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An Introduction to Workers
Compensation Alternative Risk
Transfer Mechanisms and the
Bermuda Insurance Market
James Matusiak FCAS,MAAA
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Overview
Workers Compensation Overview
Captives and Fronting Arrangements
Finite Reinsurance
The Bermuda Insurance Market
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Workers Compensation
Workers Compensation is one of the largest risks
for businesses around the world.
Workers Compensation benefits reimburse
employees for lost wages and medical expenses
incurred as a result of work-related injuries or
disease.
Benefits are usually dictated by state workers
compensation statutes. In addition, benefits are
no-fault, they are paid without regard to fault of the
employer or the employee.
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Workers Compensation
To handle the workers compensation exposure,
there are two main options:
Workers
Compensation
Risk
Traditional Insurance Programs
Alternative Risk Transfer Programs
•Traditional Insurance
•Captives
•Experience Rating
•Finite Reinsurance
•Retrospective Rating
•Large Dollar Deductible
Programs
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Workers Compensation Traditional
Risk Transfer
Historically, businesses purchased traditional
insurance policies to cover their workers
compensation risk. The insured paid a premium
and the insurer took on all of the risk (minus a
small deductible).
Premium
Business
(Insured)
Insurer
Coverage
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Workers Compensation Traditional
Risk Transfer
As workers compensation rates rose, large
businesses looked to control their insurance costs.
This evolved into experience and retrospective
rating schemes.
– Experience rating: A company’s premium is derived by
looking at their own historical loss experience.
– Retrospective rating: A company pays a deposit
premium based on historical losses but may have to pay
more or receive a premium refund based on their current
year losses. Retrospective premiums are capped at a
minimum and a maximum.
Both of these options are within the scope of
traditional insurance programs
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Workers Compensation Alternative
Risk Transfer
Companies still wanted more options to control
their insurance costs. This demand created the
need for captives and finite reinsurance.
– Captives: A subsidiary of a corporation who insurers the
risks of its parent. Premium is collected and losses are
paid into and out of a separate balance sheet.
– Finite Reinsurance: An insurance contract written by a
third party reinsurer that covers the risks of an insured.
Loss payments are capped at an aggregate or “finite”
amount.
Both of these options are typically referred to as
alternative risk transfer.
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Captives
As mentioned above, captives are usually
subsidiaries that cover the insurance risks of their
parent company. Other ownership structures are
possible.
Captives operate under a separate balance sheet.
Captives operate as reinsurers of the risk through
what is referred to as a fronting arrangement.
The majority of captives are managed by third
parties.
Parent companies still have to provide coverage
up to statutory limits.
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How a Captive Arrangement Works
Premium
Business
(Insured)
Insurer
Coverage
Premium
Captive
(Insured)
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Captives – Fronting Arrangements
 Due to the fact that workers compensation rates and policy
forms are regulated, the traditional insurance process is kept
in place for policy issuance purposes.
 The fronting insurer issues the policy on its own paper
(“policy form”).
 The fronting insurer then cedes the risk to the captive using
a reinsurance contract.
 For this service the fronting insurer collects a fronting
commission.
 It is common practice for the insured to post a letter of credit
to the fronting company to cover the credit risk of the
captive.
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Captives – In operation
Captives are domiciled in jurisdictions that have
special insurance legislation in place.
Most captives are managed in their jurisdictions
by a captive manager. The captive manager
handles the accounting and will assist the captive
in placing its reinsurance.
Claims are either adjusted using a Third Party
Administrator (“TPA”) or the fronting insurer.
Captives seldom retain all of the risk of the parent.
This is mostly due to the capital restraints of the
captive.
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Captives – Advantages
 Captives allow a company to retain its own risk. Most
companies are more likely to engage in risk control if they
are ultimately responsible for the cost of that risk.
 By “self-insuring”, an insured does not fund the profit
provisions built into the rates of a third-party insurer.
 Captives allow companies to insure themselves for unique
risks, where coverage may not be available in the
marketplace.
 Captives allow the insured to access the reinsurance
markets that may have more favorable policy terms than the
traditional marketplace.
 Captives generally have some tax advantages for the parent
company.
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Captives – Challenges
Captives must be capitalized. This capitalization
is generally dictated by the amount of risk retained
by the captive.
Captives may have high administrative costs. The
owner must pay someone to manage the captive,
pay claims, conduct actuarial work, and audit the
company.
A captive is more risky than a large book of
business with many insured entities.
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Finite Reinsurance
Finite reinsurance contracts are insurance policies
containing coverage very similar to traditional policies
but differ from traditional policies in their loss limits
and premium arrangements.
