A discussion draft of the “Pandemic Risk Insurance Act” has circulated over recent weeks. Based on the Terrorism Risk Insurance Act, the text is an excellent jumping off point to think about what would work and what would not.
The draft quickly forces to the surface an uncomfortable reality that a TRIA-style “make available” requirement would separate policyholders into the haves and the have-nots.
Large corporations with the financial wherewithal and sophistication to establish their own pandemic risk insurance companies may structure multibillion-dollar bailout plans free from government intrusion into executive pay, share buyback plans and layoff strategies. More than 500 such “captives” already participate in the Terrorism Risk Insurance Act and could claim as much as 95% of federal funding under that program.
Small and medium-sized businesses, churches, school districts and other nonprofits and local governments would not fare so well. These regular policyholders cannot afford to set up their own insurance companies. The standard insurance policies available to them only cover business interruption losses caused by “property damage.” PRIA’s “make available” requirement would cancel out a pandemic or virus exclusion – it does nothing to address the necessity of property damage.
A large corporation can simply negotiate with itself to remove the prerequisite of property damage. Regular policyholders would have to file lawsuits seeking a judicial finding of property damage as is happening right now in the context of COVID-19.
The discussion draft should be focusing attention on the needs of regular policyholders. Once we have a solution that works for them, we can worry about what the program can do for insurance companies and large corporations.
The range of risks facing company executives or directors and officers (D&Os) – as well as resulting insurance claims scenarios – has increased significantly in recent years. With corporate management under the spotlight like never before, Allianz Global Corporate & Specialty has identified, in its latest risk report, Directors and Officers Insurance Insights 2020, five mega trends that will have significant risk implications for senior management in 2020 and beyond.
1. More litigation is coming from “bad news” events
Allianz continues to see more D&O claims emanating from “bad news” not necessarily related to financial results, including product problems, man-made disasters, environmental disasters, corruption and cyber-attacks – “event-driven litigation” cases that often result in significant securities or derivative claims from shareholders after a share price fall or regulatory investigation related to the “bad news” event.
Plaintiffs seek to relate the “event” to prior company or board statements of reassurance to shareholders and regulators of no known issues. Of the top 100 US securities fraud settlements ever, 59% are event-driven.
One of the most prevalent types of these events is cyber incidents. Allianz has seen a number of securities class actions, derivative actions and regulatory investigations and fines, including from the E.U.’s General Data Protection Regulation (GDPR), in the last year, and expects an acceleration in 2020.
Companies and boards increasingly will be held responsible for data breaches and network security issues that cause loss of personal information or significant impairment to the company’s performance and reputation. Companies suffering major cyber or security breaches increasingly are targeted by shareholders in derivative litigations alleging failure to institute timely protective measures for the company and its customers.
The Marriott case – where the hotel chain announced that one of its reservation systems had been compromised, with hundreds of millions of customer records left exposed – is a recent example of a cyber breach resulting in D&O claims – one $12.5 billion lawsuit among several filings alleges that a “digital infestation” of the company, unnoticed by management, caused customer personal data to be compromised for over four years.
2. ESG and climate change litigation on the rise
Environmental, social and governance (ESG) failings can cause brand values to plummet. And investors, regulators, governments and customers increasingly expect companies and boards to focus on ESG issues, such as climate change, for example. Climate change litigation cases have been brought in at least 28 countries to date (three-quarters in the U.S.). In the U.S., there are an increasing number of cases alleging that companies have failed to adjust business practices in line with changing climate conditions.
Human exploitation in the supply chain is another disrupter and illustrates how ethical topics can cause D&O claims. Such topics can also be a major focus for activist investors whose campaigns continue to increase year-on-year.
Appropriate company culture can be a strong defense risk-mechanism. Many studies show board diversity helps reduce and foresee risk. Regulators are keen to investigate and punish individual officers rather than the entity, forcing directors into increased personal scrutiny to provide assurance that they did due diligence to prevent such cases from occurring.
Securities class actions, most prevalent in the U.S., Canada and Australia, are growing globally as legal environments evolve and in response to growing receptivity of governments to collective redress and class actions. Significantly, the E.U. has proposed enacting a collective redress model to allow for class actions, while states, such as Germany, the Netherlands and the U.K., have established collective redress procedures. The pace of U.S. filing activity in 2019 has been only marginally slower than record highs of 2017 and 2018, when there were over 400 filings, almost double the average number of the preceding two decades.
