Reinsurers and captives: a transparent approach
One of the benefits of owning a captive is the retention of claims control while being able to access reinsurance markets directly. There is a necessary intimacy between the insured-owner and its captive and, occasionally, roles get confused. Yet reinsurance protections impose obligations on a captive that must be met.
Claims transparency is vital to the success of the relationship. Lack of transparency eventually leads to disputes. However, there are several relatively simple tools available to both sides to foster longterm, profitable relationships.
A captive that relies on reinsurance should have in place basic structures and procedures that facilitate regular claims reporting to the reinsurer. Formats necessarily vary based on the type of captive and the reinsurance structure. The key is maintaining current and accurate information flow from the original insured through its captive and then to its reinsurer(s).
A proven practice is to provide narrative claim summary updates to reinsurers in a cumulative fashion, following an internal quarterly claims review performed by the captive with its insured-owners. These reports should clearly convey to reinsurers the past three months’ development. They should be factual. As discussed below, care should be taken to avoid disclosing confidential information, especially on matters in litigation. The claim summary can also double as a bordereaux and should include current total incurred figures.
In addition to quarterly reporting, many successful captive-reinsurer relationships use a system of individual claim notices to reinsurers between the quarterly reports. These then become part of the quarterly claims summary.
The claims reporting process can be greatly facilitated by an outside claims manager or claims counsel for the captive. This person functions as an intermediary between the original insured, the captive cedent and the reinsurer. His or her task is to assist the efforts of the captive’s owners to treat their captive as a real insurance company, and in so doing to help the captive meet its obligations to reinsurers. The role requires objectivity in reserving and reporting. For the reinsurer, the position is a single point source for information, and a repository of claims information for audit, if necessary. It also provides an added comfort level.
One of the obvious benefits of increased reporting is that it reduces the incidence of surprise. It provides reinsurers with the opportunity to see the claim develop and protect their own interests (and retrocessions). Regular reporting is also an effective means of self-policing that reduces some of the more common problem areas. The ability of a captive to provide accurate and timely claims information should be an element of any pre-underwriting due diligence by the reinsurer.
Common problem areas for captive structures include:
• Under-reserving and/or step reserving;
• Failing to advise reinsurers of significant developments in reported claims;
• Mishandling claims; and
• Erosion of attachments by uncovered claims or uncovered expenses of the parent company.
It is not always the case that these events happen intentionally. While captives can be exceptionally profitable businesses to reinsure, one should not assume they will, or can, function like commercial cedents when it comes to claims.
Captives are usually not separate brick and mortar companies. Pure, or single parent, captive claim functions are often performed by employees of the original insured, with some outsourced assistance. Group captives typically rely more on outside assistance. Both, however, can struggle to maintain separation between the insured and the captive. In this environment claims decisions can occur which may not reflect the reinsurer’s expectations. Furthermore, the distinctions between covered claims costs and unrelated business expenses can blur under captive insurance policy wordings, which are intentionally designed to provide broad coverage.
Despite the best intentions of a captive’s claims manager or counsel, or the parent company’s in-house counsel, obtaining current and accurate information can also be a challenge. This is particularly true with respect to precautionary claim notices or updates on claims not in litigation. When the captive’s owner is a large multinational, remote business units, language barriers and varying intra-corporate cultures contribute to delays in information flow to the insured’s staff who are responsible for the captive programme.
Group captives present similar challenges to the persons responsible for administering their claims. Not infrequently, the various insureds, each with its own corporate culture and personality, simply fail to appreciate the larger world beyond the captive, where the reinsurance protection depends on the captive’s ability to comply with commercial insurance industry standards. For this reason, it is important for a reinsurer to clearly understand the captive’s claim handling function, and whether this is institutionalised at the owner-insured level. It is also important to assess the claims personnel at the captive and parent company, in order to have confidence in the accuracy and reliability of the information being received.
What to do
An effective, but underutilised, tool is the audit function. This is not the typical ‘tick-box’ claims audit. Properly used, it can be more effective than claims cooperation clauses. (It can be a mistake to assume the claim cooperation/association clause will protect the reinsurer prospectively. In practice, this is a tool used when there is a problem.) The audit function is a proactive tool that identifies and fixes issues before they develop into costly disputes. Moreover, passive reliance on the ability to avoid the claim if the captive misteps, may no longer be adequate to comply with the growing regulatory pressure to manage risk proactively.
