Challenging Conventional Wisdom

New ways of thinking about captives, collateral and combined ratios dominated the 7th Annual Canadian Captives & Corporate Insurance Strategies Summit, held in Toronto on June 1.

Several speakers challenged the conventional wisdom that a company should consider forming a captive primarily to benefit from tax advantages offered in other jurisdictions. Rather, the emphasis should be on whether forming a captive might allow the company to gain any kind of operational advantages or efficiencies, speakers said.

Others observed that the rising cost of credit in contemporary financial markets could open the door for alternative forms of collateral – such as captive trusts, for example.

And in a background presentation on the current financial state of the property and casualty insurance industry, the traditional notion that a 100% combined ratio is a reliable indicator of solid financial performance was subject to debate.

Creating Captives

Companies should not be establishing captive insurance entities simply to capitalize on tax advantages, a number of speakers cautioned at the summit meeting.

“We’d like to emphasize that we would never ask you to start a captive because it might save you tax,” said Mal Leighl, executive director of financial services and insurance for Ernst & Young LLP. “It never would.”

Certainly tax advantages might help determine a captive’s domicile, but tax considerations should never be the reason for forming the captive in the first place, echoed conference chair Bill Morgan, managing director of Aon Insurance Managers.

“There’s a real risk service for creating and transferring risk to a captive,” added Tom Tsiopoulos, partner and head of transfer pricing at Ernst & Young LLP. “That is the point, to ask if there are any real operational benefits.”

In a case study illustrating non-tax-related reasons to form a captive, John Shelonko, vice president of risk management at Lafarge North America, said his company’s decision to form a captive helped centralize and augment its analysis of risk. Lafarge is the largest diversified supplier of construction materials in the United States and Canada.

As a result of creating a captive in B.C. in 1998, Lafarge was able to concentrate its energies on the development and implementation of loss control initiatives, thus minimizing its claims costs. This helped reduce the company’s insurance premiums at a time when the market pricing was increasing during a hard market.

One central decision the captive made was to keep “skin in the game,” Shelonko said. This meant keeping a substantial retention of risk within the captive, thus taking the company out of the higher layers of insurance. This also provided the captive with the incentive to develop its loss control measures.

By analyzing comprehensive claims data, the captive was able to make recommendations that vastly reduced the company’s exposure to workers’ compensation claims.

Shelonko noted the company’s exposure went from 1,000 claims (for 6,000 employees) in 1999 down to 165 claims (for 7,000 employees) in 2010.Having reduced its losses thus, the company benefited from a drastic reduction in insurance premiums, despite a hardening market.

Captive Trusts

Given the increasing cost of credit in today’s market, the cost of letters of credit (LOCs) has become prohibitive for captives relying on them for collateral, Robert Quinn, a vice president at Wells Fargo, told people attending the captives conference.

As of 2010, roughly 70% of captives use LOCs to fund their lines and programs, Quinn said. However, since the 2008-09 financial crisis, the cost of LOCs has increased dramatically. Captives would therefore do well to search out alternative sources of collateral – such as a captive trust, said Quinn, who sells capital trusts.

Prior to the 2008 financial crisis, the cost of LOCs on a cash collateralized basis ranged between 15 basis points and 45 basis points. “I would say the norm you are going to see for a letter of credit today is between 45 to 100 basis points,” Quinn said, “with 75 basis points appearing to be the sweet spot for these collateralized LOCs for captives.”

The business implications for captive and corporate insurance programs are huge, he continued. “If you were paying 25 basis points for collateral on $10 million, and now you’re paying 75 basis points, your cost of collateral just tripled. Therefore, the cost of your whole program just went up considerably.”

Captive owners would do well to consider a captive trust, he said. In this arrangement, the captive, the insurance carrier and the lender enter into a tri-partite agreement in which the lender is named as the trustee, the captive is the grantor and the insurance fronting carrier is the beneficiary.

In a handout accompanying his presentation, Quinn explained the trust is usually funded with the assets in the collateral account for the letter of credit. The trust is then pledged to the fronting insurance carrier as the sole beneficiary. Benefits of the approach include:

• much lower fees than a LOC;
• the income from the trust is the property of the depositor;
• the assets in the trust generally remain on the books of the corporation;
• the trust does not need to be renewed each year; and
• the trust can often replace multiple LOCs posted to the same carrier.

100% Combined “Doesn’t Cut It”

A combined ratio (COR) of 100% no longer generates sufficient return on equity in today’s depressed investment environment, according to Urs Uhlmann, senior vice president and head of Zurich Global Corporate.

“At the beginning, I said one hundred just doesn’t cut it anymore,” Uhlmann said, referencing a slide in his presentation that showed historical returns on equity (ROE) based on the U.S. P&C industry’s combined ratios. “No it doesn’t. “A combined ratio of 100[%] in 2009-10 generated about 7.5% return on equity – certainly not enough – compared to in the mid-2000s. In 2005, a 100 [per cent] combined [ratio] was about a 10% ROE.”

Uhlmann was asked to speak about emerging trends for property and casualty insurance companies in the current economic climate.

“Clearly, the investment environment is hampering the generation of the results,” Uhlmann said, referencing low interest rates, and hence lower investment yields for insurers. “If you want to know the impact of a change of 1% on the investment return on your combined ratio, it’s actually quite significant.”

For example, based on 2008 invested assets and earned premiums, a U.S. insurer had to reduce its combined ratio by 1.8% in personal lines – or by 3.6% in commercial lines – to offset a 1% decline in investment yield, in order to maintain a constant ROE.

Basically put, an insurer’s combined ratio (COR) is derived from dividing claims costs by premium collected. A number more than 100% indicates an insurer is losing money. A number below 100% suggests an insurance company is profitable, because more premiums have been collected than claims paid out.

Up until recently, a 100% COR suggested a break-even point for property and casualty insurers. With a 100% COR, U.S. insurers used to be able to generate a return on equity (ROE) of between 9% and 16%. But Uhlmann’s presentation slides showed a 99.7% COR in 2010 Q3, aided by lower catastrophe losses and more reserve releases, nevertheless produced a comparatively meager ROE of only 7.7%. And in 2009, a 99.5% COR generated a return on equity of only 7.3%

In comparison, a 100.6% COR in 1979 generated an ROE as high as 15.9%, and in 2005 a COR of 100.1% resulted in an ROE of 9.6%