Reinsurance sidecar

Reinsurance sidecars, conventionally referred to as Sidecars, are financial structures which are created to allow investors to take on the risk and return of a group of insurance policies (a "book of business") written by an insurer or reinsurer (henceforth re/insurer) and earn the risk and return that arises from that business. A re/insurer will only pay ("cede") the premiums associated with a book of business to such an entity if the investors place sufficient funds in the vehicle to ensure that it can meet claims if they arise. Typically the liability of investors is limited to these funds. These structures have become quite prominent in the aftermath of Hurricane Katrina as a vehicle for re/insurers to add risk-bearing capacity, and for investors to participate in the potential profits resulting from sharp price increases in re/insurance over the four quarters following Katrina. An earlier and smaller generation of sidecars were created after 9-11 for the same purpose.

Precedents

Sidecars have precedents in the reinsurance market under the name "quota-share reinsurance." In such an agreement, a re/insurer agrees to cede to the quota-share reinsurer a percentage of all premiums arising from a book of business in exchange for the reinsurer bearing the same percentage liability for losses. The quota-share reinsurer pays an amount called the ceding commission to compensate the ceding company for its expenses. The ceding commission typically also includes a profit allowance which increases in proportion to the expected profitability of the business. These reinsurance treaties currently and traditionally provide ceding companies with the ability to write more business than they could bear based on their own capital and to earn a certain amount of fee-based income (through the ceding commission). Quota-share reinsurers act as insurance wholesalers, allowing them to earn a return on capital without creating primary insurance distribution. Lloyd's of London "names" act as such reinsurers, placing the resources of individual and firms at risk to books of business written by professional underwriters and agents.

Early sidecars: reinsurance joint ventures

Re/insurers have occasionally created joint ventures through which multiple parties place capital at the disposal of one or more expert underwriters for the same reasons. The earliest sidecars were created in Bermuda in the 1990s in such a fashion, and included Top Layer Re and OpCat, both of which placed capacity under the control of Renaissance Re on the part of other re/insurers (Overseas Partners, State Farm).

Market growth following 9-11 and Hurricane Katrina

In the years following 9-11, the idea of raising funds from capital markets investors in addition to re/insurers to support quota-shares arose, and a handful of such ventures were consummated (Olympus, DaVinci, Rockridge). These were the first true sidecars, and were a natural outgrowth of the development of re/insurance as an asset class in the form of catastrophe bonds.
Following Hurricane Katrina the sidecar idea became very prominent among investors because it was seen as a way to participate in the risk/return of the higher-priced ("hard") reinsurance market without investing in either existing reinsurers (who might have liabilities from the past that would undermine returns) or new reinsurers ("newcos" that would have a lengthy and expensive "ramp up" period). Three such entities were up and running by year end 2005 (sidecar, capital raised, ceding re/insurer).
Flatiron, $840mm, Arch Capital
Blue Ocean, $355mm, Montpelier Re
Cyrus, $550mm, XL Capital
These entities have been created since 2006 (sidecar, capital raised, ceding re/insurer, book of business).:
Petrel, $200mm, Validus, marine and energy reinsurance
Kaith/K5, $370mm, Hannover Re, several lines of insurance and reinsurance
Helicon, $330mm, White Mountains Re, property catastrophe reinsurance
BayPoint, $150mm, Harbor Point, selected short-tailed lines of business
Timicuan/RPP, $70mm, Renaissance Re, reinstatement premium protection
Starbound, $315mm, Renaissance Re, Florida treaty business
Sector Re, $220mm, Swiss Re, property catastrophe and aviation reinsurance
Castlepoint Re, $265mm, Tower Group, program and specialty insurance
Monte Fort Re, $60mm, Flagstone Re, peak zone and ILW (industry loss warranty) coverage
Sirocco, $95mm, Lancashire Re, Gulf of Mexico offshore energy
Concord, $730mm, AIG, US commercial property business
MaRI, $400mm, Marsh / ACE, US commercial property
Together with supplementary capital raises at Olympus, DaVinci, Blue Ocean and Kaith, this brought the total capital raised to over $4bn by September 2006 and established sidecars as a major capital raising vehicle for catastrophe risk.
By year end 2006 it began to appear as though supply and demand in the reinsurance and catastrophe bond markets had achieved balance at the prevailing price level, and the market began to "soften" (fall in price), particularly following the decision by the State of Florida to expand the size of the reinsurance protection offered by the Florida Hurricane Catastrophe Fund by at least $12 billion in January 2007. Creation of new sidecars slowed markedly in the first half of 2007 in consequence, with only one transaction being closed that included an equity offering (Starbound II, itself in some respects as much a rollover of Starbound I as a new transaction). The sidecar market continued to be active however with three different issuers accessing the bank loan market for debt to leverage their own equity: Hannover Re (Kepler), the Citadel reinsurance companies (Emerson) and State Farm (Merna, primarily a 4(2) bond issuance but in part a bank loan offering).

Sidecar investments

Investors are typically offered debt (generally in the form of bank loans), preferred stock and equity investments in the sidecar. Debt may be rated by the rating agencies which include Standard & Poors, Moody's, and A. M. Best. Most sidecar debt has been rated in the "BB" category (below investment grade) but some investment grade debt has been issued. In 2007 the rating agencies offered detailed criteria discussions for this type of issuance.

