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Software tools and actuarial services for risk management and insurance professionals Latest News | Products & Services | Support | Library | Company | Shop | Search |
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Specific Software Solutions · SIGMA Actuarial Consulting Group |
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SIGMA Spectrum, Volume 6, Number 1 How to Subscribe/Unsubscribe Back to Library SIGMA Home SRBE Management: Achieving the Good, Fixing the Bad, and Avoiding the Ugly As you probably know, a small risk bearing entity (SRBE) such as a captive, pool, trust or small insurance company is subject to less regulation than an admitted insurance company. This attractive feature of a SRBE is also dangerous, as freedom from regulation can lead to a lack of financial and operational guidelines to protect surplus. The most successful SRBEs will have internal guidelines to achieve the best of both worlds - limited external regulation combined with self-discipline that ensures financial health. SIGMA's Risk Retention Model helps the SRBE to define its own guidelines through financial statement forecasts that provide a broader and more quantified understanding of how possible operational changes will affect retention level, reinsurance, dividend policy, pricing structure, and other factors. In this issue of SIGMA Spectrum, we welcome Lloyd Kelley, our Director of Strategic Consulting, to tell us more about this model and its role as a SRBE management tool. |
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The Risk Retention Model by Lloyd Kelley In business, the only certainty is change. Regardless of our current circumstances, we can expect them to change sometime, and to some extent. For large commercial insurance companies, change is constant, but with a large base of premiums and good spread of risk, the change can be managed with relatively little disruption. For small risk bearing entities (SRBEs) like captives, pools, or trusts, change is not easy. By their very nature, SRBEs do not accumulate significant surplus. They are not formed to make and accumulate profits; they are formed to bring stability and low cost to the risks of their parent company or members. Their spread of risk is limited by geography, regulation, and the risk appetite of their parent/owners. Thus, a change might be more volatile for the SRBE than for a large, multi-national insurance company. An unexpected claim settlement or a few days of bad weather could cause operating losses that could seriously impede the SRBE. A Note on RegulationRegulation is a two-edged sword. One of the reasons to form an SRBE is to avoid excessive, often onerous, regulation of rates, forms, and investments. However, since SRBEs have less regulation, managers can take financial risks that a licensed, admitted cannot. A pool board or the audit committee of a captive’s parent might not use IRIS ratios to govern the SRBE, but they can and should ask whether prudent business practice governs the manager’s decisions. Without the scrutiny of regulators or a board of directors, unacceptable risks can be assumed and, with adverse results, the damage can be immense. The Need for Management Support
The management of an SRBE, such as the risk manager, executive director of a
pool, or the risk management committee of a hospital, needs tools to measure
the volatility of new risk. As an ancillary benefit, the RRM technique
replaces the guidelines that would be imposed by regulators, but retains the
flexibility sought when forming a SRBE.
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Mapping the Risk -
SIGMA’s RRM answers the following questions:
Using the RRM as a management tool: achieving the good, fixing the bad, and avoiding the ugly The following examples demonstrate the use of the RRM. The first is an opportunistic scenario. This case describes a captive considering whether and how to use accumulated surplus to assume more risk and lower the overall cost of risk for its parent company.
The second is a crisis scenario. A pool has experienced unexpected,
unfunded losses, and one of its reinsurers is insolvent. Can it
recover? How long will it take? Read more about these scenarios below, or go ahead and download the Risk Retention Analysis Sample Study (pdf format) for a full explanation of the situations, the methodologies used in their analyses, and their conclusions. |
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Example 1 - An Opportunistic Scenario
The Situation
XYZ’s captive, XYZ Insurance Company (XYZInsCo), domiciled in Bermuda, writes workers compensation coverage for all of XYZ’s subsidiaries. The program is fronted by ABC Insurance (ABC), who also reinsures XYZInsCo excess of $250,000.
XYZInsCo has been in operation since 2003 and has accumulated surplus of $2.9 million. Based upon the 2005 year end figures, XYZInsCo’s premium to surplus ratio is 0.66 to 1.
For the next renewal, ABC will require an increase in retention from $250,000 to $750,000, without commensurate credit in the reinsurance premium. This increase is being imposed because of general market conditions, not because of adverse claims experience from XYZ. Financial and Operational Considerations XYZ needs to address five key issues in order to determine whether and how to take more risk in XYZInsCo. They are:
To see how a risk retention analysis quantifies the risk, establishes benchmarks, and answers the questions above based on a five year analysis, see the SIGMA Risk Retention Model Samples, section 2. |
Example 2 - A Crisis Scenario The Situation BLINSCO (Bad Luck Insurance Company), an offshore captive, writes the med mal cover for a not-for-profit hospital group. BLINSCO, formed in 2003 was very profitable through 2005. During those three years it made over $3 million in operating profits and accumulated over $4.5 million in surplus. However, BLINSCO had several losses that exceeded their per occurrence limit and were ceded to its primary reinsurer, Wellness Re. Several of these claims were being litigated, but the reserves were considered adequate. Early in 2006, several of these lawsuits were decided, all in favor of the claimants. These claims, plus other adverse underwriting results, caused Wellness Re to declare bankruptcy in March, 2006. Since Wellness Re was no longer an admitted reinsurer, BLINSCO had to expense $2,625,000 of claims previously ceded to Wellness Re. These judgments caused an increase in reported claims and increase in reserves for outstanding claims for BLINSCO. This run of bad luck resulted in a 200% loss ratio for BLINSCO on the business written in 2006. The $2,625,000 expense for uncollectible reinsurance, plus the 200% loss ratio resulted in a $6.9 million decline in surplus. At the end of 2006, BLINSCO had a negative surplus of $2.4 million. BLINSCO management was faced with several crises in 2006:
The Questions BLINSCO management was faced with two key questions in its rehabilitation of BLINSCO: 1. How would it measure the success of the turnaround? 2. How long will it take to return BLINSCO to solvency? To see how a risk retention analysis quantifies this risk, establishes benchmarks, and answers the questions above, see the SIGMA Risk Retention Model Samples, section 3. |
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Conclusion Because a SRBE must manage change so carefully, and often on short notice, its managers must carefully quantify the effect of the change and be nimble making their decisions. Forecasts of financial results based on the imposed change are critical. The forecasts need to be done using a range of possibilities of the effect of change, not with just a single assumption. SIGMA's Risk Retention Model accommodates that range of possibilities and moves decision making beyond the income statement because it measures the impact and variability on the entire future financial structure of the entity. To Learn More
Contact Lloyd Kelley by emailing
lloyd@SIGMAactuary.com or
calling |
About the Author A thirty-year professional in property and casualty insurance brokerage management, production and service, Lloyd Kelley joined SIGMA Actuarial Consulting Group in 2005 as its Director of Strategic Consulting. He has extensive experience in the research and development of captive and risk retention models, including establishment of the US captive management operation for Willis in Vermont. For more about Lloyd, read this press release. Please feel free to tell your colleagues about SIGMA Spectrum...it's free to everyone. If you haven't already, we encourage you to subscribe now! Easy removal instructions will be at the bottom of each email you receive from us.
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