Captive Arrangements and Reinsurance

Why Use a Captive?

Captive.com will give you chapter and verse on the reasons for and uses of captives. For our purposes, captives are used by commercial buyers of insurance for some or all of the following reasons: to reduce the cost of insurance, to take advantage of internal expertise concerning their own claims, for capital or tax reasons, and to give companies more of a say in how their risks should be managed.

Over the years, the tax laws have changed, and regulations have been altered, which affects captives both from a capital and tax perspective and from a regulatory and compliance perspective. Nevertheless, with the proliferation of captive-friendly legislation in a number of US jurisdictions and with the expansion of captives and captive management operations in Bermuda, the Cayman Islands, and other offshore jurisdictions, captives continue to flourish. In fact, captives now are being used for cyber and other emerging risks.

Captive Structures

Captive arrangements and structures vary depending on a wide variety of factors, including tax, risk management capabilities, the sophistication of management, jurisdiction, and cost. Reinsurers play an important role in captive arrangements.

Captive structures can take many forms. Here are just a few basic examples. Some companies incorporate affiliated insurance companies either domestically or offshore to issue policies to entities within their corporate group. Others enter into arrangements with unaffiliated insurance companies to issue policies to them and then arrange to have those unaffiliated insurers reinsure all or most of the risk assumed through those policies to an affiliated captive reinsurance company created to share in the premiums and in the claims. And some have arrangements where an affiliated captive issues the policies but reinsures the policies with an unaffiliated reinsurer, which then retrocedes some of the risk back to a captive reinsurer.

The Reinsurer's Role in a Captive Arrangement

As shown by the captive structure examples above, reinsurance can be part of a captive arrangement in various capacities. Where the captive is the policy issuing company, unaffiliated reinsurers are used by the captive's sponsor to assume the risk that the captive's sponsor does not want to retain. For example, if the captive writes a $5 million property policy but the captive sponsor only wants to retain $1 million of risk, the unaffiliated reinsurers will assume the remaining $4 million of the policy limit.

Where the captive is the reinsurer, it is generally the captive sponsor that wants to retain a significant portion of the risk and (more importantly) the premium but does not want to go through the expense and time of incorporating a captive direct writing insurance company. In this example, the unaffiliated policy issuing company may write a $5 million property policy but will cede $4 million to the captive reinsurer.

The reinsurer's role in a captive arrangement will be dramatically different depending on whether the reinsurer is itself the captive or whether the reinsurer is an unaffiliated reinsurer assuming risk in the ordinary course. Obviously, as a captive, the reinsurer is being used as a vehicle to maximize the profitability of the business for the sponsoring entity. An unaffiliated reinsurer will treat the captive arrangement similarly to any ordinary assumed reinsurance contract but should take care in monitoring the underwriting and claims handling of the captive ceding insurer to ensure compliance with the criteria set forth in the reinsurance agreement.

Many commercial insurance buyers choose to incorporate offshore captives as a way to lessen the expense and the regulatory requirements of creating a domestic insurer. The same is true with captive reinsurers. Generally, starting up an offshore reinsurer requires less capital and less regulatory hurdles (depending on the jurisdiction) than incorporating a US-based reinsurer.

Captive Reinsurers and Collateral

While collateral for reinsurance has changed, especially with the US/EU Covered Agreement, many US ceding insurers still require offshore reinsurers to put up collateral as a contractual security measure. In a captive arrangement where the reinsurer is the captive, the unaffiliated ceding insurer who is issuing the policies to the captive's affiliates will be even more likely to require all sorts of collateral given that the captive reinsurer will likely be paying most, if not all, of the claims. This is even more important if the captive reinsurer is domiciled offshore.

Collateral may be required for a loss fund to pay the claims as well as overall collateral to secure the ultimate liabilities, including incurred but not reported losses (IBNR). Where a captive reinsurer is assuming all or most of the risks, the ceding insurer is really acting as a fronting insurer for the real party of interest—the captive reinsurer (and, in actuality, the sponsoring entity). Given that in this arrangement, the captive reinsurer is really managing the claims, the unaffiliated ceding insurer will not want to be out of pocket for any loss payments. Therefore, a loss fund secured by collateral from the captive reinsurer often will be part of the captive arrangement.