Market participants

Investment banks including Aon Capital Markets, Goldman Sachs, Merrill Lynch, Morgan Stanley, Swiss Re Capital Markets and Deutsche Bank have advised on the creation of sidecars, typically alongside specialist consultancies such as Risk Management Solutions.

Lead equity investors that have been publicly disclosed include J.C. Flowers, First Reserves, Goldentree, Highfields, Goldman Sachs, Farallon.

Numerous law firms have been active in this space, notably Cadwalader, Wickersham & Taft, Conyers Dill & Pearman in Bermuda and Fried Frank, Wilkie Farr, Dewey & LeBoeuf, Debevoise & Plimpton, and others in the US and UK.

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Reinsurance

Reinsurance is a means by which an insurance company can protect itself with other insurance companies against the risk of losses. Individuals and corporations obtain insurance policies to provide protection for various risks (hurricanes, earthquakes, lawsuits, collisions, sickness and death, etc.). Reinsurers, in turn, provide insurance to insurance companies. The company requesting the cover is called the cedant and the reinsurer can be called the ceded, although the latter term is not in
common use.

Functions

There are many reasons why an insurance company would choose to reinsure as part of its responsibility to manage a portfolio of risks for the benefit of its policyholders and investors.

Risk transfer

The main use of any insurer that might practice reinsurance is to allow the company to assume greater individual risks than its size would otherwise allow, and to protect a company against losses. Reinsurance allows an insurance company to offer higher limits of protection to a policyholder than its own assets would allow. For example, if the principal insurance company can write only $10 million in limits on any given policy, it can reinsure (or cede) the amount of the limits in excess of $10 million.
Reinsurance’s highly refined uses in recent years include applications where reinsurance was used as part of a carefully planned hedge strategy.

Income smoothing

Reinsurance can help to make an insurance company’s results more predictable by absorbing larger losses and reducing the amount of capital needed to provide coverage.

Surplus relief

An insurance company's writings are limited by its balance sheet (this test is known as the solvency margin). When that limit is reached, an insurer can do one of the following: stop writing new business, increase its capital, or buy "surplus relief" reinsurance. Buying reinsurance is usually done on a quota share basis and is an efficient way of not having to turn clients away or raise additional capital.

Arbitrage

The insurance company may be motivated by arbitrage in purchasing reinsurance coverage at a lower rate than what they charge the insured for the underlying risk, which can be in the area of risk associated with any form of the asset that is being issued or loaned against. It can be a car, a mortgage, an insurance (personal, fire, business, etc.) and alike.
In general, the reinsurer may be able to cover the risk at a lower premium than the insurer because:

The reinsurer may have some intrinsic cost advantage due to economies of scale or some other efficiency

Reinsurers may operate under weaker regulation than their clients. This enables them to use less capital to cover any risk, and to make less prudent assumptions when valuing the risk.

Even if the regulatory standards are the same, the reinsurer may be able to hold smaller Actuarial reserves than the cedant if it thinks the premiums charged by the cedant are excessively prudent.

The reinsurer may have a more diverse portfolio of assets and especially liabilities than the cedant. This may create opportunities for hedging that the cedant could not exploit alone. Depending on the regulations imposed on the reinsurer, this may mean they can hold fewer assets to cover the risk.
The reinsurer may have a greater risk appetite than the insurer.

Reinsurer's expertise

The insurance company may want to avail of the expertise of a reinsurer in regard to a specific (specialised) risk or want to avail of their rating ability in odd risks.

Creating a manageable and profitable portfolio of insured risks

By choosing a particular type of reinsurance method, the insurance company may be able to create a more balanced and homogenous portfolio of insured risks. This would lend greater predictability to the portfolio results on net basis (after reinsurance) and would be reflected in income smoothing. While income smoothing is one of the objectives of reinsurance arrangements, the mechanism is by way of balancing the portfolio.

Managing cost of capital for an insurance company

By getting a suitable reinsurance, the insurance company may be able to substitute "capital needed" as per the requirements of the regulator for premium written. It could happen that the writing of insurance business requires x amount of capital with y% of cost of capital and reinsurance cost is less than x*y%. Thus more unpredictable or less frequent the likelihood of an insured loss, more profitable it can be for an insurance company to seek reinsurance.

Types

Proportional

Proportional reinsurance (the types of which are quota share and surplus reinsurance) involves one or more reinsurers taking a stated percent share of each policy that an insurer produces ("writes"). This means that the reinsurer will receive that stated percentage of each dollar of premiums and will pay that percentage of each dollar of losses. In addition, the reinsurer will allow a "ceding commission" to the insurer to compensate the insurer for the costs of writing and administering the business (agents' commissions, modeling, paperwork, etc.).

The insurer may seek such coverage for several reasons. First, the insurer may not have sufficient capital to prudently retain all of the exposure that it is capable of producing. For example, it may only be able to offer $1 million in coverage, but by purchasing proportional reinsurance it might double or triple that limit. Premiums and losses are then shared on a pro rata basis. For example, an insurance company might purchase a 50% quota share treaty; in this case they would share half of all premium and losses with the reinsurer. In a 75% quota share, they would share (cede) 3/4 of all premiums and losses.

The other form of proportional reinsurance is surplus share or surplus of line treaty. In this case, a retained “line” is defined as the ceding company's retention - say $100,000. In a 9 line surplus treaty the reinsurer would then accept up to $900,000 (9 lines). So if the insurance company issues a policy for $100,000, they would keep all of the premiums and losses from that policy. If they issue a $200,000 policy, they would give (cede) half of the premiums and losses to the reinsurer (1 line each). The maximum underwriting capacity of the cedant would be $ 1,000,000 in this example. Surplus treaties are also known as variable quota shares.

