Insurance exists to make accidents affordable. Without insurance, any doomsday scenario could destroy a business.

So, it’s not surprising that the first concern when considering a captive is often:

“What happens if there is a loss that the captive can’t afford?”

The answer is Reinsurance.

What Is Reinsurance?

Simply put, reinsurance is insurance for your insurance. Yes, you read that right. Even the safety net needs its own safety net.

Whether you operate a captive or pay a premium for traditional insurance, reinsurance is likely part of the equation.

With traditional insurance, the process takes place behind the scenes. The insurance company takes a portion of your premium and sends it to a reinsurer to offload the commensurate amount of risk. In fact, insurers often split up the risk across several reinsurance providers, each one responsible for any loss in excess of the lower limits written by other reinsurers. This system significantly increases the amount of coverage a primary insurer can provide, also known as capacity, while ensuring that even the biggest losses are recoverable.

Reinsurance & Captives

In a captive, the only difference when it comes to reinsurance is that you have to find a dance partner on your own, and negotiate with them directly. The process is complex, and depending on the circumstances, it can be challenging to find favorable terms. A lot depends on the type and amount of coverage you need, your risk history, and the rate you're willing to pay.

The good news is that Captive Managers can effectively offload the burden. A strong captive manager has established relationships with many reinsurance providers, knows how to shop the market, and has the experience to close the deal.

For more insights on captive management, check out Our Services.

Types of Reinsurance

There are typically three types of reinsurance coverage for captives.

1) Excess of Loss (Xs or XoL): The policy pays for the portion of any given loss that exceed a specified amount, called the Attachment Point (AP).

• Example: Consider a policy with an Attachment Point of $400K and a limit of $2M. The captive covers the first $400K of any single loss, and the reinsurance policy covers the rest, up to $2M. Anything beyond $2M would fall back to the captive.

• XoL coverage is often paired with Aggregate Reinsurance (see below) to protect a captive against a series of smaller losses that may fall below the XoL attachment point individually, yet still represent a significant cumulative loss.

2) Aggregate (Agg) Reinsurance: Provides coverage after the aggregate total of all losses exceeds a predetermined threshold, at which point all subsequent losses are covered by the policy. Aggregate reinsurance does not often apply to the very first loss on a policy, even if the amount of that loss exceeds the Aggregate Attachment Point. Once there have been multiple claims, the Agg policy is in effect.

• Example: The illustration below considers an XoL + Agg policy, with an XoL Attachment Point of $400K and an Aggregate Attachment Point of $600K.
  • If the business experienced 3 losses of $200K, the total loss is $600K. But, no single claim exceeded the $400K XoL AP, so XoL responsibility is $0.
  • However, the 3 claims have now satisfied the Aggregate AP ($600K). Any future claim is now covered by the Aggregate policy, even if XoL policy is not triggered.

• Sticking with the same scenario, let’s add a $1M loss. Since the Aggregate Attachment point is met, it pays the first $400K until the XoL kicks in to cover the remaining $600K.
• The captive's total loss is limited to $600K, despite $1.6M in actual losses.

3) Quota Share: The captive & reinsurer share risk in some proportion. E.g., A 25% / 75% Quota Share would have the Captive retain 25% of any given loss and the Reinsurer retaining the inverse at 75%.

Captives & Deductibles

Although owned by the parent company (the Insured), a captive still operates like an insurance company. That is, the Insured must write a policy and pay the captive an appropriate premium to support it. The captive then reimburses the business for claimed losses. Any surplus at the end of the policy term is considered profit for the captive and, by extension, profit for the business that owns it.

But, the policy used by a captive can still incorporate a Deductible. A deductible is the specified amount of money that the Insured must pay before the captive will pay a claim. Once the deductible is reached the Captive covers the remaining cost of the loss, until it exceeds the Attachment Point of any reinsurance policy.

For the purposes of this article and any of the included example scenarios, we will assume that there is no such deductible to consider.

Reinsurance Policy Limits

So, what happens when a loss exceeds even the reinsurance policy limits? 

When you create your captive, the team of actuaries responsible for crunching the numbers to determine your total risk exposure have exactly this type of concern in mind. They take great care to game plan even the most unlikely loss scenarios to recommend the amount needed to start your captive, the ideal reinsurance attachment points, and the coverage limits you need.

Assuming sound actuarial work and captive manager oversight, a single loss exceeding your policy limit should be extremely unlikely (otherwise the policy limits would have been set higher). 

Keep in mind that traditional insurance often operates under the exact same guidelines. Most catastrophic scenarios that would threaten your captive would similarly test the limits of your traditional insurance policy as well. To boot, insurers deny claims for any number of reason, not the least of which includes loss amount. A captive policy will be far more tailored to your specific risk experience. As a result, you gain predictability, control, and efficiency within the claims management process.

Reinsurance Premiums

Setting your attachment point is one of several ways to control reinsurance premiums and optimize your captive’s financial performance over time.

For example, based on your loss history and/or risk exposure, your business might decide it needs a bigger safety net. This means lowering your attachment point and increasing your reinsurance spend on premium to reduce your share of the risk.

Conversely, if your business has been historically good at mitigating risks, or perhaps once your captive has banked a healthy surplus, your business could choose to raise the attachment point to lower your reinsurance premium, or eliminate your need for reinsurance at all.

Understanding Reinsurance Using Example Scenarios 

Loss frequency and loss severity can impact a captive differently depending on the reinsurance policies involved. The scenarios below illustrate this relationship, and operate under the policy assumptions in the following table: 

Captive Reinsurance Scenario 1

A single loss of $300,000 with XoL and Agg policies.

Captive Reinsurance Scenario 2

A single loss of $300,000 with XoL and Quota Share policies.

Captive Reinsurance Scenario 3

A single loss of $199,999 with XoL and Agg policies.

Captive Reinsurance Scenario 4

A series of 5 losses of $80,000 each with XoL and Agg policies.

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Captive Reinsurance Scenario 5

A series of 10 losses of $80,000 each with XoL and Agg policies.

Captive Reinsurance Scenario 6

A single loss of $3,000,000 with XoL and Agg policies.

Note: Although the claim is larger than the $400K Aggregate Attachment point, the Aggregate policy is not triggered because there has been only one claim.

Captive Reinsurance Scenario 7

Two losses: $3M, then $3.5M with XoL and Agg policies.

Reinsurance provides a safe framework to manage risks in a captive. By understanding the intricacies of reinsurance, companies can form a safety net to support their financial stability, even in the face of significant losses and unforeseen circumstances. The protection available through Excess of Loss, Aggregate, and Quota Share coverage provide a customizable shield to balance insurance needs with financial prudence.

Through meticulous planning, negotiation, and the expertise of captive managers, reinsurance can empower businesses to navigate their growth journeys with confidence and resilience. For more information on XN Services related to Reinsurance, visit our Services page.

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