Part1: Retaining limited underwriting risk could offer MGAs a way to bolster revenue
Editor’s Note: The following is part one of a discussion of the risk retention options available to MGAs, the sundry variables which may affect their execution, and the means and modes of analysis available.
The second part of this article will appear in the June 2 issue of Insurance Journal.
With the specter of a soft market looming over the industry, insurance producers everywhere are looking for ways to supplement revenue lost to decreased pricing. Short of compromising underwriting integrity and under-pricing the market, and thus potentially tarnishing loss results and relationships, managing general underwriters and managing general agents (MGAs) customarily have limited recourse in a market downturn and the resultant effect on their bottom line.
However, retaining limited amounts of underwriting risk — as opposed to relinquishing the entirety of profitable business to carriers — may provide MGAs with just the revenue bolstering solution they need.
Traditionally, the relationship between MGAs and risk is a tenuous one. In most situations, risk is confined to the realm of basic business operations, production volume and volume-fixed commissions, whereas insurance risk is generally avoided altogether.
But in the current soft and still-softening insurance marketplace, players are increasingly seeking alternative revenue sources and solutions to satisfy stakeholders and excess capital is being deployed in a variety of creative and non-traditional ways. Depending on the quantity, quality and characteristics of a particular agency’s insurance program business, taking on insurance risk may provide an excellent solution to slackening premiums and resultant diminishing revenue.
MGAs can achieve risk retention in a variety of ways, though several factors need to be considered when determining the form and feasibility of taking this route. Due to the unique and complex nature of the risk business, a thorough analysis of each individual opportunity must be conducted in order to ensure selection of an appropriate method. Ultimately some methods may be better than others, and some may be simply untenable.
Alternative commission structures
The most straightforward method of administering agency risk sharing is through the implementation of a performance based commission structure. Sliding scale commissions are somewhat commonplace and can be structured variously. However, by nature they are linked inversely to the loss ratio of a particular exposure being written.
With a sliding scale agreement, if the quality of subject business written is high, and the resultant loss ratio at the end of a specified period is low, an MGA would conceivably receive a higher commission (subject to a specified maximum) than on a flat commission basis. Conversely, if the experience for a line of business subject to a sliding scale is poor, an MGA would conceivably receive a lower commission (subject to a specified minimum) than on a flat commission basis. Some carriers will require an MGA to collateralize the potential commission downside in order to ensure adequate reimbursement for any excess provisional commission paid to an MGA is returned to the insurer in the event of adverse experience.
Profit-sharing commissions can also be negotiated. Such commissions serve fundamentally the same purpose as sliding scale commissions — they benefit an MGA for producing profitable business — though are structured differently and offer the production company a unilateral benefit. Profit-sharing commissions arrange for producers to receive a specified percentage of total profits in addition to a flat commission. Profits are generally calculated by deducting associated commissions, expenses (usually including a minimum profit percentage stipulated by the carrier) and losses from the total program premiums written or earned. Profit-sharing commissions can prove more difficult to negotiate with a carrier since the potential downside for a producer is minimal.
The effects of alternative commission structures are manifold though they differ significantly by business type. Performance based commissions are much more easily administered on short-tail rather than long-tail business since ultimate loss ratios can be ascertained and commission calculations completed within a much shorter timeframe. Due to the nature of long-tail business, payment schedules on such commissions can extend years into the future and an MGA may not realize the actual dollar benefit of a performance based arrangement until well after the business has been produced. Long-tail business often also comes with the burden of actuarial uncertainty which can add significant difficulty to ultimate commission settlement negotiations.
There are several barriers to entering the risk business. Establishing a captive insurance company for risk-sharing purposes can pose certain distinct difficulties for an MGA. Foremost among these difficulties is gaining access to sufficient capital. Financing a risk-bearing entity can prove prohibitive from both an operational and a regulatory standpoint.
Expertise, or lack thereof, is perhaps the second most common concern. Managing an insurance company is not now — and never has been — a task for greenhorns.
Daunting as these primary obstructions may seem, they are wholly surmountable and, with motivation, some concerted study and access to the appropriate resources, captive creation can be markedly facilitated.
MGAs willing to share underwriting risk in any manner will attract more lenient carriers and will secure for themselves an added degree of operational autonomy and control.
Such risk-tolerant MGAs will also be able to distinguish themselves more readily from their risk-averse peers and share in the underwriting profits of lucrative lines of business.
However, MGAs with sister captive insurance companies in particular acquire the ability to share different types of risk in a multitude of ways, to offer and obtain reinsurance, and to expand creatively their corporations’ earnings profiles.