Shareholder activism has increased. Approximately 82% of public company merger transactions valued over $100 million gave rise to litigation by shareholders of the target company threatening that the target company’s board will have breached its duties by underpricing the company, should the merger succeed.
4. Bankruptcies and political challenges
With most experts predicting a slowdown in economic growth, Allianz expects to see increased insolvencies, which may potentially translate into D&O claims. Business insolvencies rose in 2018 by more than 10% year-on-year, owing to a surge of over 60% in China, according to Euler Hermes. In 2019, business failures are set to rise for the third consecutive year by more than 6% year-on-year, with two out of three countries poised to post higher numbers of insolvencies than in 2018.
Political challenges, including significant elections, Brexit and trade wars, could create the need for risk planning for boards, including revisiting currency strategy, merger and acquisition (M&A) planning and supply chain and sourcing decisions based on tariffs. Poor decision- making may also result in claims from stakeholders.
5. Litigation funding is now a global investment class
These mega trends are further fueled by litigation funding now becoming a global investment class, attracting investors hurt by years of low interest rates searching for higher returns. Litigation finance reduces many of the entrance cost barriers for individuals wanting to seek compensation, although there is much debate around the remuneration model of this business.
Recently, many of the largest litigation funders have set up in Europe. Although the U.S. accounts for roughly 40% of the market, followed by Australia and the U.K., other areas are opening up, such as recent authorizations for litigation funding for arbitration cases in Singapore and Hong Kong. Next hotspots are predicted to be India and parts of the Middle East. Estimates are that the litigation funding industry has grown to around $10 billion globally, although some put the figure much higher, in the $50 billion to $100 billion range, based on billings of the largest law firms.
The state of the market
Although around $15 billion of D&O insurance premiums are collected annually, the sector’s profitability is challenged due to increased competition, growth in the number of lawsuits and rising claims frequency and severity. Loss ratios have been variously estimated to be in excess of 100% in numerous markets, including the U.K., U.S. and Germany in recent years due to drivers such as event-driven litigation, collective redress developments, regulatory investigations, pollution, higher defense costs and a general cultural shift, even in civil law countries, to bring more D&O claims both against individuals and the company in relation to securities.
The increased claims activity, combined with many years of new capital and soft pricing in the D&O market has resulted in some reductions in capacity. In addition, there has also been an increase in the tail of claims. Hence, there is a double impact of prior-year claims being more severe than anticipated and a higher frequency of notifications in recent years. As for claims severity, marketplace data suggests that the aggregate amount of alleged investor losses underlying U.S. securities class action claims filed last year was a multiple of any year preceding it.
Despite rising claim frequency and severity, the industry has labored under a persistent and deepening soft market for well over a decade before seeing some recent hardening. Publicly disclosed data suggests D&O market pricing turned modestly positive in 2018 for the first time since 2003. However, D&O rates per million of limit covered were up by around 17% in Q2 2019, compared with the same period in 2018, with the overall price change for primary policies renewing with the same limit and deductible up almost 7%.
From an insurance-purchasing perspective, Allianz sees customers unable to purchase the same limits at expiration also looking to purchase additional Side A-only limits and also to use captives or alternative risk transfer (ART) solutions for the entity portion of D&O Insurance (Side C). Higher retentions, co-insurance and captive-use indicate a clear trend of customers considering retaining more risk in current conditions.
To drive operational effectiveness and capital deployment efficiency, leaders of captive insurance companies are increasingly in need of improved methods for performance evaluation and tools that go beyond simple financial ratio analysis or industry benchmarking comparisons. This need includes validation of the risk management program relative to the captive’s purpose, strategy and goals, as well as transaction and decision process transparency, performance tracking, formal decision-support analytics and informed disclosure to oversight groups.
For many organizations, captives offer considerable strategic and financial value; consequently, they play an increasingly significant role in the overall risk management program. Additionally, captives often compose an integral element of an organization’s strategic planning efforts.
Captive growth and business strategies can be more fully supported by an enhanced ability to monitor, analyze and track performance relative to the captive’s existing risk portfolio and new coverage opportunities. The benefits of these measures can include improved risk transfer and control decisions, as well as validation of risk and insurance management practices, activities and decisions.