A lead reinsurer may also have legal obligations to its following market to diligently manage the business written. Finally, there is growing sentiment that arbitration has become as costly and unpredictable as the jury trial it was meant to replace. All of this suggests the effort managing the claims relationship with captives is well spent.
Auditing a captive
Where to look
The important claims data may or may not be located in the captive claim file. In the US, IRS Revenue Ruling 2002-91 and the decision in Ocean Drilling & Exploration Co v United States, 988 F.2d 1135 (DC Circ 1993) emphasise the need for independent claim verification by the captive. It is an element the IRS considers in determining whether the captive is a legitimate insurance entity for tax purposes. Consequently, for these captives there should be some basic documentation in the captive’s files, separate from the original insured. However, captive owners frequently maintain much of their own data, and in truth the IRS hurdle is not high.
Therefore, at the outset, time needs to be spent identifying the repositories of relevant claim documentation, which may require collection from several locations in order to provide a full picture. In a typical captive structure this may involve some, or all, of the following file locations:
• The insured’s general counsel;
• The outside claim’s counsel for the captive (if any);
• The original insured’s defence counsel;
• The reinsurance broker; and
• The captive management company.
How to look
The audit function in this environment adds value by gathering important information for reinsurers and interpreting it, rather than simply comparing the captive’s claim handling to insurance industry standards. The real role of the audit function here is to:
• Document the captive’s claim functions;
• Assist the reinsurer understand how those functions affect it;
• Identify and discuss claims threatening the attachment point(s);
• Produce objective views of the reserves; and • Identify and recommend constructive improvements.
A captive audit is likely to involve interaction with in-house litigation counsel for the insured-owner of the captive. Occasionally, the function is outsourced, usually to a firm having a long history with the parent company and its captive programme.
"If the audit is approached in a spirit of transparency, and is fair, balanced and inclusive, the long-term benefit is the education it affords both captive owner and reinsurer."
One of the most valuable functions an audit serves is that of an outside review. In-house counsel is often crucial to an understanding of nuanced and pivotal aspects of complex claims. But it is difficult to see the battlefield at ten thousand feet when your job is to fight from one hedgerow to another. Yet this is precisely the overview most reinsurers need from their captive insurance cedents, and one which the audit function can provide. If one accepts the idea that it is usually less expensive to fix issues before they become disputes, the audit function can also serve as a tool to establish future claims transparency in existing captive reinsurance programmes.
Notwithstanding this, the audit is also an investigation. A common problem is the erosion of attachments by uncovered claims that went unchallenged because they were not viewed as threats to the reinsured layer. Once paid, they disappear from memory. A subsequent covered claim may not, in fact, properly attach to the reinsurance. A healthy claims reporting protocol will help minimise that risk. However, an audit is essential when this is a concern.
Because of the relationship between the original insured and its captive, an audit may be greeted with concerns over waiver of confidentiality. The attorney-client privilege and work product privilege are commonly cited by in-house counsel. These are, usually, legitimate concerns. Courts generally recognise the extension of the attorney-client privilege to reinsurers under the so-called common interest rule. The complication is that the reinsurer is essentially auditing the original insured when its contractual relationship is with the captive. Much of the reported case law rests on traditional, commercial re/insurance relationships. As such, the legal precedents may not be as clear when doing a reinsurance audit of a captive.
One approach is to negotiate a joint defence agreement. Depending on the captive structure, this agreement may be between the original insured and the reinsurer, or between the captive and reinsurer, or all three. It helps if the auditor and reinsurer can assert a separate privilege over their communications. The key, however, is to give careful advance thought to whose law will apply to any confidentiality dispute, and understand fully how the common interest extensionapplies in that jurisdiction. Then structure the audit’s scope and methodology to maximise the relevance of the claims association wording, and the chance of retaining confidentiality if challenged.
A spirit of transparency
If the audit is approached in a spirit of transparency, and is fair, balanced and inclusive, the long-term benefit is the education it affords both captive owner and reinsurer about each other’s perspectives, concerns and needs.
Used proactively, a combination of reporting protocols and audit functions can contribute significantly to finding the right balance between the captive owner’s objectives and the legitimate expectations of the reinsurer regarding the captive’s stewardship of the partnership.
Matthew Pifer is practice leader of the insurance law and claims consulting practice at Paul Frank + Collins. He can be contacted at: email@example.com