Fall 2008 Version Professor Dan C. Jones FINA 4355 Handout

Fall 2008 VersionFall 2008 Version

Professor Dan C. Jones

FINA 4355

Handout

Risk Management and Insurance: Perspectives in a Global EconomyRisk Management and Insurance: Perspectives in a Global Economy

13. Internal Loss Financing 13. Internal Loss Financing ArrangementsArrangements

Professor Dan C. Jones

FINA 4355

Handout

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Note to the ProfessorNote to the Professor

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.

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Study PointsStudy Points

Motivations for internal loss financing

Self-insurance

Captive insurance companies

Other ART techniques

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Internal Loss Financing ArrangementsInternal Loss Financing Arrangements

UnplannedThe firm is unaware of the loss exposure.

PlannedInformal

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.

Motivations for Internal Loss Financing

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MotivationsMotivations

Stronger control of risk management programEven 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 firm’s cost of riskLower administrative expenses

Avoid subsidizing others

Provide access to reinsurance

Grain tax advantages

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MotivationsMotivations

Better cash flow control

Capture investment incomeWhen facing long-term loss exposures

When using a captive

Avoid inefficiencies with traditional insuranceCounterparty risk

Subsidizing poor risks

Information asymmetry

Self-insurance

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Self-insuranceSelf-insurance

Individual self-insurance

Group self-insurance

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Risk AnalysisRisk 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 desirableA self-insured firm still faces the problem of possible correlation among loss exposures.

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Risk Analysis – Reliability AnalysisRisk Analysis – Reliability Analysis

CaseA 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.

Pages 324-325

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Risk Analysis – Setting ReservesRisk Analysis – Setting Reserves

Maintaining financial solvency is critical even in self-insurance

Factors to be examinesLoss development factor

Exposure factor

Trending factor

Table 13.1You may not agree with

these factor classifications.

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Estimation of Loss Reserves Estimation of Loss Reserves (Table 13.1)(Table 13.1)

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Use of Self-insurance – the U.S.Use of Self-insurance – the U.S.

Commercial liability risks

Group health plans

Workers’ compensation benefits

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Third Party Administrator Third Party Administrator (Figure 13.1)(Figure 13.1)

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The Future of Self-insurance The Future of Self-insurance (Table 13.2)(Table 13.2)

Captive Insurance

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BackgroundBackground

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 world’s largest firms was 80% in 2001

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BackgroundBackground

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.

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Definition and ClassificationDefinition and Classification

DefinitionA 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 insurerOwnership and management controlScope of operation

ClassificationSingle-parent captiveGroup (association) captiveRent-a-captiveProtected cell companies (sponsored captives)

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Single-parent Captive Single-parent Captive (Figure 13.2)(Figure 13.2)

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Group CaptiveGroup Captive

Organizations using it typically exhibit the following traits:

Entities sharing common needs

Capital constraints

Business volume constraints

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Group Captive Group Captive (Figure 13.3)(Figure 13.3)

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Rent-a-CaptiveRent-a-Captive

Fronting Insurer

Client Firm B

Client Firm A

Client Firm C

RAC

Client Account A

Client Account B

Client Account CPremium/Insurance

Premium/Reinsurance

Segregated by contract and shareholders agreements

Not in the book!An illustration involving a fronting company (see

also Figure 13.5)

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Protected Cell Company ArrangementProtected Cell Company Arrangement

Fronting Insurer

Client Firm B

Client Firm A

Client Firm C

PCC

Cell A

Cell B

Cell CPremium/Insurance

Premium/Reinsurance

Segregated by statutes

Not in the book!An illustration involving a fronting company (see

also Figure 13.5)

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Risk Retention Group (RRG)Risk Retention Group (RRG)

A type of U.S. group captive created underThe 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 marketsThe 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

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Use of Captive as a Risk Financing TechniqueUse of Captive as a Risk Financing Technique

Capital commitment and expensesSee Figure 13.4

See also Table 13.4

Risk of adverse results

Captive as a distraction

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Captive Feasibility Study Captive Feasibility Study (Figure 13.4)(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 availablein the next page.

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Captive Feasibility Study Captive Feasibility Study (Figure 13.4)(Figure 13.4)

Turnover greater than £50 million?Yes

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?

Does existing or planned risk retention exceed £1 million for property, £500,000 for general liability, or £1 million for motor liability?

