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A New Safe Harbor Is Empowering Captive Owners To Go It Alone

The emerging, independent captive changes the equation for risk distribution.
By: | March 28, 2018 • 6 min read

Risk distribution is a fundamental tenet of insurance.

Underwriting a large number of statistically-independent risks allows insurers to diversify losses and distribute risk across a pool of insureds, minimizing the damaging impact of a large loss from any one policyholder.

“If I insure five buildings, I have way too much volatility; I lose everything if all five burn to the ground. But if I insure 1,000, I decrease that volatility significantly,” said Rob Walling, FCAS, MAAA, CERA, Principal and Consulting Actuary, Pinnacle Actuarial Resources, Inc. “Spreading out the risk is central to successful insurance operations.”

But captives change the equation.

The relationship between insurer and insured as one and the same can make it more difficult for captive owners to effectively distribute risk within their own organizations. In order to successfully mitigate risk and satisfy insurance risk distribution requirements, captive owners have leveraged two primary safe harbors to achieve the level of required risk distribution.

One is the group captive — pooling the risks and resources of multiple insureds under one structure. Combining the exposures of 10 to 15 different companies ensures the loss potential is adequately dispersed.

Reinsurance facilities represent another safe harbor. These involve using reinsurance to pool risks from unrelated third parties. For companies which lack the resources and diversification to be single-parent captive owners, these two structures offer ways to enjoy the flexibility and control of being self-insured by substantially reducing the captive’s risk volatility.

But now a third safe harbor is emerging — one that enables companies with enough statistically-independent risk units to form fully-owned, independent captives without reinsuring unrelated third-party risks based on internal risk distribution. By going solo, more single-parent captives no longer have to assume third-party risk and the uncertainty that comes with it. An independent structure can also be more streamlined and allow for more control.

Setting the Precedent for Risk Units

Rob Walling, FCAS, MAAA, CERA
Principal and Consulting Actuary

To shed group captives or reinsurance pools, companies can demonstrate risk diversification and reduced loss volatility by breaking down their exposures into definable, statistically-independent risk units. The U.S. Tax Court has long been pushing the captive insurance industry to embrace risk units as a way of measuring risk distribution.

Some recent cases show that the industry is finally embracing the idea that a risk unit approach is an effective way for companies to achieve enough internal distribution to form single-parent captives.

In a 2014 decision around Rent-A-Center, Inc. (RAC) and Affiliated Subsidiaries v. Commissioner, the Tax Court determined that the number of insured parties was less important than the number of discrete risk units covered by a captive.

The Court found that “RAC’s subsidiaries owned between 2,623 and 3,081 stores; had between 14,300 and 19,740 employees; and operated between 7,143 and 8,027 insured vehicles. RAC’s subsidiaries operated stores in all 50 states, the District of Columbia, Puerto Rico and Canada. RAC’s subsidiaries had a sufficient number of statistically-independent risks.”

“In several captive insurance decisions since 1991, tax courts have said: Stop worrying about corporate structure and retention of unrelated risk. Pay more attention to internal unrelated risk units,” Walling said. “It came to a crescendo in the Rent-A-Center case, where the argument was stated most directly and most loudly.”

“We are seeing more and more medium to large businesses pursue captive formations without reinsurance facilities. Reinsurance pooling structures are facing increased scrutiny, and satisfying risk distribution internally can be a viable alternative,” Walling said.

Measuring Risk Distribution

There is currently no clear-cut way for companies to determine how many independent risk units will satisfy risk distribution and reduce volatility sufficiently to justify a single-parent structure.

“No test exists that says 50 trucks is enough, but 25 isn’t. Five thousand customers are enough, but 2,000 are not,” Walling said. “This is becoming a real challenge.”

Pinnacle developed a methodology called Expected Adverse Deviation (EAD) to determine how much of the volatility associated with any individual risk unit is diversified away by the insurance program overall. EAD refers to the average amount of loss that an insurance company incurs when losses are greater than expected.

“EAD is computed using a stochastic simulation model based on the anticipated claim frequencies and severities for the captive,” Walling said.

The ratio of expected adverse loss to expected loss indicates how much volatility or “down-side” risk an insurance program is taking on. The higher the EAD ratio, the greater the loss volatility. Conversely, the lower the EAD ratio, the more risk distribution.

“The idea is to focus on the units of risk that matter for each line of coverage,” Walling said. “If we’re dealing with workers’ compensation, then we focus on payroll or number of employees. For commercial auto coverage, it’s the number of vehicles. For a hospital’s professional liability, it may be number of beds and/or doctors.”