Appetite for Risk
Once risk-sharing via captive formation has been identified as a worthwhile pursuit, the first task incumbent upon an MGA is to determine the organization’s tolerance of, or appetite for, risk. Some of the common parameters used to gauge risk tolerance include an MGA’s allocable surplus, the availability of external capital, cost of capital requirements, the various characteristics of the book of business being shared, the results of associated risk analyses and the availability of reinsurance protection.
MGAs interested in captive formation must also determine whether to establish a pure agency captive or whether an agency captive cell, or rent-a-captive, will suffice. The main differences between these two overarching types of captive entities include the degree of control they grant and their associated costs.
Pure captives are owned outright by their parent entities and can be used to insure a parent company’s risks in a variety of different ways. While they offer their owners operational autonomy and explicit control over their application, they are more expensive to administer than rent-a-captives due to a variety of fixed initial and ongoing administrative costs. Use of pure captives can often prove prohibitive for smaller programs.
Regardless of their form, agency captives, like any other business venture, require an initial infusion of capital. Funding can come from a variety of sources though the type, quantity and origin of capital used will integrally affect a captive’s operations. Most MGAs will want to fund a captive insurance company with their own surplus funds if possible.
If an MGA is unable to fulfill a captive’s initial capital requirement, external sources of funding may be sought.
Once the level of risk tolerance has been determined and adequately capitalized, the manner of risk-sharing must be agreed upon. This depends primarily upon the selected issuing carrier’s willingness and ability to share risk, but ordinarily takes the form of a pro rata reinsurance agreement. In such a typical situation, a carrier will first agree to issue policies for an MGA’s program. The subject business will then be written directly on the carrier’s paper and proportionately reinsured by the agent’s captive. Such quota share arrangements will usually allow for the proportional sharing of premiums, losses, commissions and expenses associated with subject business.
Other methods of risk sharing are available, though most are not suitable for new captives. Some carriers, for example, will act as pure fronts, meaning they will transfer 100 percent of fronted risk to a captive for a fee. Due to the costs associated with captive management and fronting, this is often not a viable risk-sharing option for nascent captive organizations that have limited resources and program volume to support the wholesale assumption of risk.
It is also possible for business to be written directly onto a new captive’s paper. However, a new captive, regardless of the strength of its balance sheet, will likely be unable to obtain a rating from an independent rating company or a license to operate as an admitted carrier from a state. Thus, the feasibility of this approach depends primarily upon how prospective and existing insureds will regard the security of their insurer and whether they will accept unauthorized insurance coverage.
With the manner of risk assumption decided upon, to ensure a captive’s total liability is capped adequately, captive owners will want to obtain some form of reinsurance protection in order to avoid volatility — either an unanticipated frequency or severity of losses. The use and availability of reinsurance varies significantly depending upon the nature and manifold qualities of subject business, though protection can feasibly be obtained in a variety of ways.
Reinsurance is perhaps most commonly obtained by an MGA captive via the carrier fronting the subject business. Most carriers maintain some form of reinsurance coverage and cede any program business written to their in-force agreements. In a risk-sharing situation a carrier may chose to extend its reinsurance coverage to an MGA’s captive for an equitable share of the reinsurance premium costs. Calculating this cost can be complicated depending on the type and scope of reinsurance maintained by the carrier and any quotes for such coverage received should be thoroughly reviewed.
If this method is somehow not feasible, specific reinsurance can be marketed on a book of program business and the ensuing reinsurance costs can be split proportionately amongst the risk-sharing partners. Alternatively, an MGA captive engaged in risk-sharing can purchase specific reinsurance on its portion of risk assumed. However, since the volume of risk assumed by a new captive will likely be less than total program risk, purchasing reinsurance in this manner is often less cost-effective because of simple volume constraints and fixed reinsurer expenses.
Perhaps the most effective captive liability safeguard entails the acquisition of a stop-loss guarantee from a fronting carrier for a fee. Such an agreement provides an MGA captive with both horizontal (frequency) and vertical (severity) coverage against loss and is usually linked to the loss ratio performance of a program. It also skirts the involvement of third-party reinsurers providing for added ease of administration. However, stop-loss coverage may not be available for every line of business being shared and any such proposed coverage should be reviewed to ensure it is effective and economical in relation to available reinsurance.
Once established, a captive can provide an MGA with a dynamic and profitable alternative enterprise, though one should not be formed as a short-term solution (despite the potential short-term benefits). The most successful captive companies operate with viable, long-term, analytically supported business plans and budgetary forecasts.
The next article will discuss some of the intricacies of captive formation and operation, including the types of risks to share, the dynamics of carrier relationships, the analytical and regulatory requirements surrounding captive insurance and the various risk-sharing resources available to MGAs.
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