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W. Jean Kwon, Ph.D., CPCU

School of Risk Management, St. Johns University
101 Murray Street
New York, NY 10007, USA
Phone: +1 (212) 277-5196
E-mail: Kwonw@stjohns.edu
 Risk Management and Insurance: Perspectives in a Global Economy

13. Internal Loss Financing Arrangements

There are two sections which add discussions (or figures) to the book.
One is about rent-a-captive and protected cell company.
The other is about contingent capital as an ART technique.

Click Here to Add Professor

and Course Information
Study Points

Motivations for internal loss financing

Self-insurance

Captive insurance companies

Other ART techniques

3
Internal Loss Financing Arrangements

Unplanned
The firm is unaware of the loss exposure.

Planned
Informal
The firm makes no special arrangements to finance losses
(internally)

Formal
Self-insurance
Captive insurance

We cover mainly self-insurance and

captive insurance in this chapter.

4
Motivations for Internal Loss Financing

5
Motivations

Stronger control of risk management program

Even when transferring residual risks to an insurance company, the
firm may benefit from:
Greater bargaining
Broader and more uniform coverage
Less problems of coverage availability/affordability

Lower firms cost of risk

Lower administrative expenses
Avoid subsidizing others
Provide access to reinsurance
Grain tax advantages

6
Motivations

Better cash flow control

Capture investment income

When facing long-term loss exposures
When using a captive

Avoid inefficiencies with traditional insurance

Counterparty risk
Subsidizing poor risks
Information asymmetry

7
Self-insurance

8
Self-insurance

Individual self-insurance

Group self-insurance

9
Risk Analysis

The self-insured borrows several key techniques used by

insurers.

But, self-insurance is not a solution to every risk. Candidate

risks may include:
Exposures exhibiting both low frequency and severity
Exposures reasonably expected to exhibit high frequency and low
severity

A large number of exposure units is desirable

A self-insured firm still faces the problem of possible correlation
among loss exposures.

10
Risk Analysis Reliability Analysis
Pages 324-325
Case
A manufacturer examines its exposure to workplace injuries.
The number of injuries has been 10 percent of the number of
employee years.
Willing to self-insure these injuries, if a minimum of 95% of the
injuries does not exceed 125% of the expected value.

Workplace injuries commonly follow a pattern typified by a Poisson

distribution

Using the central limit theorem, we approximate the Poisson

distribution via a normal distribution. Hence, using a 95% confidence
interval, we get 433 as the number of full-time employees during a
year the number the firm needs for self-insurance.

11
Risk Analysis Setting Reserves

Maintaining financial solvency is critical even in self-

insurance

Factors to be examines
Loss development factor
Exposure factor
Trending factor

Table 13.1

You may not agree with these factor

classifications.

12
Estimation of Loss Reserves (Table 13.1)

13
Use of Self-insurance the U.S.

Commercial liability risks

Group health plans

Workers compensation benefits

14
Third Party Administrator (TPA) (Figure 13.1)

15
The Future of Self-insurance (Table 13.2)

16
Captive Insurance

17
Background

Captives are not new to risk management and insurance

professionals.
However, not until the 1960s did several pioneers flight the
resistance of established commercial insurers and persuade many
U.S. corporations to create their own insurers.

Captive insurance has become a significant market force

internationally
More than 90 percent of the top 500 U.S. firms own a captive.
The share of the global captive insurance market by 2,500 worlds
largest firms was 80% in 2001

18
Background

Captive insurance use is not limited to the private sector.

Captives exert a disproportionate influence on the

commercial insurance market.

Captives also are a result of the growing instability and

unpredictability of modern economic activities.

19
Definition and Classification

Definition
A closely held corporation whose insurance business is supplied
primarily by its owner(s) and in which the owners are the principal
beneficiaries.