By improving decision-support information, the leader of an organization’s captive may gain increased recognition and commitment from senior management, which in turn leads to greater ability to write new coverages and enhance the existing program. The following method for improving decision processes for a captive offers a new approach for measuring its current performance and evaluating its potential.
Strategic Captive Opportunity and Utilization Technique
The strategic captive opportunity and utilization technique (SCOUT) is a performance evaluation methodology that consists of a performance scorecard and a reporting dashboard. It provides a framework to evaluate, rank and prioritize current and potential business/risk opportunities and a foundation for improving decision-making and enhancing strategic utilization and planning.
The scorecard is a database that captures strategic and tactical factors while the dashboard consolidates the scorecard data for monitoring, analysis and reporting. Together, these tools support decision-making capabilities.
As a technique for measuring captive opportunity and utilization, SCOUT conveys meaningful information with simplicity, converts qualitative benefits into quantitative terms and delivers a formal process that is consistent and reusable. The SCOUT process involves evaluating the performance of each coverage underwritten by the captive, as it relates to the original purpose, strategy and goals for captive formation. It also provides a framework for assessing the potential success of proposed coverages, including pro forma financial analysis, volatility considerations and risk profile changes.
The scorecard represents a model to evaluate quantitative and qualitative metrics through a consistent scoring methodology (see below). The metrics, or key performance indicators (KPIs), include strategic goals, operational objectives and expected economic benefits.
Specifically, the model assesses five primary KPIs: 1) achieve operational excellence; 2) reduce costs; 3) build surplus; 4) maximize return on invested funds; and 5) improve the risk management function. Each KPI is broken down into critical components to fully capture economic and non-economic performance evaluation criteria. Accordingly, the KPI structure builds from strategic performance goals to detail-oriented tactical objectives.
The KPIs provide a framework for monitoring the effectiveness of the organization’s captive strategies, including identifying gaps between actual and targeted performance, as well as assessing overall organizational effectiveness and operational efficiency. KPIs can also help track progress toward a desired outcome.
Specific KPIs are selected based on their ability to determine if a strategy is working, gauge performance changes over time and focus management’s attention on what matters most. The KPIs also allow measurement of accomplishments, provide a common language for communication, help reduce intangible uncertainty and can be validated and verified.
Using the SCOUT process, each coverage underwritten by the captive is analyzed separately using selected KPIs. Input data is obtained through annual financial statements, actuarial analysis and internal and external captive and coverage specialists.
Each KPI component is rated based on the priority of the goal or objective (mapped on the x axis) and performance evaluation of the goal or objective (y axis). Ratings criteria range from a score of “1,” which represents “minimal importance/not met” relative to goal/objective priority and goal/objective performance evaluation, through “5,” which represents “critical/exceeded” for goal/objective priority and goal/objective performance evaluation.
Additionally, each KPI component can be rated as quantitative or qualitative. When a dollar figure can be used to support the performance evaluation, the KPI component is quantitative; when benefits are more intangible and difficult to quantify, then the qualitative selection ensures these benefits are included in the performance evaluation process.
Components of the Key Performance Indicators
The five KPIs are made up of critical components that offer enhanced measurement detail. For example, the components within the “achieve operational excellence” KPI include current and historical loss ratios as well as premium materiality.
Components of the “reduce costs” KPI are based on loss versus non-loss costs. Loss costs refer to lower insurance premiums achieved through the captive’s ability to change risk retentions, based on commercial insurance rates, risk tolerance and appetite and internal strategic business financial needs. A second element of “reduce costs” is savings from claims management and loss control activities as illustrated by loss rate trends. Claims management activities include early reporting, cost containment strategy, improved legal defense and subrogation, and increased management attention. Loss control activities include engineering, cost of risk allocation and contractual risk transfer. Non-loss cost components refer to tax dynamics, fronting fees, collateral needs or third-party vendor fees.
The “build surplus” KPI represents the buildup of underwriting profit. Performance evaluation criteria are based on insured coverage versus pure balance sheet risk and whether the coverage is intended to protect business assets or stabilize premiums and losses or represents diversification into a profitable new business, such as extended warranties or service maintenance agreements.
