Risk Pooling - It´s Not Just a Tax Thing!

Pooling is a common practice for captives owned by SMEs. Many participants know that this helps with tax compliance but few will know all of the benefits of a pooled program.

At the heart of insurance is the law of large numbers that provides the insurer with a more predictable underwriting result. The bigger the pool of risks being insured the more stable the underwriting result is likely to be. Captives don’t necessarily have the law of large numbers on their side so they may decide to insure other risks from a risk pool with which to diversify their portfolio.

Participation in a risk pool involves the swapping of own risk for an proportion of the mix of all pool participants risk. Group captive structures do this with the “A” and “B” fund structure and for pure captives there are structures that combine the risks of the many and reinsure a cession back to the captive on a quota share basis.

The nature of the pooling structure for a pure captive is generally a function of the type of risk accepted, different program structures are likely for high frequency low severity risks as compared to low frequency high severity risk.

For a high frequency, low severity program such as insuring a deductible for workers compensation the loss results are likely to be actuarially predictable most years. The risks are more suitable for quota share cessions with little own risk being retained as a cushion to the pool.

For low frequency, high severity risks such as certain property and business interruption risks, especially those designed around an ERM platform it may be more likely to have a staggered approach to the risk cession that leaves more own risk with the captive.

The actual structure will depend on many other factors as well such as pool participant numbers, premium and claim volume.

The reasons to pool risk are far more than simply to meet IRS expectations. By sharing its individual loss experience with other pool members, a captive participating in a risk pool can benefit some or all of the following benefits:

• Diversification of its underwriting portfolio.

• Reduced volatility of underwriting result.

• Stabilization of cash flow.

• Access to third-party risk 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).

Many participants have concerns heading into a pooling structure. The lack of control of matters goes against what many anticipate of a captive structure. In such cases it is essential that the prospective member consider such things as: -

• General operations – as with captives, the pool must operate as an insurance company, risks covered must be insurable and policy documentation must reflect the risk being underwritten. Pool pricing and any reinsurance cession must be reasonable and be actuarially supported.

• Historic performance – stable underwriting performance is preferred.

• Distribution of risk - understand how many participants, what proportion of risk is being accepted etc.

• Corporate governance –The pool should be run independently of the participants. No participant should have undue influence on any matter. All parties must fully understand their obligations, the transactions and be treated fairly and equally, this is usually done by means of a pooling agreement.

• Exit strategy – circumstances change and the participant needs to understand how to leave the structure and what penalties, if any, may apply.

• Collateral – The pool will require collateral to ensure that losses can be paid quickly and without issue. Without collateral a pool may have insufficient funds to pay claims. If a pool does not require collateral then you may be more exposed than you think.

• Stable underwriting – an even-handed approach to all risks for all participants is a necessity. Make sure that underwriting philosophy does not change wildly from year to year or even quarter to quarter. Check pricing to alternative benchmarks such a commercial insurers quotation.

• Documentation – make sure that the operation of the pool is clearly explained in writing. Make sure there is regular performance reporting.

• Claims will occur - remember that a pool participant is contractually obligated to pay claims within the pool. Claims will arise and the captive can lose money. If that is no clearly explained do not participate in the pool! If you are told not to expect any claims DO NOT PARTICIPATE!

A well-run pool can be a valuable tool to a captive and not just something to consider for tax compliance. However, a poorly managed pool can have significant repercussions to a captive and its sponsor. Make sure you fully understand the pooling structure before you decide to participate.

Albion has been involved with the design of several pool structures including commercial lines, cat risk, healthcare, high deductible and others. Albion currently provides independent risk analysis, underwriting and guidance for corporate governance for many pooling structures

If you would like advice on participation or would like assistance with the management, underwriting or establishment of a pool contact us.

Greg Taylor

Albion Risk Consulting S.A.

*Albion Risk Consulting is not a tax adviser and does not provide tax advice. Before entering into a captive structure it is suggested that advice be sought from a tax professional.