Differences from traditional insurer

Ownership and management control
Scope of operation

Classification
Single-parent captive
Group (association) captive
Rent-a-captive
Protected cell companies (sponsored captives)

20
Use of Captive Simplified

Business

Purchase insurance

Captive
Insurer

1) Retains all, or
Reinsurer
2) Retains a small portion
of the risk and purchase reinsurance
Single-parent Captive (Figure 13.2)

22
 Not in the Book!
Benefits from Captive Operations

Alignment with corporate goals (ERM)

Tailored coverage

Control over claims

Direct access to the reinsurance market

Possible tax benefit

Inclusive of concession tax benefit

23
Captives in New York (Selected)

First Mutual Transportation Assurance Company (Metropolitan

Transportation Authority)
CM Insurance Company, Inc. (Columbus-McKinnon Inc.)
Moodys Assurance Company Incorporated (Moodys Corporation)
TSI Insurance Incorporated (Town Sports International)
Sammarnick Insurance Corporation (Viacom Inc.)
Haversine Insurance (Omnicom Group)
Customer Asset Protection Company (CAPCO Holdings)
Owned equally by fourteen financial institutions
Bergstresser Insurance (Dow Jones & Company)

24
Group Captive

Organizations using it
typically exhibit the
following traits:

Entities sharing common

needs

Capital constraints

Business volume
constraints

25
Rent-a-Captive
Characteristics
Use by one firm of
management, investment,
and other services of an
existing captive owned and
operated by an unrelated
firm, for a fee
De facto, capital lease
agreement
Usually offshore created by
insurance brokerage firms or
institutional investors
Be careful!
Responsible for underwriting
results of its own
Commingles assets (e.g.,
investment) of the sponsoring
captive
Possible high
collateralization and usage
cost
Counterparty risk
Short-term solution
26
Rent-a-Captive

Client Account
Segregated by A
contract and Client Account
Client Firm shareholders B
Client Account
A agreements
Premium/ C
Insurance
Premium/
Client Firm Fronting Reinsurance
RAC
B Insurer

Client Firm
C

Not in the book!

An illustration involving a fronting company (see
also Figure 13.5) 27
Protected Cell Company (PCC)

A.k.a. sponsored captive

Creation of captive within a captive
Only the sponsoring captive subject to regulatory compliance of its
own and all sponsored captives

Sponsored captives shielded from the operation of sponsoring

captive
At the underwriting level
At the operational level

Only limited jurisdictions permit PCCs

28
Protected Cell Company (PCC) Arrangement

Segregated by Cell A
statutes Cell B
Client Firm
A Cell C
Premium/
Insurance
Premium/
Client Firm Fronting Reinsurance
PCC
B Insurer

Client Firm
C

Not in the book!

An illustration involving a fronting company (see
also Figure 13.5) 29
Risk Retention Group (RRG)

A type of U.S. group captive created under

The Product Liability Risk Retention Act of 1981
The Liability Risk Retention Act of 1986

Unlike typical insurers, they need to be licensed in a single

state only by default, their domiciliary state but can
operate in all U.S. states.

Declining RRG markets

The restriction of business to liability lines and the unavailability of
state insurance guarantee benefits to their insureds.
A lack of uniform accounting standards, non-uniformity in RRG
management standards

30
Use of Captive as a Risk Financing Technique

Capital commitment and expenses

See Figure 13.4
See also Table 13.4

Risk of adverse results

Captive as a distraction

31
Captive Feasibility Study (Figure 13.4)

There are two typos in the figure

(first printing of the book).

The third box on the left has exiting,

which should be existing.

The fourth box on the left states Is

involving financial officer possible? The
correct one should be Is involving a
financial officer possible?

The corrected figure is made available

in the next page.

