Thomas Keist, global captive solutions leader at Swiss Re Corporate Solutions, talks to Captive Review about how stop-loss protection can help captive insurers boost capacity and tackle more types of risk in a cost-effective way.
Captive Review (CR): What is cross-class stop-loss protection and when should a captive consider buying it?
Thomas Keist (TK): Cross-class stop-loss protection is worth considering if you are concerned the exposure accumulated in your captive raises issues as to whether there is enough capital to cover potential loss accumulation coming from all lines.
Usually, the consideration for reinsurance is on a per-loss basis, how much do you keep in the captive, and when do you start to buy reinsurance. For stop-loss protection, you look instead at the capital in the captive.
If the captive retains a €10m loss, how many instances can the captive withstand with the existing level of capital? Stop-loss reinsurance is a capital protection solution and cross-class protection allows you to get coverage for multiple business lines over multiple years.
CR: What are the advantages of using stop-loss reinsurance?
TK: It is a relatively simple and flexible capital surrogate. It could also prove to be cheaper than capitalising the captive insurer from the corporate’s point of view and depends on availability and opportunity cost.
It also offers captives the ability to assume risks that are difficult to insure such as cyber risk, for example. Currently, the insurance industry does not have the right products or capacity for cyber, meaning corporates must consider alternative options. If a captive starts to assume new risks, it will need more capital, so it will have to consider capitalising or buying stop loss.
Commercial insurance premiums are increasing and the market is likely to remain hard for the foreseeable future. This could mean captives being asked to retain more risk – for example, a €20m loss rather than €10m – to reduce premiums paid to the commercial insurance market.
To enable this, the corporate could put in more capital, but stop-loss reinsurance can be a useful capital surrogate.
CR: How can a captive insurer best prepare itself for stop-loss protection?
TK: As an internal business unit, a captive is perfectly placed to access all the data needed for reinsurance purposes. Captives should make sure they use that advantage and have data in as detailed, deep and accurate condition as possible.
Secondly, make sure you understand where the risks to your capital come from. If you write multiple lines of business, is there a meaningful level of risk coming from business line 10, for example? Or are the capital risks predominantly coming from lines one, two and three? Do your actuarial and mathematical analysis to be sure of where the risk – that is, the volatility of results around the expected – is coming from.
CR: How do you decide which lines of business to include?
TK: If you have 10 lines of business, for example, it is likely that the bulk of the risk will come from perhaps two or three of these, and the rest are minor contributors. Focus on these signifi cant lines, as this will be more cost efficient.
If you buy stop-loss protection for all 10 lines, the reinsurer will charge for capacity for all 10, even though some don’t really contribute significantly to the overall level of risk in the captive. In addition, the premium you get will likely be out of proportion as it will be skewed by the minor risks.
By reducing the business lines included in the stop loss, you give yourself a better chance of getting quotes as there is less data to process, and you will have a higher likelihood of getting cover for many years in a sustainable way and at a fair price.
CR: What are the other key considerations when buying stop-loss reinsurance?
TK: You also want to understand the ‘event probability’ that will trigger a problem with your capital. Put simply, do you want protection from a one-in-10-years event onwards, so the 90th percentile, or onein-20-years, the 95th percentile? In other words, when does a loss level start to eat into your capital in a meaningful way and with what probability?
The rule of thumb is to begin from the 90th percentile as an attachment point for the stop loss. We see a lot of enquiries from captives that want to buy cross-class stop loss beginning around the 70th percentile. That is within a standard deviation, so you will pay a high premium for that – it’s not efficient. Your existing capital should be enough to cover that probability of loss.
A similar consideration is where the protection ends. Is it at the one-in-100-years event – the 99th percentile – or the one-in-200-years event? Think about the attachment point and the limit that you need.