A contract is written with an aggregate limit offering a
fixed maximum amount of coverage.
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Finite Reinsurance (cont.)
 The premium for the contract is split into two components: the
funds withheld account and the underwriting fee.
– The fee is paid directly to the reinsurer and is booked as
profit on day 1.
– The funds withheld account is set up and losses are paid
out of this account. The account also earns interest that
lowers the amount of premium needed to fund the losses.
– In the event the funds withheld account is deficient, the
insurer pays for additional losses up until their aggregate
limit. Any money remaining in the funds withheld account at
the end of the contract period are returned to the insured.
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How a Finite Reinsurance Contract
Works
$120 in Insurance
Coverage
Purchased for
$100
$5 in fees to the reinsurer
$95 to the funds withheld
account
Year End
Reinsurer
Funds Withheld
Account = $95
$5 in interest earned
by the FWH account.
Result:
Result:
Reinsurer pays
nothing and
the insured
receives $50
refunded
premium.
Good Loss Year,
Losses = $50
Funds Withheld
Account = $100
Poor Loss Year,
Losses = $110
Reinsurer pays
$10, the insured
receives no
refunded
premium.
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Finite Reinsurance – Advantages
Finite reinsurance provides many of the risk
retention characteristics of a captive because of
the return premiums but does not require the
capitalization of a captive.
Essentially finite reinsurance allows you to
“borrow the balance sheet” of the reinsurer.
Finite reinsurance does not require the
administration and setup costs of a captive.
The policyholder is allowed to use the investment
gains of the funds withheld account to offset their
insurance costs.
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Finite Reinsurance – Challenges
Finite reinsurance contracts may contain high
reinsurer fees. These fees are high due to:
– The reinsurer’s profit provisions.
– The use of the reinsurers capital.
The accounting for finite reinsurance contracts is
very complex and under certain scenarios may not
qualify for insurance accounting treatment.
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The Bermuda Insurance Market
Bermuda is an island 600 miles off of the coast of
North Carolina. It is roughly 22 square miles in
size and has a population of 60,000.
Beginning in the seventies, a significant number of
large corporations began forming captive
insurance companies in Bermuda.
Currently Bermuda has over 1,500 insurance
companies with over 1,300 of those being
captives.
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The Bermuda Insurance Market
In addition to captives, Bermuda is home to some
of the world’s largest reinsurers:
– Renaissance Re
– Ace Ltd
– XL Capital
Almost every player (brokers, insurers, captive
managers, audit firms and consultants) in the
insurance market has a presence in Bermuda.
“The Silicon Valley of Insurance”
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Why Bermuda?
Bermuda has a regulatory system that is favorable
to insurers.
Bermuda companies do not pay income tax.
Over the years, Bermuda has attracted some of
the most talented players in the insurance
industry.
The proximity to financial centers such as London
and New York.
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Bermuda Regulations
Bermuda has four classes of insurance licenses to
meet the needs of companies ranging from small
captives to large multinational reinsurers.
Bermuda has an Insurance Advisory Committee
which is made up of local executives that advise
the government on new applications for insurance
licenses.
Bermuda has minimal capitalization standards and
requires an annual actuarial opinion.
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Bermuda Regulations
Bermuda has become home to many boutique
and alternative insurance products due to its
regulatory framework. Such as:
– Catastrophe Bond Issues
– Weather Derivatives
– Collateralized Debt Obligations
– Shrimp Mortality Insurance????
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Who are the big players in
Bermuda?
ACE
– $38 Billion in assets
– Multi-national, multi-line insurer
XL
– $28 Billion in assets
– Multi-national, multi-line insurer
Renaissance Re
– $3 Billion in assets
– Major Property Catastrophe Insurer
20 Other Insurers (and growing) with an asset
base over $1 Billion
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The September 11th Effect
On September 11th the industry lost as much as
$40 Billion.
Within 6 months Bermuda saw an influx of some
$10 Billion of capital and five new insurers
capitalized at over $1 Billion dollars each:
– Arch Capital Group
– Axis Specialty Ltd.
– Allied World Insurance Company
– Endurance Specialty Insurance Ltd.
– Montpelier Reinsurance Ltd.
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Future Bermuda Challenges
Can a small, highly populated island continue to
support the growth of the international business
sector:
– Housing
– Schools
– Health Care
– Underwriting and Management Talent
Bermuda is subject to political risk both
domestically and abroad (ie tax changes).
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Contact Information
If anybody has any questions regarding this
presentation or just wants to talk about the
insurance industry feel free to contact me:
James Matusiak
KPMG
(441) 294-2624
jmatusiak@kpmg.bm
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