liability exposures

– 1981 - 1986:only products liability– after 1986: other liability exposures

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Methods of Paying Retained Methods of Paying Retained LossesLosses

_______ Funds

– Cash Flows– Dedicated assets

Lines of credit & contingent equity

Issue new ________ following a loss

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Trends and Innovations in Trends and Innovations in Loss FinancingLoss Financing

More _______ & ______ use of alternative market (captives, RRG, finite risk plans)

Why?

Theory Liability insurance crisis in mid-1980s

Insurers’ response

New policies with _______ retentions, _______ approach to risk management (basket or integrated policies)