Non-proportional

Non-proportional reinsurance only responds if the loss suffered by the insurer exceeds a certain amount, which is called the "retention" or "priority." An example of this form of reinsurance is where the insurer is prepared to accept a loss of $1 million for any loss which may occur and they purchase a layer of reinsurance of $4 million in excess of $1 million. If a loss of $3 million occurs,then insurer will retain 1 Million and will recover $2 million from its reinsurer(s). In this example, the reinsured will retain any loss exceeding $5 million unless they have purchased a further excess layer (second layer) of say $10 million excess of $5 million.

The main forms of non-proportional reinsurance are excess of loss and stop loss.

Excess of loss reinsurance can have three forms - "Per Risk XL" (Working XL), "Per Occurrence or Per Event XL" (Catastrophe or Cat XL), and "Aggregate XL". In per risk, the cedant’s insurance policy limits are greater than the reinsurance retention. For example, an insurance company might insure commercial property risks with policy limits up to $10 million, and then buy per risk reinsurance of $5 million in excess of $5 million. In this case a loss of $6 million on that policy will result in the recovery of $1 million from the reinsurer.

In catastrophe excess of loss, the cedant’s per risk retention is usually less than the cat reinsurance retention (this is not important as these contracts usually contain a 2 risk warranty i.e. they are designed to protect the reinsured against catastrophic events that involve more than 1 policy). For example, an insurance company issues homeowner's policies with limits of up to $500,000 and then buys catastrophe reinsurance of $22,000,000 in excess of $3,000,000. In that case, the insurance company would only recover from reinsurers in the event of multiple policy losses in one event (i.e., hurricane, earthquake, flood, etc.).

Aggregate XL affords a frequency protection to the reinsured. For instance if the company retains $1 million net any one vessel, the cover $10 million in the aggregate excess $5 million in the aggregate would equate to 10 total losses in excess of 5 total losses (or more partial losses). Aggregate covers can also be linked to the cedant's gross premium income during a 12 month period, with limit and deductible expressed as percentages and amounts. Such covers are then known as "Stop Loss" or annual aggregate XL.

Risk-attaching Basis

A basis under which reinsurance is provided for claims arising from policies commencing during the period to which the reinsurance relates. The insurer knows there is coverage for the whole policy period when written.
All claims from cedant underlying policies incepting during the period of the reinsurance contract are covered even if they occur after the expiration date of the reinsurance contract. Any claims from cedant underlying policies incepting outside the period of the reinsurance contract are not covered even if they occur during the period of the reinsurance contract.

Loss-occurring Basis

A Reinsurance treaty from under which all claims occurring during the period of the contract, irrespective of when the underlying policies incepted, are covered. Any claims occurring after the contract expiration date are not covered.
As opposed to claims-made policy. Insurance coverage is provided for losses occurring in the defined period. This is the usual basis of cover for most policies.

Claims-made Basis

A policy which covers all claims reported to an insurer within the policy period irrespective of when they occurred.

Contracts

Most of the above examples concern reinsurance contracts that cover more than one policy (treaty). Reinsurance can also be purchased on a per policy basis, in which case it is known as facultative reinsurance. Facultative reinsurance can be written on either a quota share or excess of loss basis. Facultative reinsurance is commonly used for large or unusual risks that do not fit within standard reinsurance treaties due to their exclusions. The term of a facultative agreement coincides with the term of the policy. Facultative reinsurance is usually purchased by the insurance underwriter who underwrote the original insurance policy, whereas treaty reinsurance is typically purchased by a senior executive at the insurance company.

Reinsurance treaties can either be written on a “continuous” or “term” basis. A continuous contract continues indefinitely, but generally has a “notice” period whereby either party can give its intent to cancel or amend the treaty within 90 days. A term agreement has a built-in expiration date. It is common for insurers and reinsurers to have long term relationships that span many years.

Markets

Most reinsurance placements are not placed with a single reinsurer but are shared between a number of reinsurers. For example a $30,000,000 excess of $20,000,000 layer may be shared by 30 or more reinsurers. The reinsurer who sets the terms (premium and contract conditions) for the reinsurance contract is called the lead reinsurer; the other companies subscribing to the contract are called following reinsurers.

About half of all reinsurance is handled by reinsurance brokers who then place business with reinsurance companies. The other half is with “direct writing” reinsurers who have their own production staff and thus reinsure insurance companies directly. In Europe reinsurers write both direct and brokered accounts.

Using game-theoretic modeling, Professors Michael R. Powers (Temple University) and Martin Shubik (Yale University) have argued that the number of active reinsurers in a given national market should be approximately equal to the square-root of the number of primary insurers active in the same market. Econometric analysis has provided empirical support for the Powers-Shubik rule.

Insurers (that is to say, reinsureds) tend to choose their reinsurers with great care as they are exchanging insurance risk for credit risk. Risk managers monitor reinsurers' financial ratings (S&P, A.M. Best, etc.) and aggregated exposures regularly.

