Reinsuring Captive Insurance Companies

Quota Share Treaty Reinsurance

Quota Share reinsurance is ideal for start-up portfolios where the experience is less predictable, or for programs which have a higher degree of volatility but which over a period of time are profitable.

Using the quota share method, a captive cedes a pre-agreed percentage of its premium to a reinsurer, who in turn agrees to pay the same percentage of claims.

The costs of acquiring and handling the business, known as ceding commission, are deducted from the premium passed to the reinsurer, who normally also agrees to pay an additional commission based on the profits of the treaty.

By reducing the amount to which the captive is exposed from any one loss to a level commensurate with the captive's capital base, the captive does not face financial ruin in the event of a large individual loss.

A 75.00% Quota Share Treaty describes an arrangement whereby a reinsurer pays 75.00% of all losses and is paid 75.00% of all premiums after commissions and expenses. If a 75.00% quota share is secured the captive is left with 25.00% of the risk. Whilst it may lose out on retaining some of the profits, its downside will be limited.

If a fronting company is required that requires collateral, then that collateral requirement will be reduced assuming that the quota share reinsurer’s security is acceptable to the front company.

Quota share reinsurance contracts protect policies which start or renew during a specific period until expiry or renewal, regardless of when losses occur.

Risk Excess of Loss Reinsurance

Risk Excess of Loss Reinsurance is normally preferred by captives with established portfolios which are better able to predict overall loss ratios but who need to reduce the impact of any one loss above a certain level. Individual risks which are either too large or which fall outside the treaty parameters can be reinsured on a facultative (case by case) excess of loss basis following the same approach as a risk excess of loss treaty.

Risk Excess of Loss reinsures a captive's exposure on any one individual risk event excess of a predetermined amount known as an excess.

Unlike quota share arrangements, a risk excess reinsurer only pays when the loss exceeds a pre-agreed amount which is retained by the captive, known as a net retention. As payments of losses are not split proportionately, reinsurers charge a percentage rate of the total premium. This can increase or decrease as negotiated by the reinsurance intermediary at each renewal. By reducing the amount to which the captive is exposed from any one loss to a level commensurate with the captive's capital base, the captive does not face financial ruin in the event of a large individual loss.

Risk Excess reinsurance can usually be secured on a risks attaching basis which protects all risks underwritten by the captive during the underwriting year until expiry or renewal, or alternatively on a losses occurring basis which protects losses happening during the underwriter year, regardless of when the original policies incepted. 

Catastrophe Reinsurance

Whilst quota share and risk excess reinsurance respond to individual losses, there is always the risk that a loss ratio may be impacted by an accumulation of losses. Catastrophe reinsurance provides protection for such an eventuality, which arises from a single event or occurrence.

Examples of such exposures are the potential effect of acts of God such as windstorms to property portfolios or having a number of policyholders affected by a single occurrence under a liability portfolio.

Liability catastrophe reinsurance policies are generally known as clash covers and often include coverage for run-away costs arising from an individual risk, as well as an individual loss involving a number of insureds.

Catastrophe reinsurance always has a finite recovery amount and the emphasis is on the captive and its advisors to ensure that sufficient coverage is purchased for any accumulations of risk after the impact of any quota share or risk excess reinsurance.

Catastrophe reinsurance is normally secured on a losses occurring basis which protects losses happening during the underwriting year, regardless of when the original policies incepted.

Protecting the Net Retention with Aggregate Excess of Loss Reinsurance

Once a net retention has been established, either by risk excess of loss or quota share reinsurance, depending on the class of business a captive may still have a potential exposure to an unexpected series of losses for its net retention.

Aggregate reinsurance can protect a captive once losses to its net retention exceed a percentage of its net retained income (the residual premium after reinsurance premium and taxes). Normally the trigger point will be in the region of 120% of net retained income to ensure that the captive is not guaranteed to profit from poor underwriting.

This approach is always required by rent-a-captives where a single capital base is at risk from different and unrelated end-users. Since a rent-a- captive's capital base could be impacted by the poor loss experience of an individual cell which is only renting the capital base of the captive, reinsurance is required to ensure that the captive’s capital base is fully protected from frequency or severity of claims. The exception to this is the difference between net retained premium and the aggregate excess or attachment point and this is known as the “Gap”.

The Concept of The Gap

As with any self-insured organization, a captive assumes risk by accepting the first portion of any individual loss.

Risk Excess of Loss or Quota Share reinsurance is purchased to limit the captive's maximum exposure to any single loss leaving a self-insured retention which is in turn protected by aggregate coverage so that the capital of the captive is not put at risk from an attrition of poor losses.

The amount at risk to the captive against net premiums is known as the captive's gap and can be defined as the difference between the captive's net premium (defined as Gross Premium Income less returns and cancelations, commissions, underwriting expenses, issuing carrier and reinsurance costs) and the aggregate attachment point.

Therefore the gap, which represents the true financial risk to the captive, is a variable of two component parts as follows:

1. The level of specific individual loss deductible or the amount of quota share reinsurance purchased

2. The aggregate excess of attachment point

For rent-a-captives, this gap is normally required to be collateralized by cash or a letter of credit in order that the capital base of the captive is completely protected from the poor experience of a single user.

Also in this section

A Brief History of Captive Insurance
Reasons to Set Up a Captive Insurance Company
Performing a Captive Insurance Company Feasibility Study
Different Types of Captive Insurance Company
Selecting a Captive Insurance Domicile and Captive Manager
Reinsuring Captive Insurance Companies