Companies can then use their EAD ratio to determine how many of those risk units their captive needs to reduce volatility to a level at which forming a single-parent captive would be prudent and acceptable. It provides an actuarial standard to assess whether there is sufficient internal risk distribution.

Pinnacle’s actuarial team has also computed the EAD results of existing group captives or reinsurance facilities to evaluate the results of EAD in relation to existing risk distribution safe harbors.

“The goal of the EAD model is to recognize that each insurance coverage has its own exposure and measure how that mitigates risk in a captive insurance company,” Walling said.

Leaders in Captive Risk

Pinnacle’s new methodology grew out of its work in captive funding studies, which it has performed for decades. The company focuses exclusively on property/casualty risks, and is among the largest independent P/C actuarial firms in the U.S.

Two-thirds of its client base are captives and other alternative structures like risk retention groups and self-insurance pools. It’s also heavily involved in captive regulatory work and works frequently with state insurance departments.

The Expected Adverse Deviation model demonstrates Pinnacle’s key areas of expertise: the actuarial science of measuring risk, the U.S. tax code, and the regulatory parameters set around captive solutions.

That expertise is also demonstrated through its actuarial consultants’ dedication to educating and advocating for the captive industry. With more than 30 consultants and credentialed actuaries participating in more than 50 industry events each year, Pinnacle’s team takes pride in providing thought leadership and fueling innovative solutions.

“We have a group of very talented actuaries writing thoughtful articles, speaking from prominent podiums and serving amazing clients,” Walling said. “We take the idea of supporting our industry quite seriously.”

To learn more about Pinnacle Actuarial Resources, visit https://www.pinnacleactuaries.com/.

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This article was produced by the R&I Brand Studio, a unit of the advertising department of Risk & Insurance, in collaboration with Pinnacle Actuarial Resources, Inc. The editorial staff of Risk & Insurance had no role in its preparation.




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Cyber Resilience

No, Seriously. You Need a Comprehensive Cyber Incident Response Plan Before It’s Too Late.

Awareness of cyber risk is increasing, but some companies may be neglecting to prepare adequate response plans that could save them millions. 
By: | June 1, 2018 • 7 min read

To minimize the financial and reputational damage from a cyber attack, it is absolutely critical that businesses have a cyber incident response plan.

“Sadly, not all yet do,” said David Legassick, head of life sciences, tech and cyber, CNA Hardy.

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In the event of a breach, a company must be able to quickly identify and contain the problem, assess the level of impact, communicate internally and externally, recover where possible any lost data or functionality needed to resume business operations and act quickly to manage potential reputational risk.

This can only be achieved with help from the right external experts and the design and practice of a well-honed internal response.

The first step a company must take, said Legassick, is to understand its cyber exposures through asset identification, classification, risk assessment and protection measures, both technological and human.

According to Raf Sanchez, international breach response manager, Beazley, cyber-response plans should be flexible and applicable to a wide range of incidents, “not just a list of consecutive steps.”

They also should bring together key stakeholders and specify end goals.

Jason J. Hogg, CEO, Aon Cyber Solutions

With bad actors becoming increasingly sophisticated and often acting in groups, attack vectors can hit companies from multiple angles simultaneously, meaning a holistic approach is essential, agreed Jason J. Hogg, CEO, Aon Cyber Solutions.

“Collaboration is key — you have to take silos down and work in a cross-functional manner.”

This means assembling a response team including individuals from IT, legal, operations, risk management, HR, finance and the board — each of whom must be well drilled in their responsibilities in the event of a breach.

“You can’t pick your players on the day of the game,” said Hogg. “Response times are critical, so speed and timing are of the essence. You should also have a very clear communication plan to keep the CEO and board of directors informed of recommended courses of action and timing expectations.”

People on the incident response team must have sufficient technical skills and access to critical third parties to be able to make decisions and move to contain incidents fast. Knowledge of the company’s data and network topology is also key, said Legassick.

“Perhaps most important of all,” he added, “is to capture in detail how, when, where and why an incident occurred so there is a feedback loop that ensures each threat makes the cyber defense stronger.”

Cyber insurance can play a key role by providing a range of experts such as forensic analysts to help manage a cyber breach quickly and effectively (as well as PR and legal help). However, the learning process should begin before a breach occurs.

Practice Makes Perfect

“Any incident response plan is only as strong as the practice that goes into it,” explained Mike Peters, vice president, IT, RIMS — who also conducts stress testing through his firm Sentinel Cyber Defense Advisors.

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Unless companies have an ethical hacker or certified information security officer on board who can conduct sophisticated simulated attacks, Peters recommended they hire third-party experts to test their networks for weaknesses, remediate these issues and retest again for vulnerabilities that haven’t been patched or have newly appeared.

