“We hoped we were wrong,” said Peter Taffae, managing director of Executive Perils Inc., of the financial troubles that recently befell American International Group. In early June 2008, Taffae and several of his colleagues began to hear alarm bells surrounding the financial future of AIG when its stock price was cut more than in half, falling to a per-share price between $25 and $30. Turns out they were not wrong, and the insurance scheme they designed to protect some of their larger clients from a sudden sinking of AIG may have introduced the insurance world to a whole new way to hedge a client’s risk associated with the stability of an insurance carrier.
About a week transpired following the initial unease in Taffae’s and his colleagues’ minds over the unclear financial futures of AIG and a second major carrier Taffae prefers not to name and the development of an apparent workable solution which has become known as “super continuity.” Super continuity is generally a calculus term, but in insurance lingo it now represents a pre-negotiated package of coverage that immediately takes the place of an insurance program that is compromised or collapses due to the financial downfall of the lead carrier or one of the carriers providing a key layer.
Building the super continuity program requires negotiating two separate insurance programs. The first is the current program’s renewal necessary to firm up its terms, conditions, pricing and different layers of coverage (including the carriers involved). A second “shadow program” that can be activated quickly is negotiated and designed from scratch. The same care and due diligence are required in building this second coverage structure; a major difference is that the carrier or carriers that pose a threat to the financial viability of the renewing plan are not included in the shadow program; and while many of the same carriers may be a part of the shadow program, they may not be in the same layers or provide the same limits as in the existing program. Further, there is no guarantee that the exact same coverages can be built in the alternative program since there may be a different lead carrier unwilling to match the existing terms. (The term “shadow program” is used due to the nature of the protection provided and also because all the elements of an insurance protection program are present, it simply has not been put in force. It sits idle waiting to be called into action.)
The pre-negotiated shadow program is built to look and act, as much as can be negotiated, like the program in force. However, it remains dormant until the insured triggers the option following a specified event such as a sudden drop in the financial rating of a carrier as is the case with Executive Perils’ program. Taffae was careful to point out that it is the insured’s option to discontinue the potentially impaired program and activate the shadow program; further the insured does not have to take the option even after the agreed upon event occurs. Neither is the insured limited to a specific time frame in which to act; they can make the move immediately or wait until the day before the policy and the super continuity option expires.
When the insured does make the move, they immediately have a 12 month policy in force – regardless of when the call is made. The shadow package comes out of the shadows and immediately assumes all the pre-negotiated risks, providing 12 months of coverage from the day it is activated. The price, terms, conditions and payment plan to which the parties agreed when the shadow policy was originally negotiated are likewise activated. Much of the uncertainty is removed from the insured’s mind when they know that a policy is immediately available should the unwanted or unthinkable occur.
As its name suggests, Executive Perils Inc, located in Los Angeles, California, focuses exclusively on executive risks such as directors’ and officers’ coverage, employment practices liability, fiduciary liability and other such risks. The super continuity program Taffae and his colleagues designed involved five of their larger client’s directors’ and officers’ coverage. Four of the five put up a real battle according to Taffae. They did not have the same fears that drove Executive Peril to design this program.
Put in financial investment terms, this looks and acts much like an options contract, specifically a call option. The insured pays a small fee (one to two percent of the policy premium) to purchase an option on the shadow program. If the necessary trigger is tripped and the insured chooses to enact the optional coverage, the insurance carrier(s) must provide the terms, conditions and pricing agreed upon some months earlier, even if the market has shifted. If the trigger point is not crossed or the insured does not exercise the option, the insurer(s) that offered the option keep the fee.
Whether insurance hedging programs such as this will become more common as the inner working are put to the test is not known. Taffae says that he has had a lot of inquiries from agents and even insureds regarding the specifics of the program. But such a program is not for every insured. This program is designed for insureds that want to maintain their relationship with their current carrier but want to have an exit strategy should something go awry that threatens the protection. According to Taffae, if one or more of the following conditions exist, that client might be a good candidate for such hedging:
1) If there is a “mega claim” pending with the current insurance carrier and the insured does not want to cut and run during that process;
2) If there is unique contractual language. The more manuscripted the policy is, the more advantageous it is for the insured to stay where they are;
3) If there is a positive long-term relationship between the insured and the insurance carrier; or
4) If the current insurance is giving the insured a fantastic economic deal.
Christopher J. Boggs, CPCU, ARM, ALCM, LPCS, AAI, APA, is an associate editor for MyNewMarkets.com. Additional articles from Boggs can be found at www.mynewmarkets.com. Past series have included topics such as workers’ compensation, flood insurance and property valuation.
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