“Maximize return on invested funds” is the lone KPI that measures a potentially negative result as based on the amount of investment income that can be earned on surplus within the captive versus repatriating funds back to the parent to invest in higher income-producing opportunities. Known as opportunity cost, the performance evaluation criteria are based on selection of an appropriate internal capital rate, regulatory surplus requirements, catastrophic loss potential and future coverage needs. Determination of the internal rate of return is based on the organization’s financial strength, including cash and collateral needs, earnings, borrowing capacity and asset strength.
Finally, the “improve the risk management function” KPI includes various qualitative criteria about the captive’s ability to improve control and administration of the risk management function and the flexibility of the risk management program. Component KPI metrics that measure improved control over the risk management function include the ability to negotiate or replace fronting insurers or reinsurers, consistent application of risk management throughout the organization, cost of risk allocation support, alignment of risk appetite and risk tolerance, underwriting dynamics and emerging risk identification.
The component KPI metrics for improved flexibility of the risk management program include coverage forms and rates, coverage requirements and unbundled services. Component KPI metrics for improved administration of the risk management function include ability to protect reputation, governance structure and reporting, enterprise risk management application, coverage renewal automation, data warehousing and analytical capabilities.
The SCOUT dashboard offers predictive capabilities using a visual tool to track trends and align activities with goals and helps to identify when and where important adjustments should be made to the program. The visual display should allow end users to monitor what is going on at a glance by focusing on only the most important information needed to achieve objectives. Thus, managers will be able to step back from the details contained in the scorecard and identify key trends and relationships.
The dashboard also serves as a reporting tool for senior management and board discussions and presentations while specific supporting data is contained within the performance scorecard. From a software perspective, the scorecard represents the back-end database while the dashboard represents the front-end interface and reporting. Scorecard results are designed to link to the dashboard for automatic updating.
Because the dashboard is built upon information obtained in the scorecard, its final look and feel is unique to the captive’s original purpose and mission, goals and objectives. A potential dashboard application offers four design graphics, comprising: 1) select quantitative results; 2) quantitative metrics; 3) qualitative metrics; and 4) financial ratios.
As the focal point of the dashboard, the “select quantitative results” section embodies the primary analysis in the display. Figures are taken directly from the performance scorecard. Each coverage underwritten within the captive can be detailed separately and sorted by policy year. Measurements include results for underwriting, loss rate, surplus and opportunity cost KPIs. Conditional formatting can be used to illustrate a check, exclamation point or X depending on performance result, in accordance with pre-defined rules. Sparkline graphics can be used to illustrate trends.
The quantitative and qualitative metrics are captured within bubble charts through rankings of goal/objective priority and goal/objective performance evaluation within the scorecard. The bubble charts represent an effective xy scatter diagram, based on the metrics used for scorecard ranking.
Finally, a financial ratios graphic can offer a traditional analysis of the financial performance of the captive as a whole. Within this analysis, actual versus benchmark ratios can be illustrated and sorted by fiscal year, including premium/reserves to surplus, risk retention to surplus, expense, loss, combined, policy year operating, investment income, asset to liability, reserves to liquid assets and operating ratios.
Integrating SCOUT Into Organizational Risk Management Culture
SCOUT offers a platform for supporting the business and growth strategies of the organization’s captive insurance company by offering a fully defined framework and methodology for consistent, sophisticated and continuous assessment of captive performance.
The next step is for the organization to integrate SCOUT into its risk management culture to help in decision-making. For this to happen, the captive leader needs to develop a formal process for updating and maintaining the scorecard and dashboard, including data extrapolation of actuarial and financial statements and input from coverage specialists and strategic business unit leaders.
When in place as a formal business process, SCOUT enables detailed and usable monitoring and tracking of risk management and risk financing functions related to a captive insurance subsidiary. It can also illustrate current and future economic benefits with both quantitative and qualitative metrics for strategic business unit leaders, board members, treasury and C-suite executives.
As a platform for making better, faster decisions, the scorecard and dashboard can fit into the organization’s enterprise risk management efforts. Information is rolled up through the dashboard function while the scorecard allows for drill-down into the specific details needed to fully support decisions. Improved management and governance can then help captives take advantage of opportunities for new coverage types, enhancements, program improvements and corrective actions.
Reprinted with permission from Risk Management Magazine. Copyright 2017 RIMS Inc. All rights reserved.