“You need to plan for every type of threat that’s out there,” he added.

Hogg agreed that bringing third parties in to conduct tests brings “fresh thinking, best practice and cross-pollination of learnings from testing plans across a multitude of industries and enterprises.”

“Collaboration is key — you have to take silos down and work in a cross-functional manner.” — Jason J. Hogg, CEO, Aon Cyber Solutions

Legassick added that companies should test their plans at least annually, updating procedures whenever there is a significant change in business activity, technology or location.

“As companies expand, cyber security is not always front of mind, but new operations and territories all expose a company to new risks.”

For smaller companies that might not have the resources or the expertise to develop an internal cyber response plan from whole cloth, some carriers offer their own cyber risk resources online.

Evan Fenaroli, an underwriting product manager with the Philadelphia Insurance Companies (PHLY), said his company hosts an eRiskHub, which gives PHLY clients a place to start looking for cyber event response answers.

That includes access to a pool of attorneys who can guide company executives in creating a plan.

“It’s something at the highest level that needs to be a priority,” Fenaroli said. For those just getting started, Fenaroli provided a checklist for consideration:

  • Purchase cyber insurance, read the policy and understand its notice requirements.
  • Work with an attorney to develop a cyber event response plan that you can customize to your business.
  • Identify stakeholders within the company who will own the plan and its execution.
  • Find outside forensics experts that the company can call in an emergency.
  • Identify a public relations expert who can be called in the case of an event that could be leaked to the press or otherwise become newsworthy.

“When all of these things fall into place, the outcome is far better in that there isn’t a panic,” said Fenaroli, who, like others, recommends the plan be tested at least annually.

Cyber’s Physical Threat

With the digital and physical worlds converging due to the rise of the Internet of Things, Hogg reminded companies: “You can’t just test in the virtual world — testing physical end-point security is critical too.”

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How that testing is communicated to underwriters should also be a key focus, said Rich DePiero, head of cyber, North America, Swiss Re Corporate Solutions.

Don’t just report on what went well; it’s far more believable for an underwriter to hear what didn’t go well, he said.

“If I hear a client say it is perfect and then I look at some of the results of the responses to breaches last year, there is a disconnect. Help us understand what you learned and what you worked out. You want things to fail during these incident response tests, because that is how we learn,” he explained.

“Bringing in these outside firms, detailing what they learned and defining roles and responsibilities in the event of an incident is really the best practice, and we are seeing more and more companies do that.”

Support from the Board

Good cyber protection is built around a combination of process, technology, learning and people. While not every cyber incident needs to be reported to the boardroom, senior management has a key role in creating a culture of planning and risk awareness.

David Legassick, head of life sciences, tech and cyber, CNA Hardy

“Cyber is a boardroom risk. If it is not taken seriously at boardroom level, you are more than likely to suffer a network breach,” Legassick said.

However, getting board buy-in or buy-in from the C-suite is not always easy.

“C-suite executives often put off testing crisis plans as they get in the way of the day job. The irony here is obvious given how disruptive an incident can be,” said Sanchez.

“The C-suite must demonstrate its support for incident response planning and that it expects staff at all levels of the organization to play their part in recovering from serious incidents.”

“What these people need from the board is support,” said Jill Salmon, New York-based vice president, head of cyber/tech/MPL, Berkshire Hathaway Specialty Insurance.

“I don’t know that the information security folks are looking for direction from the board as much as they are looking for support from a resources standpoint and a visibility standpoint.

“They’ve got to be aware of what they need and they need to have the money to be able to build it up to that level,” she said.

Without that support, according to Legassick, failure to empower and encourage the IT team to manage cyber threats holistically through integration with the rest of the organization, particularly risk managers, becomes a common mistake.

He also warned that “blame culture” can prevent staff from escalating problems to management in a timely manner.

Collaboration and Communication

Given that cyber incident response truly is a team effort, it is therefore essential that a culture of collaboration, preparation and practice is embedded from the top down.

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One of the biggest tripping points for companies — and an area that has done the most damage from a reputational perspective — is in how quickly and effectively the company communicates to the public in the aftermath of a cyber event.

Salmon said of all the cyber incident response plans she has seen, the companies that have impressed her most are those that have written mock press releases and rehearsed how they are going to respond to the media in the aftermath of an event.

“We have seen so many companies trip up in that regard,” she said. “There have been examples of companies taking too long and then not explaining why it took them so long. It’s like any other crisis — the way that you are communicating it to the public is really important.” &

Antony Ireland is a London-based financial journalist. He can be reached at [email protected] Dan Reynolds is editor-in-chief of Risk & Insurance. He can be reached at [email protected]