Why Risk Pooling Is Still Critical for Captives
Since its inception in 1997, Marsh’s Green Island Reinsurance Treaty (Green Island) has become the largest, most diversified pooling facility of its kind and we can offer insight into lessons learned in risk pooling over the last two decades.
Risk Pooling is when a company exchanges a portion of its own risk for a percentage of the combined losses of all pool members. It is an important, if not critical, practice for many captives.
Types of Risk Pooling Facilities
Pooling arrangements can include different lines of coverage and generally fall within two broad risk categories:
- More predictable long-tail lines such as workers’ compensation, general/product liability, or auto liability (high-frequency/low severity risks).
- Less predictable high-severity/low-frequency risks such as earthquake, wind storm, excess liability, and other property lines.
Pooling arrangements with high-frequency, low-severity risks should have more stable results than facilities offering low-frequency catastrophic lines. The diversification depends on the number of members, the amount of premium, the nature of the exposures insured, and the volume of claims. In general, as the number of members and the diversity of insured exposures increases, so does the pooling effect. The more diversification, the more stable the pooled losses should be.
Why Do Captives Participate in Risk Pools?
By sharing its individual loss experience with other pool members, a captive participating in a risk pool can experience some or all of the following benefits:
- Diversification of its underwriting portfolio.
- Reduction in the variability of retained captive losses by trading its own losses for a smaller portion of a large pool of more diversified losses.
- Stabilization of cash flow.
- Access to third-party premium in support of the captive’s status as an insurance company for tax purposes (allowing the captive to deduct premium and accelerate the deduction of losses).
Most Common Concerns With Risk Pooling
One drawback of risk pooling is that members have no control over the underlying loss control and claims management of other pool members from whom they are assuming losses. When joining a pool, each member should be comfortable that all counterparties’ profiles including their loss histories, loss controls, and safety and claims management processes have been vetted to ensure the mitigation of underwriting risk. Carefully crafted contractual terms should clarify member expectations and responsibilities and mitigate counterparty credit risk.
The Green Island arrangement favorably addresses potential situational issues through clear contractual guidelines and active individual participation from its member captives. A key component of Green Island is that new members must receive approval from current participants to join. As such, participants know quite a bit about each other’s risk and safety management and loss processes and are confident in how member organizations’ risks are being managed.
Recent Trends in Risk Pooling
The use of risk pools has remained steady over the years, but there have been some changes in the risk pooling world, particularly around whether certain captive pools provide their captive members with sufficient risk shifting and risk distribution to support insurance company treatment:
- Given their potential for tax deduction advantages, pooling arrangements are attracting the attention of the Internal Revenue Service (IRS). The success of some larger captive pools, along with the increasing number of captives forming to take advantage of the Section 831(b) election under the Internal Revenue Code has led to rapid growth in the establishment of small captive pooling facilities.
- The IRS recently increased its focus on pooling facilities with captives electing to be taxed under Section 831(b). Of most concern to the IRS is whether the pooling arrangement actually provides members with sufficient risk shifting and distribution and whether lines insured in the facility represent true insurance risks.
- For purposes of establishing a captive as an insurance company for tax purposes, IRS Revenue Ruling 2002-89 outlines a safe-harbor for captives writing at least 50% third-party risk (providing that other key factors in the ruling are met). It is critical for captives to seek tax advice to support their own risk shifting and distribution position. Despite greater IRS scrutiny, continued growth is expected in well-structured pooling arrangements for captives of all sizes given the inherent benefits of third-party premium, risk diversification, and underwriting stabilization.
What Makes a Pooling Arrangement Successful?
The following elements have contributed to Green Island's success:
- A proven, long-term track record.
- A facility large enough to provide sufficient level of risk diversification and unrelated premium.
- A structure that supports stable underwriting results.
- A structure that mitigates credit risk.
- Clear governance based on contractual guidelines and transparency with active member participation.
- Clearly established exit provisions.
Pooling is one of the tools a captive can use, potentially in conjunction with others, to build a more stable underwriting portfolio to optimize overall captive effectiveness.