Top Reinsurers

1. Münchener Rück – Germany (US$31.4 billion Gross Written Premiums)
2. Swiss Re – Switzerland (US$30.3 billion)
3. Berkshire Hathaway / General Re – USA (n.a.)
4. Hannover Rück – Germany (US$12 billion)
5. SCOR – France (US$6.9 billion)
6. Reinsurance Group of America – USA (US$5.7 billion)
7. Transatlantic Re – USA (US$4.2 billion)
8. Everest Re – Bermuda (US$4.0 billion)
9. Partner Re – Bermuda (US$3.8 billion)
10. XL Re – Bermuda (US$3.4 billion)
(Based on the last company figures)
Retrocession
Reinsurance companies themselves also purchase reinsurance, a practise known as a retrocession. They purchase this reinsurance from other reinsurance companies. A reinsurance company that sells reinsurance is a "retrocessionaire". A reinsurance company that buys reinsurance is a "retrocedent".
It is not unusual for a reinsurer to buy reinsurance protection from other reinsurers. For example, a reinsurer that provides proportional, or pro rata, reinsurance capacity to insurance companies may wish to protect its own exposure to catastrophes by buying excess of loss protection. Another situation would be that a reinsurer which provides excess of loss reinsurance protection may wish to protect itself against an accumulation of losses in different branches of business which may all become affected by the same catastrophe. This may happen when a windstorm causes damage to property, automobiles, boats, aircraft and loss of life, for example.
This process can sometimes continue until the original reinsurance company unknowingly gets some of its own business (and therefore its own liabilities) back. This is known as a "spiral" and was common in some specialty lines of business such as marine and aviation. Sophisticated reinsurance companies are aware of this danger and through careful underwriting attempt to avoid it.
In the 1980s, the London market was badly affected by the creation of reinsurance spirals. This resulted in the same loss going around the market thereby artificially inflating market loss figures of big claims (such as the Piper Alpha oil rig). The LMX spiral (as it was called) has been stopped by excluding retrocessional business from reinsurance covers protecting direct insurance accounts.
It is important to note that the insurance company is obliged to indemnify its policyholder for the loss under the insurance policy whether or not the reinsurer reimburses the insurer. Many insurance companies have experienced difficulties by purchasing reinsurance from companies that did not or could not pay their share of the loss (these unpaid claims are known as uncollectibles). This is particularly important on long-tail lines of business where the claims may arise many years after the premium is paid.

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Financial reinsurance

Financial Reinsurance (or fin re), is a form of reinsurance which is focused more on capital management than on risk transfer. In the non-life segment of the insurance industry this class of transactions is often referred to as finite reinsurance.

One of the particular difficulties of running an insurance company is that its financial results - and hence its profitability - tend to be uneven from one year to the next. Since insurance companies generally want to produce consistent results, they may be attracted to ways of hoarding this year's profit to pay for next year's possible losses (within the constraints of the applicable standards for financial reporting). Financial reinsurance is one means by which insurance companies can "smooth" their results.

A pure 'fin re' contract for a non-life insurer tends to cover a multi-year period, during which the premium is held and invested by the reinsurer. It is returned to the ceding company - minus a pre-determined profit-margin for the reinsurer - either when the period has elapsed, or when the ceding company suffers a loss. 'Fin re' therefore differs from conventional reinsurance because most of the premium is returned whether there is a loss or not: little or no risk-transfer has taken place.

In the life insurance segment, fin re is more usually used as a way for the reinsurer to provide financing to a life insurance company, much like a loan except that the reinsurer accepts some risk on the portfolio of business reinsured under the fin re contract. Repayment of the fin re is usually linked to the profit profile of the business reinsured and therefore typically takes a number of years. Fin re is used in preference to a plain loan because repayment is conditional on the future profitable performance of the business reinsured such that, in some regimes, it does not need to be recognised as a liability for published solvency reporting.

History

'Fin re' has been around since at least the 1960s, when Lloyd's syndicates started sending money overseas as reinsurance premium for what were then called 'roll-overs' - multi-year contracts with specially-established vehicles in tax-light jurisdictions such as the Cayman Islands. These deals were legal and approved by the UK tax-authorities. However they fell into disrepute after some years, partly because their tax-avoiding motivation became obvious, and partly because of a few cases where the overseas funds were siphoned-off or simply stolen.

More recently, the high-profile bankruptcy of the HIH group of insurance companies in Australia revealed that highly questionable transactions had been propping-up the balance-sheet for some years prior to failure. To be clear, although fin re contracts were involved, it was the fraudulent accounting for those contracts - and not the actual use of fin re - which was the problem. As of June 2006, General Re and others are being sued by the HIH liquidator in connection with the fraudulent practices.

In the life segment, fin re has been widely used in Europe.

Fin Re for Life Insurers

The regulator's perspective

When looking at the financial position of a Life insurer, the company's assets and liabilities are measured. The difference is called the 'free assets' of the company. The greater the free assets relative to the liabilities, the more 'solvent' the company is deemed to be.

There are different ways of measuring assets and liabilities - it depends on who is looking. The regulator, who is interested in ensuring that insurance companies remain solvent so that they can meet their liabilities to policyholders, tends to under-estimate assets and over-estimate liabilities.

In taking this conservative perspective, one of the steps taken is to effectively ignore future profits. On the one hand this makes sense - it's not prudent to anticipate future profits. On the other hand, for an entire portfolio of policies, although some may lapse - statistically we can rely on a number to still be around to contribute to the company's future profits.

