Chapter Outline 11.1 11.2

Traditional Insurance Contracts Basis of Coverage Deductibles and Self-Insured Retentions Policy Limits, Excess Policies Layering Coverage Umbrella Liability Coverage 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

11.5

11.6

Methods of Paying Retained Losses Internal Funds Cash Flows Dedicated Assets Lines of Credit Issue New Securities Trends and Innovations in Loss Financing 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 claims made policies over 1995-1998 period 1995 1998 5

Exposure Diagram with no Insurance 6 5 4 3 2 1 0 0 1 2 3

Loss Am ount

4 5 6 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 Retention Center $100,000 per claim  1st Layer  2nd Layer $10 million from Am Home Assurance and Home Indemnity $290 million from 11 companies  3rd Layer  4th Layer  5th Layer $100 million from 5 companies $100 million from 68 syndicates at Lloyd’s of London $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 $0 4,000 -400 -2,000 _____ Year 2 $ 4,000 -400 -4,000 _____ Year 3 $ 4,000 -400 -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 $0 4,000 -400 -1,000 _____ Year 2 $ 4,000 -400 -12,000 ______ Year 3 $ 4,000 -400 -1,000 _____ 18

Smoothing Effect of Finite Risk Plans $12 $6 1 2 3 4 5 6 years 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 Corporation Insurers Insurer A Captive Insurer Sister Subsidiary 1 Sister Subsidiary 2 Insurer B Unrelated Non Insurance Entity 1 Unrelated Non Insurance 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 Source: Business Insurance, April 14, 1997.

1,050 373 324 167 134 134 235 293 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