Transcript Captives - John Garvey

Reinsurance & ART
Week 6
Course Structure
Week 1:
Week 2:
Week 3:
Week 4:
Week 5:
Week 6:
Week 7:
Week 8:
Week 9:
Week 10:
Week 11:
Week 12:
Introduction/Background
Traditional Reinsurance (Proportional)
Traditional Reinsurance (Non-Proportional)
Implementing Reinsurance Contracts &
Reinsurance Operation and Strategy
Insurability and Climate Change & Exam I
Corporate Risk Management (Self-Insurance
/Captives)
Ratemaking & Estimating the XL Premium &
Regulation t
Risk Swaps/ILWs
Finite Reinsurance
Background to Derivatives (Risk Mgmt /
Hedging/Weather Deriv)
Catastrophe Bonds
Review
Insurability and Climate Change

Climate Risk
◦ Health Issues
◦ Agriculture
◦ Energy

Increased frequency and severity of hurricanes and
flooding
◦ “Of the 10 most expensive natural catastrophes over the
past 56 years, six occurred in 2004 and 2005.”
Charpentier, 2008, P.94.
Insurability and Climate Change

Climate change will stretch the limits of insurability.
◦ Difficult to estimate an accurate premium…
………….difficult to diversify….
…to charge an affordable premium…

Legal insurability,
Actuarial insurability,
Economic insurability.


Insurability and Climate Change

“the private insurance industry feels that it cannot
continue to provide coverage against hurricanes and
earthquakes as it has done in the past without opening
itself up to the possibility of insolvency….”
Kleindorfer and Kunreuther, 1999
Insurability and Climate Change
Solutions
 Traditional Reinsurance

Alternative Reinsurance

Financial Reinsurance

The Government
Reading

Charpentier, A., 2008, Insurability of Climate
Risks, The Geneva Papers, 33, 91-109.
Reinsurance

Learning Objective
◦ Reasons why risk transfer matters,
◦ Corporate Risk Management: Theory and
Practice,
◦ Self-Insurance/Captives.

Corporate risk management can be broken down
into:
◦ Risk avoidance, risk reduction, risk transfer
and risk retention.
8
Alternative Risk Transfer
Introduction



Definition: The use of risk transfer mechanisms
other than traditional insurance and reinsurance.
The rise of ART
◦ 1. Equity ‘bear’ market.
◦ 2. Rise in expected claims costs.
◦ 3. Financial markets.
Reasons why risk transfer matters.
◦ Managerial self-interest,
◦ Cost of financial distress,
◦ Capital market imperfections,
◦ Non-linearity of taxes.
9
Risk Transfer



Managerial self-interest
◦ Managers have limited ability to diversify their
own personal wealth position,
◦ Stability preferred to volatility.
Risk of bankruptcy (financial distress)
◦ Increased cost of finance,
◦ Relationship with client,
◦ Departure of key personnel,
◦ Stock price.
Capital market imperfections
◦ Cost of volatility is the forgone investment in each
period that the firm is forced to seek external
funds,
◦ Equity & debt issuance have associated costs.
10
Risk Transfer

Nonlinear tax functions
◦ Income ‘smoothing’ reduces the effective tax
rate.
◦ Tax functions facing firms are convex
 Higher levels of earnings lead to higher rates
of marginal taxation
 Above a certain threshold, earnings pass
through several marginal rates
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Risk Transfer

Insurers are in the risk business
◦ they assume various kinds of actuarial and
financial risks
◦ risks may be eliminated or mitigated
 reinsurance, pricing and product design

Many risks are superfluous to the institution’s
business purpose.
12
Corporate Risk Management
Example
BP – exploration, extraction, refinement,
and distribution of oil and gas.
1987-91: Profits were $2bn per year,
Assets of $50bn (1991).
Adopted a strategy of purchasing less
coverage against very large losses.
Local managers purchased coverage for
losses up to $10m.
Losses between $10m and $500m are
generally not insured.
Corporate Risk Management
Example
(1)
(2)
(3)
(4)
Reasons for change in strategy:
BP had paid over $1.15bn in premiums during the
prior decade and had received $250m in claim
payments;
Coverage disputes with insurers were more likely for
losses of this magnitude;
The impact of losses of this size on firm value was
small, given BP’s size; and
Insurers have no advantage compared to BP in
providing safety and loss control services.
Corporate Risk Management
Example
For losses above $500m BP doesn’t purchase insurance:
(1) Insurance market capacity to provide coverage to losses
this large is limited;
(2) The ability to deduct losses from taxable income reduces
demand for coverage, and
(3) A loss of this size due, for example, to destruction of a
major oil rig could increase the price of oil, thus
mitigating the loss.
The ART Market


Risk Carriers
Self
insurance/captives
Capital Markets




Risk Products
Finite risk
(re)insurance
Contingent capital
Weather derivatives
(e.g. Hurricane Call
Options),
Securitisation / ILS.
16
The ART Market
Risk Carriers

‘In 2001, the size of the global ART carrier market
was estimated at about $88billion’
SwissRe, sigma No. 1/2003

Self-insurance / captives are the major carrier.

Self-insurance makes up 75% of the total
alternative market.
17
The ART Market
Risk Carriers

Self-insurance
Definition: Establishing reserves for future
losses instead of purchasing insurance.

In reality: No Insurance.

Accounting mechanism that moves expense
from one period to another, i.e. the management
of earnings.
18
The ART Market
Risk Carriers
Captives
 An insurance/reinsurance company owned by a
corporation or group of companies which are not
active in the insurance business themselves.

Rapid growth during the hard markets of 1970’s
and 1980’s.

Currently over 5,000 captives globally.

Approximately 150 captives registered in Ireland.
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Captives


Who uses a captive?
◦ Over 70% of Fortune 500 companies.
◦ Many private companies.
◦ Associations or affinity groups.
Uses of a captive
◦ Can write all classes of insurance benefits,
incl. life, employee benefits.
◦ Most common covers are property and
casualty.
◦ Act as insurer or reinsurer.
◦ Corporate or customer risk.
Captives

Benefits (1)
◦ Minimise external premium spend
◦ Participate in underwriting performance
◦ Stabilises effects of insurance market cycle
◦ Improved cash flow
◦ New revenue stream
◦ Fiscal benefits
Captives

Benefits (2)
◦ Broad cover, flexible design
◦ Create additional capacity
◦ Management buy in
◦ Discipline of running a regulated entity
◦ Direct access to reinsurance markets
Captives

Locations
◦ Many on and offshore jurisdictions
◦ Legislation and regulation
◦ Developed financial infrastructure
Bermuda, Cayman Islands, Isle of Man, Ireland,
Vermont, Malta, Gibraltar, Guernsey,
Luxembourg, Singapore, Hawaii.
Captives

Candidates
◦ Companies with predictable attritional losses.
◦ Companies with better than market average
loss experience.
◦ Companies with poor loss experience but
dedicated to improved risk management.
◦ Companies with uninsured risks.
◦ Global programmes consolidation.
◦ Companies able to sell insurance products to
their customers.