Risks in Using an Offshore Captive Reinsurer

Here, the credit risk falls on the ceding insurer, not to the commercial insurance buyer that created the captive. The risk to the ceding insurer is that if an offshore reinsurer, whether a captive or not, fails to pay its obligations, obtaining recovery is that much more difficult in a non-US jurisdiction. Collateral helps, but it has to be maintained and periodically updated as premiums and claims come in.

What happens when a captive arrangement is put in place using an offshore captive reinsurer and the captive reinsurer fails to provide the collateral promised? A New York federal court addressed that issue recently.

In AmTrust North Am., Inc. v. Signify Ins. Ltd., No. 18-cv-3779(ER), 2019 U.S. Dist. LEXIS 115576 (S.D.N.Y. Jul. 11, 2019), a captive arrangement was negotiated between an entity that provided outsourced human resources (HR) services to its clients, including workers compensation insurance, and an unaffiliated ceding insurer and its affiliates to issue the workers compensation policies to the HR company's clients. In turn, the unaffiliated ceding insurer would cede the policies it issued to the HR company's clients to an offshore reinsurer created and owned by the HR company.

The reinsurance agreement required that the reinsurer post collateral to secure the reinsurance obligations, including the loss fund that would be used to pay the workers compensation claims. The collateral included loss fund collateral, gap collateral, and any additional collateral required by law. The reinsurance agreement required the collateral to be posted on certain dates and provided for increases in the collateral either on certain dates or based on calculations derived from gross written premium.

After issuing 65 policies, the unaffiliated ceding insurer stopped issuing policies to the HR company's clients and demanded that the captive reinsurer post the required collateral, which it had not done. The ceding insurer's demand letter made it clear that unless the reinsurer posted the collateral within 30-days, the ceding insurer would terminate the reinsurance agreement from inception.

The reinsurer posted a significant portion of the required collateral 2 days later through 2 letters of credit but 30-days later wrote to the ceding insurer to accept the termination of the reinsurance agreement back to its inception. Meanwhile, the ceding insurer withdrew its notice of intent to terminate the reinsurance agreement but demanded that the rest of the collateral be posted.

Subsequently, the ceding insurer and its affiliates commenced a breach of contract action against the captive reinsurer because of the reinsurer's failure to post the increased gap collateral required and all of the loss fund collateral, which the reinsurer never posted. The lawsuit also sought a declaration that the reinsurer was required to and shall remain required to maintain the security obligations until the written policies ran off. The reinsurer counterclaimed that the reinsurance agreement had been terminated from inception by the ceding insurer when it sent the original demand letter and, in the alternative, that the court should rescind the reinsurance agreement. Other counterclaims were filed as well.

Both parties moved to dismiss each other's case. The ceding insurer asked the court to dismiss the first two counterclaims filed by the reinsurer, and the reinsurer asked the court to dismiss the ceding insurer's complaint in its entirety.

The court granted the ceding insurer's motion and denied the reinsurer's motion. The court found that a reasonable person would understand the ceding insurer's demand letter to be a request for a cure and was insufficient to effect a rescission of the reinsurance agreement. The court also rejected the reinsurer's argument that it had accepted the ceding insurer's offer of rescission. The court held that there was no offer. The court found that the ceding insurer had sufficiently pled that the reinsurer had not adequately performed under the reinsurance agreement and denied the reinsurer's motion to dismiss the complaint. Notably, the court found that, under the reinsurance agreement, the ceding insurer's obligation to cede gross and net premium arose only after a series of events, one of which was receipt of confirmation from the bank that the letter of credit (the collateral) had been increased to the levels required by the loss fund. Thus, said the court, the ceding insurer's duty to cede the premiums never arose.

The cautionary tale here is that no matter how tight your reinsurance agreement is, the counterparty still has to comply and waiting too long for compliance can leave you holding the bag. With an offshore reinsurer, you do not want to be left holding the bag.

Conclusion

Reinsurance plays a critical role in captive arrangements and can manifest in many different forms. The reinsurer may be unaffiliated or may be the captive itself. While there are captive arrangements where the commercial insurance buyer is happy to keep all its risk net, that is the exception and not the rule, and more likely than not a reinsurance agreement will be part of any captive structure.