Structured Insurance Programs

What Is Structured Insurance?

Structured insurance is a fancy name for a program with a significant amount of self-insurance—funded (not passive) self-insurance. Passive self-insurance is tantamount to a deductible or self-insured retention (SIR). Losses under passive self-insurance arrangements are paid from retained earnings or cash flow, not from any dedicated loss reserve fund. Before we finally decided on the term "structured," we used monikers such as "fully funded" and "finite risk." But, much to our collective dismay, these terms proved to be too straightforward, too obvious. Lots of people got into deep trouble using these terms, especially "finite." We needed another name. We needed a name that, as in the finance world, would sound very cool and at the same time provide the requisite amount of obfuscation. "Structured" seemed to fill the bill nicely.

Structured insurance converts passive retentions into a funded program—a loss reserve fund. Insurers that offer such programs do so in several formats, so we're going to focus on one popular variety: the cell captive approach.

A Structured Insurance Example

Now let's get back to your immediate problem—your D&O renewal (or lack thereof). The expiring program had a $5 million retention for Sides A&B separately. The premium was $1 million annually, but as Inspector Clouseau might say, "Not anymore." Now, to set up an effective structured deal, your company must be able to dedicate serious bucks to the endeavor. Let's assume that your firm is willing to allocate almost $20 million in a structured program. Here's how it might work.

So far so good. Now let's have a look at how the financing might run.

I know it looks confusing, but stay with me, and all will become clear. The best way to sort this out is to start from the bottom. Your goal was to structure a program that includes $20 million of insurance limits. Included in that $20 million is an excess layer of $5 million. So far so good.

Your total financial commitment of $18,478,500 is comprised of the following.

1. Gross Written Premium, which includes expected losses, expenses, and the cost of the reinsurance layer ($8,478,500).
2. Capital & Surplus ($1,700,000)
3. Collateral ($8,300,000)

The ceding commission and captive management fee are paid to L&M Insurance Company, and the expected losses (as determined by an actuary on a prospective basis, not on a retrospective basis) are paid into the cell captive.

The reinsurance cost, $2,500,000, is of course paid to the reinsurer. So the captive's total funding, including expected losses, the capital & surplus, and the collateral is $15,000,000.

The collateral ($8,300,000) is, in this case, deposited into the cell captive in the form of a letter of credit to conserve cash. However, it certainly may take the form of cash. If anyone is confused at this point, please feel free to give me a call or write an email.

Tax and Accounting Issues

Far be it from me to dispense tax and accounting advice, so the following comments are for educational purposes only. From an accounting standpoint, FAS 113 provides the guidance, which states, among other things, that a reinsurance transaction must include a reasonable chance of a significant loss. This applies to Generally Accepted Accounting Principles (GAAP). For statutory accounting purposes (that which is used by insurance companies), the governing standard is the National Association of Insurance Commissioners (NAIC) SSAP 62. FAS 113 and SSAP 62 are virtually the same.

In our example, we have to look at two things: (1) the risk transfer percentage, and (2) the rate-on-line for the reinsurance layer.

In our case, the risk transfer percentage is 25 percent ($5 million divided by $20 million). Over the years, many practitioners applied what was called the "10/10 Rule." This meant a 10 percent chance of a 10 percent loss was thought to satisfy the reasonable chance of a significant loss mandate. Since the dust-up over certain finite reinsurance arrangements, few people use this rule anymore because there's not enough chance of a significant loss. Our example can be said to satisfy a "25/25 percent rule" if such a thing existed. If we hued to the old 10/10 Rule, our reinsurance layer would be only $2 million instead of $5 million.

Our rate-on-line is 50 percent ($2,500,000 premium divided by the $5,000,000). This is not a particularly low rate-on-line, but is probably low enough to constitute risk transfer as the present value of the premium will not come close to equaling the insured limit at the end of the 3-year policy term, especially at today's extremely low interest rates.

From a tax standpoint, the premium component ($8,433,000) might, I repeat might, be deductible from your U.S. federal income taxes. A prudent approach would be to deduct only the hard costs, e.g., the reinsurance premium, ceding commission, etc. None of the other expenditures would come close to qualifying for insurance treatment.

Capital and Surplus

Every insurance company, including cell captives, requires capital and surplus. As Bermuda's minimum premium-to-capital and surplus ratio is 5:1 on the first $6 million of premium, our capital and surplus ($1,700,000) represents roughly 20 percent of the premium.

Conclusion

So why would anyone opt to fund a structured program in lieu of just accepting a $20 million passive retention? I can think of two good reasons. First, in cases where a statutory or contractual need mandates evidence of insurance, structured programs provide first-dollar coverage. Certificates of insurance need not include a deductible or self-insured-retention. Second, using a structure can be an effective method of leveraging excess insurance capacity.

Through a single example, this article provides just a glimpse into the world of structured programsâ€"the tip of the iceberg, so to speak. Perhaps it has whetted your appetite for a deeper understanding of the subject. If so, contact me and I'll direct you to additional resources.