Chapter Outline
11.1
Traditional Insurance Contracts
Basis of Coverage
Deductibles and Self-Insured Retentions
Policy Limits, Excess Policies
Layering Coverage
Umbrella Liability Coverage
11.2
Loss Sensitive Contracts
Experience Rated Policies
Large Deductible Policies and Retrospectively Rated Policies
Related Loss Sensitive Plans
Loss Portfolio Transfers
Finite Risk Contracts
1
Chapter 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
2
Chapter 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
3
Traditional Commercial
Insurance 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
4
Claims-Made versus
Occurrence Policies

Compare risk bearing effects of a series of
occurrence policies with a series of claimsmade policies over 1995-1998 period
1995
1998
5
Exposure Diagram with no Insurance
6
5
Loss Paid by Firm
4
3
2
1
0
0
1
2
3
4
5
6
Loss Am ount
6
Exposure Diagram with a
Deductible

Exposure Diagram with $1 million
deductible (w and w/o premium)
7
Types 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 ______
8
Exposure Diagram with a
Policy Limit
– Usually called excess policy: $3m excess of $1m
9
Layering Coverage


Purchase $3m excess of $1m SIR
Purchase $5m excess of $4m
10
Coverage for the World Trade
Center

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)
11
Umbrella 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
12
Loss Sensitive Contracts

Main feature:
– Policyholders’ payment depends on______during the
policy period


usually requires a letter of credit
Examples:
– _________ rating
– Large deductible policies
13
Retrospectively Rated Policies
– Characteristics


minimum & maximum premium
payment based on
– ________ losses
– paid losses
– Exposure diagram
14
Why Use Loss Sensitive?
– Want to retain risk but obtain

____________ of insurance

Purchase claims processing services

Satisfy __________ insurance laws
15
Other 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
16
Finite 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)
At beginning of year:
Balance from previous year
Premium
Insurer’s fee
Beginning balance
At end of year:
Claim payments
Plus interest on beginning balance
Ending balance
Year 1
Year 2
Year 3
$0
4,000
-400
$
4,000
-400
$
4,000
-400
-2,000
_____
-4,000
_____
-5,000
_____
17
Finite 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)
At beginning of year:
Balance from previous year
Premium
Insurer’s fee
Beginning balance
At end of year:
Claim payments
Plus interest on beginning balance
Ending balance
Year 1
Year 2
Year 3
$0
4,000
-400
$
4,000
-400
$
4,000
-400
-1,000
_____
-12,000
______
-1,000
_____
18
Smoothing Effect of Finite Risk Plans
$12
$6
years
1
2
3
4
5
6
19
Captive 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
20
Relationships with Captive
Parent
Insurers
Corporation
Insurer A
Sister Subsidiary
1
Captive Insurer
Insurer B
Sister
Subsidiary 2
Unrelated NonInsurance Entity 1
Unrelated NonInsurance Entity 2
21
Location of Captive Insurers
Locations of Captive Insurers in 1996
Location
Bermuda
Cayman Islands
Guernsey
Barbados
Dublin
Isle of Man
Luxembourg
Vermont
Number of Captives
1,050
373
324
167
134
134
235
293
Source: Business Insurance, April 14, 1997.
22
Motivations 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
23
Motivations 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
24
Tax Treatment of Captives

Tax Treatment
– General legal principles

risk ________ matters

_________ boundaries matter
25
Tax 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
26
Risk Retention Groups

Just like ______ _______

Pool liability exposures
– 1981 - 1986: only products liability
– after 1986:
other liability exposures
27
Methods of Paying Retained
Losses

_______ Funds
– Cash Flows
– Dedicated assets

Lines of credit & contingent equity

Issue new ________ following a loss
28
Trends and Innovations in
Loss 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)
29