Yes

Is involving a financial officer possible?Yes

Single-parent Captive

Can you accept the following indicative costs of £20,000 for feasibility study, £25,000 of annual operating cost, plus a minimum capitalization of £500,000?

Yes

No Conventional Insurance Market

or

If premium or retention amount exceeds £250,000 in any line, will you consider a cell captive in a protected cell company?

Yes

No

Is involving financial officer possible?Yes

Cell Captive

Can you accept the following indicative costs of £20,000 for feasibility study, £25,000 of annual operating cost, but without capitalization commitment?

Yes

Continue Feasibility Study

No

No

No

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Captive Operational IssuesCaptive Operational Issues

Underwriting

Direct insurance and reinsurance

Captive reinsurance and fronting arrangements

Captive management

Selection of captive domicile

Tax situation

Corporate governance

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Captive in a Fronting Arrangement Captive in a Fronting Arrangement (Figure 13.5)(Figure 13.5)

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

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

Business Insurance (March 3, 2008)

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Considerations in Selecting a Domicile Considerations in Selecting a Domicile (Insight 13.1)(Insight 13.1)

Quality of regulation and supervisionInvestment restrictionsMinimum capitalization requirementsPremium and other taxes and expensesUnderwriting restrictions and reserve requirementsReinsurance restrictionsReporting requirementsTax relationship of domicile with home country of the ownerCurrency stability and convertibilityQuality of local infrastructurePolitical and economic stabilityQuality and ease of transportation and communications

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The Tax SituationThe Tax Situation

Conditions for tax deductibility of premiumsThe captive assumes underwriting risk.

Risk distribution is present.

The captive operates according to accepted industry practices.

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Captive Corporate GovernanceCaptive 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.

Other ART Techniques: Contingent Capital

Not in the book!

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FundamentalsFundamentals

Contingent capitalSimply, an option to issue a corporate security

Contingent capital facilityRight to issue new debt, equity or structured security

During a specified period

At a predefined issue price

On the occurrence of a triggering event

Unexpected & substantial loss by the right holder

High correlation between the loss exposure and the price of the security

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Contingent Capital - ElementsContingent Capital - Elements

UnderlyingDebt, equity or hybrid security defined at the beginning of the option period; that is, before the security is issued

Tends to be deeply subordinated debt or preferred stock

TenorLimited duration; for example, right to issue five-year, fixed rate subordinate debt at any time during the next three months

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Intrinsic value (strike price)Usually at-the-money at inception; that is,

Price set prior to loss realization

Value tied to the price of the underlying on the date of contingent capital negotiation

Cost-of-capital difference between

[1] One under the arrangement and

[2] The other in the open market at the time of exercise

No option exercise if [1] > [2]

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Exercisability – dual triggers

The underlying with a greater-than-market value and an objectively defined loss event

First trigger usually American, thus giving the right holder to issue the securities at any time during the tenor period

Instead of loss, the second occasionally tied to a variable beyond the firm’s influence, thus minimizing problems of moral hazard

Linking the firm’s negative earnings shock to the average industry earnings, for example

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PlacementCommonly a private placement with a (lead) option writer

Until exercise, the writer collects a periodic commitment (premium) until the facility is exercised

On exercise and in case of a put option, the writer gets a security in return for the (cash) payment to the owner of the facility

Compare it with an insurance contract!

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Committed Capital Facility ExampleCommitted Capital Facility Example

Insurer

Purchase the option, pay the premium until exercise

SPVPrior to exercise, holds capital,

say, commercial papers

On exercise by the insurer, liquidate its own securities to

purchase, say, preferred stock issued by the insurer

Investors

Put Option CommitmentFee/Premium

CashIssue

Securitiesw/

Collateral

Investment

Coupon + Premium

Trust

Discussion Questions

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Discussion Question 1Discussion 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?

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Do you believe it is necessary for very large, well diversified MNCs to purchase excess insurance over their self-insurance limits?

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Why might a widely held corporation utilize a captive even though it would not purchase commercial insurance if it had no captive?

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What types of exposures might a firm specifically want to avoid writing in its captive and why?

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Do tax laws in your country discriminate for or against captives or are they neutral toward them vis-à-vis commercial insurers? Vis-à-vis non-captive self-retention?

Documents

Fall 2008 Version Professor Dan C. Jones FINA 4355 Handout