Since that revelation, several people have asked a question along the lines of, “If captives are in effect reinsurers and always reinsure fronting carriers, how can captives be concerned about reinsurance?”

The question is a good one in that terms are often tossed about as if everyone has the same understanding of their use, which often is not the case.

To clarify:

? A reinsurer accepts risk and premium from a primary carrier, which issues policies and offers other services. Increasingly that reinsurer is a captive.

? However, the captive usually does not wish to accept 100 percent of the risk, so other risk-transfer arrangements are investigated. These can be offered by the “front” as a package deal often the most cost-effective route.

? Reinsurance is insurance of insurance, and is used to preserve capital and protect the balance sheets of insurers. Reinsurance has been around for centuries and comes in many forms.

? It should be noted that, in general, reinsurance is neither regulated nor standardized. Careful study of the reinsurance contract is therefore important.

One attraction of setting up a captive is that as an insurer, the captive gains direct access to the reinsurance market not something traditional insureds have available to them. When used thoughtfully, direct access can improve pricing, coverage and terms.

Reinsurance and excess insurance can be structured to protect a captive from a single loss above its capacity, or from an aggregation of many losses in a policy period. These are often called vertical and horizontal losses, or specific and aggregate.

A typical structure would occur when the “front” accepts little or no risk, placing up to 100 percent of the exposure with others. The captive can then arrange reinsurance behind its limits, or obtain excess coverage over and around its limits.

This difference is all important. If reinsurance of the captive is chosen, the costs to operate the captive can be increased as it will be responsible for higher premium taxes (where they apply) and may well face increased capital demands.

Regulators might question the captive's ability to accept responsibility for the limits if the reinsurer fails, as all exposure is on the captive's books.

For this reason, reinsurance of the captive is usually done as excess of the captive's retention. This may reduce some costs, capital requirements and regulatory concerns.

An excess insurance policy can be written to not respond until the loss reaches beyond the attachment point of the captive known as straight excess. Attachment points and actuarial projections become critical to the captive's acceptability and probability of success.

Concern expressed by this year's respondents to the CICA survey seems to be focused on the security of reinsurers following a year of expensive catastrophes.

In addition, the issue of price has returned for many captives in regard to reinsurance. Some captive owners report a hidden cost increase by tightening terms and reducing coverage while the rate remains steady.

In the heat of battle, the terms “excess” and “reinsurance” have become synonymous, although in fact they are not. Shortcuts in speech are hopefully corrected in the structure and documentation of a program.

Michael R. Mead, CPCU, is president of M.R. Mead & Company in Chicago.

Reproduced from National Underwriter Edition, April 15, 2005. Copyright 2005 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.