Much has been written about the financial and tax power of forming and operating a captive insurance company that qualifies for the tax benefits of section 831(b) of the Internal Revenue Code. But all too often, promoters of this concept forget that each captive must be first and foremost a risk management tool with legitimate risks and properly priced premiums.
An “831(b)” captive is an insurance company whose premiums do not exceed $1.2 million a year and that elects to have those premiums exempted from taxation. If the captive has proper “risk distribution” (a topic for another article), then the insured company can deduct the premium being paid to the captive, while the captive pays no income taxes on that premium. After the payment of losses and expenses, any profits in that captive can be distributed at a favorable dividend rate or can be distributed in a full liquidation of the captive, and the shareholders will receive those accumulated profits at capital gains rates. And if the captive is owned by trusts or adult children, the entrepreneur can also enhance the benefits in his or her estate plan by sidestepping the estate tax.
But these benefits are only possible if you first get the underwriting right. Over the years, we have conducted audits on existing 831(b) captives formed by some of our competitors. We have been amazed by what people are charging for risks, many of which can be insured in the traditional insurance market at much lower rates. We call it “underwriting by the blind.” The IRS is well aware of the pricing abuses in our industry. As we understand it, the majority of negative audits recently have not been because of faulty “risk distribution” mechanisms, but because of badly overpriced premiums being paid to the captive.
For example, we found a $10 million (revenue) manufacturer that had purchased a $1 million general liability policy, including products liability, in the insurance market for an estimated $25,000 annual premium. The new captive issued a “differences in condition” policy with a $1 million limit and charged the insured more than $200,000 in annual premium. This type of policy covers things like exclusions in the underlying policy. It does not take an insurance expert to realize that such a premium is unreasonable and bears no relation to either market rates or the real risk that is being assumed (particularly because the insured was manufacturing a non-hazardous consumer product).
Another example of egregious pricing is in the area of terrorism risk. One provider is promoting captives with more than $600,000 in premium for $10 million in limits for this type of risk even though the client could purchase that same coverage in the standard insurance market for less than $5,000. How can such a payment be “ordinary and necessary” and therefore be deductible?
Knowing that these captives were approved by a regulator, we keep asking ourselves, “Where are the actuaries and the regulators, and why do they not concern themselves with the relationship between the risk assumed and the premiums charged?”
The simple fact is that the requirements of the captive insurance laws fall far short of the requirements of the IRS. The laws of each captive insurance jurisdiction in the U.S. require that an actuarial opinion accompany each application for an insurance license. But that opinion is limited to determining “the amount and liquidity of its [the captive’s] assets relative to the risks to be assumed [meaning the policy limits].” Thus, a regulator’s primary concern is to ensure the solvency of the captive. Typically, this is achieved through pro-formas showing 3- to 5-year expected and adverse loss scenarios. Note that there is no requirement to examine or opine on individual rates used to price specific exposures being assumed by the captive.
This “gap” between the captive insurance law and the realities of the tax authorities can be immense. One of the first questions asked by the IRS in the audit of a captive is, “How were the premiums (pricing) determined for each risk assumed?” Without an opinion of an actuary regarding these rates, it then comes down to the knowledge of the underwriter used by the captive management company. It is apparent that many captive managers do not have sufficient depth in this area or do not care to go beyond the specific requirements of the captive licensing requirements. (We, however, require that our actuaries examine every rate that we use in our feasibility studies.)
A rule of thumb is that a properly priced portfolio of risk for a captive should equate to total premiums equal to 1% to 2% of the insured’s revenue. The reason revenue is a good guide is because the majority of risks being transferred to section 831(b) captives are casualty risks. And the exposure base for casualty risks is generally revenue. The underwriter cannot change the exposure base, but he can raise the rate that is multiplied times the exposure base to get to a higher premium as desired by the client. But the captive will not survive an audit if rates are raised too high.
That estimate of 1% to 2% of revenue is only a guideline: There are exceptions. But if you see a captive manager suggest that the premiums payable to an 831(b) captive can be 6% to 10% (or more) of revenue, run! That manager is ignoring the important risk management requirements of this captive concept, to the detriment of its clients. And the clients are playing audit roulette, hoping their “number” does not come up.
James Landis collaborated with Rick Eldridge in writing this article. Eldridge is the president and CEO of Intuitive Insurance and the managing partner of Intuitive Captive Solutions.