Future profits can thus be seen to be an inadmissible asset - an asset which may not (from the regulator's point of view, anyway) be taken into account. (Current developments, particularly Solvency 2 in Europe, will likely base solvency tests on market to market assets and liabilities, thereby including some value for future profits. Solvency 2 looks more like banks' Value at risk.)

A banker's perspective

If a bank were to give the insurer a loan, the insurer's assets would increase by the amount of the loan, but their liabilities would increase by the same amount too - because they owe that money back to the bank.

With both assets and liabilities increasing by the same amount, the free assets remain unchanged. This is generally a sensible thing, but it's not what financial reinsurance is aiming for.

The reinsurer's perspective

In setting up a financial reinsurance treaty, the reinsurer will provide capital (there are a number of ways of doing this, discussed below). In return, the insurer will pay the capital back over time. The key here is to ensure that repayments only come out of surplus emerging from the reinsured block of business. The benefit of this surplus-limitation comes from the fact that in the regulatory accounts there is no value ascribed to future profits - which means the liability to repay the reinsurer is made from a series of payments which are deemed to be zero.
The impact is that there is an increase in assets (from the financing), but no increase in liabilities. In other words, financial reinsurance increases the company's free assets.

Different accounting regimes

Financial reinsurance is generally intended to impact the regulatory balance sheet on the premise that that balance sheet provides a distorted view of a company's solvency otherwise. Many financial reinsurance transactions, particularly for life insurers, have little impact on GAAP accounts and shareholder-reported profits.
Over the 2004-2006 period a number of financial or finite reinsurance transactions attracted regulatory scrutiny, notably from New York Attorney General Eliot Spitzer, due to the concern that their primary result was to distort and manage accounting presentation rather than to transfer risk. In particular, a transaction between AIG and General Re through which the former buttressed its reserves was identified as transferring insufficient risk, and this review led to management changes at both companies. Accountants, regulators and other constituencies proposed a variety of tests for such transactions.

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Captive insurance

Captive insurance companies are insurance companies established with the specific objective of financing risks emanating from their parent group or groups but they sometimes also insure risks of the group's customers as well. Using a captive insurer is a risk management technique where a business forms its own insurance company subsidiary to finance its retained losses in a formal structure. The term "captive" comes from the "father of captive insurance", Frederic M Reiss, who coined the term while he was bringing his concept into practice for an industrial client in Ohio in the 1950s. The term "captive" came to Reiss when working with his first client, the Youngstown Sheet & Tube Company. The company had a series of mining operations and its management referred to the mines whose output was put solely to the corporation's use as captive mines. When Reiss helped them incorporate their own insurance subsidiaries, they were referred to as captive insurance companies because they wrote insurance exclusively for the captive mines. Reiss continued to use the term for his concept, and both the captive and the term have adopted a far wider context. The term also made sense as the policyholder owns the insurance company i.e. the insurer is captive to the policyholder. If the captive only insures its parent and affiliates it is called a pure captive.

Domicile

Captives are licensed by many jurisdictions with the primary jurisdiction known as the captive's domicile. Many captive insurers make their home "offshore". Belize, Bermuda, The Cayman Islands, Vermont, Guernsey, Luxembourg, Barbados, Malta, Singapore and the British Virgin Islands are a few examples.

Several offshore jurisdictions have lower capitalization requirements, which may allow captives to be set up for less. Offshore captive insurers also sometimes have lower tax rates on investment and underwriting income which reduces expected tax payments relative to domestic captives. However, many such advantages have been eliminated in recent years for U.S. entities that own offshore captives.

Bermuda is the leading captive domicile, although its market dominance has decreased as many jurisdictions enacted captive-friendly legislation in order to attract or preserve this business. The onshore regulatory burden and cost of operating either a US-based or Lloyd's-based captive in the early 1960s drove Reiss to seek out a jurisdiction that would allow his captive concept to flourish. After significant travel and investigation, Bermuda was Reiss' first choice for its geographic location, clean reputation and its position as a British Dependent Territory which removed the risks and uncertainties often experienced by international businesses operating in politically unstable and unaccountable jurisdictions. Bermuda's captives are predominantly owned by large U.S. corporations. Thus, for instance, American International Group (AIG) operated a captive insurance scam that involved fraudulent use of Bermuda as an offshore tax haven, see Lucy Komisar: "AIG’s Past Could Return to Haunt". International Press Service. http://thekomisarscoop.com/2008/12/19/aigs-past-could-return-to-haunt/. Retrieved on 2008-12-20. The Cayman Islands is the second largest licensing jurisdiction in terms of the number of captives licensed. Vermont is second in terms of insurance company assets but third in terms of captives licensed.

In the United States, Vermont is home to more captive insurers than any other U.S. state, with over 800 licensed captive companies as of December 2007. Other U.S. states with significant numbers of captive insurers calling the state home include: Hawaii, South Carolina, Arizona, Montana, Nevada and New York. In many U.S. licensing jurisdictions, a captive insurer is subject to an annual audit and annual loss certification by a consulting actuary.

Policies

Reiss conceptualized the captive to provide his clients with coverages they needed but could not obtain through the traditional insurance market, thereby reducing the high cost of insurance to large corporations. Almost simultaneously he recognized the tax advantages under the concept under the US Tax Reform Act 1962. The tax advantages often attracted corporations to form captives solely for tax-reduction, but, over the years the business purposes for establishing a captive remained long after the tax loopholes were gone. Companies have turned to captives to reduce costs, enhance risk management, gain greater control over their insurance and directly access the reinsurance market. Today, captives are established to insure a wide variety of risks. Virtually every risk underwritten by a commercial insurer is provided for in a subset of captive insurers. Examples include: property, workers' compensation, casualty (general and auto liability, product liability), and employee benefits such as long-term care and supplemental life insurance plans.