32
Captive Feasibility Study (Figure 13.4)

Conventional Insurance
Turnover greater than 50 million? No Market
Ye
s
Does the premium spending exceed 1 million
for property, 500,000 for general liability, 1
million for motor liability, or 1 million for other
liability? If premium or retention amount
exceeds 250,000 in any line,
or No No
will you consider a cell captive
in a protected cell company?
Does existing or planned risk retention exceed
1 million for property, 500,000 for general Ye
s
liability, or 1 million for motor liability?
Is involving financial officer
Ye No
possible?
s Ye
s
Is involving a financial officer possible? Cell Captive
Ye
s Can you accept the following
indicative costs of 20,000 for
Single-parent Captive No
feasibility study, 25,000 of
Can you accept the following indicative costs of annual operating cost, but
20,000 for feasibility study, 25,000 of annual without capitalization
operating cost, plus a minimum capitalization commitment? Ye
of 500,000? s
Ye
s
Continue Feasibility Study
33
Captive Operational Issues

Underwriting

Direct insurance and reinsurance

Captive reinsurance and fronting arrangements

Captive management

Selection of captive domicile

Tax situation

Corporate governance
34
Considerations in Selecting a Domicile (Insight
13.1)

Quality of regulation and supervision

Investment restrictions
Minimum capitalization requirements
Premium and other taxes and expenses
Underwriting restrictions and reserve requirements
Reinsurance restrictions
Reporting requirements
Tax relationship of domicile with home country of the owner
Currency stability and convertibility
Quality of local infrastructure
Political and economic stability
Quality and ease of transportation and communications

35
The Tax Situation

Conditions for tax deductibility of premiums

The captive assumes underwriting risk.
Risk distribution is present.
The captive operates according to accepted industry practices.

36
Captive Corporate Governance

The Sarbanes-Oxley Act

The captive must be managed based on a well-established code of

ethics. The code governs the scope of responsibilities and authority
of the board and its members.

The board of the captive bears the responsibility for overseeing

sound captive operations.

The board bears the responsibility for financial reporting according to

the laws governing the captive. The responsibility includes
appointment of an auditor or an auditing committee as well as
oversight of the auditing process.

37
Captive in a Fronting Arrangement (Figure 13.5)

Multinational Corporation
in France

U.S. Subsidiary U.K. Subsidiary France Subsidiary Sweden Subsidiary Japan Subsidiary
Liability Exposure Liability Exposure Liability Exposure Liability Exposure Liability Exposure

Fronting Insurer Fronting Insurer Fronting Insurer Fronting Insurer

in the U.S. in the U.K. in Sweden in Japan

Captive
(Functioning as Reinsurer)

Retrocession

38
Places of Domicile

Outside the Continent

Bahamas
U.S. States
Barbados Arizona
Bermuda Colorado
British Virgin Islands Delaware
Cayman Islands Georgia
Gibraltar Illinois
Guam Kansas
Guernsey
Hong Kong
Maine
Ireland Montana
Isle of Man Nevada
Luxemburg New York
Malta Rhode Island
Panama South Carolina
Singapore South Dakota
States of Jersey
St. Lucia
Tennessee
Turks & Caicos Vermont
US Virgin Islands Virginia
West Virginia

Red Popular places

39
Number of Captives by Domicile (Table 13.3)
(Updated)

40
10 Largest Captive Management Firms (Table 13.5 )
(updated)

Business Insurance (March 3, 2008)

41
42
43
44
Discussion Questions

45
Discussion Question 1

Other than the involvement of a third party, can we argue

that self-insurance and traditional insurance are virtually
identical? What bases of arguments for or against this
statement can you provide?

46
Discussion Question 2

Do you believe it is necessary for very large, well diversified

MNCs to purchase excess insurance over their self-
insurance limits?

47
Discussion Question 3

Why might a widely held corporation utilize a captive even

though it would not purchase commercial insurance if it had
no captive?

48
Discussion Question 4

What types of exposures might a firm specifically want to

avoid writing in its captive and why?

49
Discussion Question 5

Do tax laws in your country discriminate for or against

captives or are they neutral toward them vis--vis
commercial insurers? Vis--vis non-captive self-retention?

50