The most common use of captive insurance is to provide liability coverages for those lines of business, such as workers compensation, that have regular and predictable loss payments and for working layer professional liability coverage in order to access the reinsurance market, including Lloyd's syndicates, for excess protection that may be unavailable or cost-prohibitive at the primary level such as products liability, general and professional liability and directors & officers liability. Vehicle insurance, both property damage and third party liability of corporate fleets and vehicles is also quite common.

Regulation

For some lines of business a captive can operate without restriction. In other cases, such as workers' compensation in the U.S., for example, a captive often must go through a fronting process. They pay a fee, usually somewhere between 5 and 15 percent, to participate in the risk. The fronting insurer issues the required policy using its insurance licenses and then the company "cedes" (sends some or all the risk and some of the premium) to the captive. If there is a loss, the captive provides the funding to pay the loss even though the contractually responsible party from the injured party’s perspective is the commercial "front". Because premiums paid to captives are deductible, the terms of the policy (including the premium amount) must be reasonable. A captive cannot arbitrarily set the premium amount simply to generate a deduction for the parent. For example: Smith Dentists Inc. is insured by the company's captive, Acme Insurance for loss of employee wages, fire, loss of computer equipment, etc. Acme Insurance cannot arbitrarily set the policy premium at $50,000, but rather, should base the premium amount on actuarial projections.

In the European union a new set of regulatory requirements (Solvency II) is planned with additional tasks and responsibilities for captives and reinsurance companies. Some European captives ask for simplified regulation.

Captive Manager

Reiss created the first captive management company, International Risk Management Limited (IRML), in Bermuda in 1962 to provide the administration of his client's captives. Most captive management is usually outsourced to a captive manager located in the jurisdiction that holds the primary license for the captive. The two largest captive insurance company managers in the world are units of Marsh & McLennan Companies and Aon Corporation -- the two largest commercial insurance company brokerages in the world. Each manages more than 1,000 captive insurers.
In 2007, Frederic Reiss was posthumously inducted into the Insurance Hall of Fame for his significant achievements in the insurance industry.

Types of captive

There are several types of insurance captives, the most common are defined below:

Single Parent Captive - is an insurance or reinsurance company formed primarily to insure the risks of its non-insurance parent or affiliates.
Association Captive - is a company owned by a trade, industry or service group for the benefit of its members.

Group Captive - is a company, jointly owned by a number of companies, created to provide a vehicle to meet a common insurance need.

Agency Captive - is a company owned by an insurance agency or brokerage firm so they may reinsure a portion of their clients risks through that company.

Rent-a-Captive - is a company that provides 'captive' facilities to others for a fee, while protecting itself from losses under individual programs, which are also isolated from losses under other programs within the same company. This facility is often used for programs that are too small to justify establishing their own captive.

Two other types of insurance companies which have developed recently are special purpose vehicles (SPV) and segregated portfolio companies (SPC):

SPV - Although used extensively in the past for various financing arrangements, recently they have been used for catastrophe bonds and reinsurance sidecars.

SPC - SPCs can be formed as a rent-a-captive facility to enable those companies who lack sufficient insurance premium volume, or who are averse to establishing their own insurance subsidiary, access to many of the benefits associated with an offshore captive.

Commercial advantages and issues

The key issues with captive insurers is that they are conduits for risk -- unless risk is placed with the captive it remains with the owner. There are a number of commercial advantages to using captives to provide a better risk management than the conventional insurance market.

Cost. Premiums charged by commercial insurers include amounts to cover the insurer's profit margin and overheads. Such overheads can be significant when considering insurers with large corporate structures to maintain.

Flexibility. When the market is soft, the captive can take advantage of the low rates by reinsuring a relatively large proportion of its risks. The low cost of reinsurance allows the captive to build its reserve base. When the market hardens, the captive is able to retain a larger proportion of its risks, and can maintain cover for its parent even when commercial insurance is unavailable or prohibitively expensive.

Claims management. The process of making a claim from a third party insurer can be long and involve a good deal of cost for the claimant. Where the insurer is a captive, the claims handling procedures can be dictated by management, cutting down on the delays and bureaucracy that are often a necessary part of the claims handling procedures of commercial insurers.

Claims experience benefits. Captives generally retain a portion of the overall risk and reinsure the remainder. For this reason, when claims experience is better than anticipated, the excess of net premiums over claims is retained by the group. The reinsurance taken out by the captive is tailored to minimize the group's exposure where claims experience is worse than projected.

The types of risk that a captive can underwrite for the parent include property damage, public and products liability, professional indemnity, employee benefits, employers liability, motor and medical aid expenses.

Captives are becoming an increasingly important component of the risk management and risk financing strategy of their parent. A number of reasons have been put forward as the basis for the growth in the use of captives:
heavy and increasing premium costs in almost every line of insurance coverage.
difficulties in obtaining coverage for certain types of risk.
differences in coverage in various parts of the world.
inflexible credit rating structures which reflect market trends rather than individual loss experience.
insufficient credit for deductibles and/or loss control efforts.

Setting Premiums

Because premiums paid to captives generate valid business deductions, the terms of the policy (including the premium amount) must be reasonable. A captive cannot arbitrarily set the premium amount simply to generate a deduction for the parent and, on a consolidated basis, a US taxpayer gets no deduction for premiums paid to wholly-owned captives that write only related business. However, on a consolidated basis, a non-insurance parent can deduct amounts actuarially accrued as loss reserves, on a discounted basis for tax purposes and, for most lines of business, an undiscounted basis for US GAAP earnings. Other corporations may not accrue or expense any general loss provisions, insurance-related or otherwise until the amount is identifiable, measurable and owed. Incurred-but-not-reported (IBNR) losses are excepted from this accounting rule for insurance and reinsurance entities.

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Agency (law)

Agency is an area of commercial law dealing with a contractual or quasi-contractual tripartite, or non-contractual set of relationships when an agent is authorized to act on behalf of another (called the Principal) to create a legal relationship with a Third Party. Succinctly, it may be referred to as the relationship between a principal and an agent whereby the principal, expressly or impliedly, authorizes the agent to work under his control and on his behalf. The agent is, thus, required to negotiate on behalf of the principal or bring him and third parties into contractual relationship. This branch of law separates and regulates the relationships between:

Agents and Principals;

Agents and the Third Parties with whom they deal on their Principals' behalf; and

Principals and the Third Parties when the Agents purport to deal on their behalf.

The common law principle in operation is usually represented in the Latin phrase, qui facit per alium, facit per se, i.e. the one who acts through another, acts in his or her own interests and it is a parallel concept to vicarious liability and strict liability in which one person is held liable in Criminal law or Tort for the acts or omissions of another.

The concepts

The reciprocal rights and liabilities between a principal and an agent reflect commercial and legal realities. A business owner often relies on an employee or another person to conduct a business. In the case of a corporation, since a corporation is a fictitious legal person, it can only act through human agents. The principal is bound by the contract entered into by the agent, so long as the agent performs within the scope of the agency.
A third party may rely in good faith on the representation by a person who identifies himself as an agent for another. It is not always cost effective to check whether someone who is represented as having the authority to act for another actually has such authority. If it is subsequently found that the alleged agent was acting without necessary authority, the agent will generally be held liable.

Brief statement of legal principles

There are three broad classes of agent
1. Universal agents hold broad authority to act on behalf of the principal, e.g. they may hold a power of attorney (also known as a mandate in civil law jurisdictions) or have a professional relationship, say, as lawyer and client.
2. General agents hold a more limited authority to conduct a series of transactions over a continuous period of time; and
3. Special agents are authorized to conduct either only a single transaction or a specified series of transactions over a limited period of time.

Authority

There are three bases by which parties may be held to have assumed the duties of principal and agent. These are actual authority, apparent authority, and implied authority.

Actual authority

Actual authority arises where the principal's words or conduct reasonably cause the agent to believe that he or she has been authorized to act. This may be express in the form of a contract or implied because what is said or done make it reasonably necessary for the person to assume the powers of an agent. If it is clear that the principal gave actual authority to agent, all the agent's actions falling within the scope of the authority given will bind the principal. This will be the result even if, having actual authority, the agent in fact acts fraudulently for his own benefit, unless the third party with whom the agent is dealing was aware of the agent's personal agenda. If there is no contract but the principal's words or conduct reasonably led the third party to believe that the agent was authorized to act, or if what the agent proposes to do is incidental and reasonably necessary to accomplish an actually authorized transaction or a transaction that usually accompanies it, then the principal will be bound.

Apparent authority

Apparent or ostensible authority exists where the principal's words or conduct would lead a reasonable person in the third party's position to believe that the agent was authorized to act, even if the principal and the purported agent had never discussed such a relationship. For example, where one person appoints a person to a position which carries with it agency-like powers, those who know of the appointment are entitled to assume that there is apparent authority to do the things ordinarily entrusted to one occupying such a position. If a principal creates the impression that an agent is authorized but there is no actual authority, third parties are protected so long as they have acted reasonably. This is sometimes termed "agency by estoppel" or the "doctrine of holding out", where the principal will be estopped from denying the grant of authority if third parties have changed their positions to their detriment in reliance on the representations made.

Implied authority

Implied authority considered held by the agent by virtue of being reasonably necessary to carry out his express authority. As such, it can be inferred by virtue of a position held by an agent. For example, partners have authority to bind the other partners in the firm, their liability being joint and several, and in a corporation, all executives and senior employees with decision-making authority by virtue of their position have authority to bind the corporation.
• Authority by virtue of a position held:
To deter fraud and other harms that may befall individuals dealing with agents, there is a concept of Inherent Agency power, which is power derived solely by virtue of the agency relation.
For example, partners have apparent authority to bind the other partners in the firm, their liability being joint and several (see below), and in a corporation, all executives and senior employees with decision-making authority by virtue of their declared position have apparent authority to bind the corporation.
Even if the agent does act without authority, the principal may ratify the transaction and accept liability on the transactions as negotiated. This may be express or implied from the principal's behavior, e.g. if the agent has purported to act in a number of situations and the principal has knowingly acquiesced, the failure to notify all concerned of the agent's lack of authority is an implied ratification to those transactions and an implied grant of authority for future transactions of a similar nature.

Liability of agent to third party

If the agent has actual or apparent authority, the agent will not be liable for acts performed within the scope of such authority, so long as the relationship of the agency and the identity of the principal have been disclosed. When the agency is undisclosed or partially disclosed, however, both the agent and the principal are liable. Where the principal is not bound because the agent has no actual or apparent authority, the purported agent is liable to the third party for breach of the implied warranty of authority.

Liability of agent to principal

If the agent has acted without actual authority, but the principal is nevertheless bound because the agent had apparent authority, the agent is liable to indemnify the principal for any resulting loss or damage.
Liability of principal to agent
If the agent has acted within the scope of the actual authority given, the principal must indemnify the agent for payments made during the course of the relationship whether the expenditure was expressly authorized or merely necessary in promoting the principal’s business.

Duties

An agent owes a fiduciary duty to be loyal to the principal.
An agent must not accept any new obligations that are inconsistent with the duties owed to the principal. An agent can represent the interests of more than one principal, conflicting or potentially conflicting, only after full disclosure and consent of the principal.
An agent also must not engage in self-dealing, or otherwise unduly enrich himself from the agency. An agent must not usurp an opportunity from the principal by taking it for himself or passing it on to a third party.
In return, the principal must make a full disclosure of all information relevant to the transactions that the agent is authorized to negotiate and pay the agent either a prearranged commission, or a reasonable fee established after the fact.

Termination

An agent's authority can be terminated at any time. If the trust between the agent and principal has broken down, it is not reasonable to allow the principal to remain at risk in any transactions that the agent might conclude during a period of notice.

As per Section 201 to 210 The Indian Contract Act, 1872, an agency may come to an end in a variety of ways:

(i) By the principal revoking the agency – However, principal cannot revoke an agency coupled with interest to the prejudice of such interest. Such Agency is coupled with interest. An agency is coupled with interest when the agent himself has an interest in the subject-matter of the agency, e.g., where the goods are consigned by an upcountry constituent to a commission agent for sale, with poor to recoup himself from the sale proceeds, the advances made by him to the principal against the security of the goods; in such a case, the principal cannot revoke the agent’s authority till the goods are actually sold, nor is the agency terminated by death or insanity. (Illustrations to section 201) (ii) By the agent renouncing the business of agency; (iii) By the business of agency being completed; (iv) By the principal being adjudicated insolvent (Section 201 of The Indian Contract Act. 1872)

The principal also cannot revoke the agent’s authority after it has been partly exercised, so as to bind the principal (Section 204), though he can always do so, before such authority has been so exercised (Sec 203).

Further, as per section 205, if the agency is for a fixed period, the principal cannot terminate the agency before the time expired, except for sufficient cause. If he does, he is liable to compensate the agent for the loss caused to him thereby. The same rules apply where the agent, renounces an agency for a fixed period. Notice in this connection that want of skill continuous disobedience of lawful orders, and rude or insulting behavior has been held to be sufficient cause for dismissal of an agent. Further, reasonable notice has to be given by one party to the other; otherwise, damage resulting from want of such notice, will have to be paid (Section 206). As per section 207, the revocation or renunciation of an agency may be made expressly or impliedly by conduct. The termination does not take effect as regards the agent, till it becomes known to him and as regards third party, till the termination is known to them (Section 208).
When an agent’s authority is terminated, it operates as a termination of subagent also. (Section 210).

This has become a more difficult area as states are not consistent on the nature of a partnership. Some states opt for the partnership as no more than an aggregate of the natural persons who have joined the firm. Others treat the partnership as a business entity and, like a corporation, vest the partnership with a separate legal personality. Hence, for example, in English law, a partner is the agent of the other partners whereas, in Scots law where there is a separate personality, a partner is the agent of the partnership. This form of agency is inherent in the status of a partner and does not arise out of a contract of agency with a principal. In the English Partnership Act 1890 provides that a partner who acts within the scope of his actual authority (express or implied) will bind the partnership when he does anything in the ordinary course of carrying on partnership business. Even if that implied authority has been revoked or limited, the partner will have apparent authority unless the Third Party knows that the authority has been compromised. Hence, if the partnership wishes to limit any partner's authority, it must give express notice of the limitation to the world. However, there would be little substantive difference if English law was amended (see Law Commission Report 283): partners will bind the partnership rather than their fellow partners individually. For these purposes, the knowledge of the partner acting will be imputed to the other partners or the firm if a separate personality. The other partners or the firm are the principal and third parties are entitled to assume that the principal has been informed of all relevant information. This causes problems when one partner acts fraudulently or negligently and causes loss to clients of the firm. In most states, a distinction is drawn between knowledge of the firm's general business activities and the confidential affairs as they affect one client. Thus, there is no imputation if the partner is acting against the interests of the firm as a fraud. There is more likely to be liability in tort if the partnership benefited by receiving fee income for the work negligently performed, even if only as an aspect of the standard provisions of vicarious liability. Whether the injured party wishes to sue the partnership or the individual partners is usually a matter for the Plaintiff since, in most jurisdictions, their liability is joint and several..

Agency relationships

Agency relationships are common in many professional areas.
employment procurement
real estate transactions (real estate brokerage, mortgage brokerage). In real estate brokerage, the buyers or sellers are the Principals themselves and the broker or his/her salesperson who represents each Principal is his/her Agent.
financial advice (insurance agency, stock brokerage, accountancy)
contract negotiation and promotion (business management) such as for publishing,fashion model ,music,movies, theatre, show business and sport.

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