CONTINGENCY POLICY: IN BRIEF
Status: Insurance policy issued by Castletown Insurance Company Limited. Profit commission pays surplus underwriting results back to the insured.
Suitable for: Companies with smaller insurance programmes: no minimum premium.
Benefits: (Same as a captive)
- Capture underwriting profits
- Smoothing premium cycles
- Underwrite risks not easily insurable
- Create contingency reserves
- Fiscal benefits
- Access to the reinsurance market
- Risk management focus.
Cost: A percentage of premium, 3-5% (depending on volume), minimum fee £2,500.
Capital requirement: Not required.

 

FEATURES, COST AND BENEFITS OF A CONTINGENCY POLICY

What is a contingency policy?

A contingency policy is literally what it says: an insurance policy that will protect an insured against an unforeseen event, by providing a contingency fund to meet the costs of such an event. It is derived from the concept of the Captive Insurance Company and is similar to the arrangement known as a "Rent-a-Captive", but with no requirement for a capital injection.

Captives are not usually suitable for clients with small insurance programmes, because of the costs associated with forming and running them. The annual cost of a captive is approximately £45,000 per annum. It is usually not cost-effective to operate a captive with a premium income of less than £500,000 per annum.

A contingency policy offers many of the benefits of a captive at a much lower cost. The arrangement is "insurance contract orientated" and includes a mechanism to return surplus funds to the Insured.

 

How much do they cost?

The cost of a contingency policy is determined as a percentage of premium. The fee is dependent on size, but a normal fee is 3 - 5% of gross premium with a minimum fee of £2,500.

 

What are the benefits of a contingency policy?

Each contingency policy is unique and each one is formed for different reasons. Highlighted below are some of the most important benefits.

1.

Capture underwriting profits. Conventional insurers aim to make an underwriting profit: it makes sense for insured companies to retain a portion of the underwriting profits made in the years of normal losses by writing the insurance in a contingency policy and protecting themselves against a catastrophe through reinsurance.

2.

Smoothing the cost of premiums. It is well known that premiums in the conventional market follow a cyclical pattern. This can lead to budgeting and cashflow problems. A contingency programme can assist in smoothing these fluctuations. A "deductible infill" policy (a policy that covers risks at the lower levels) may be written below a policy from the conventional insurance market.

 

In this way an insured company can decide what level of premium to pay for risk transfer: the more risk it funds at a lower level in the deductible layer, the less premium will be charged by conventional insurers.
3. Contingency reserves. These can be built up within a contingency programme offering protection against a higher than expected level of claims, or offer cover to the insured company against losses that may be low frequency but high severity.

  Reserves can be retained in any currency including US Dollars, Sterling or the Euro, acting as a hedge against currency movements.

4. Access to Reinsurance market. Using a contingency policy, as with a captive, it is possible to access the reinsurance market. Often known as the "wholesale market", this market offers cover to insurance companies and as such tends to have lower overheads, such as marketing related costs. As a result it can often offer lower terms than the conventional market and will sometimes pay commissions back to the insurer (in this case to the contingency policy) for producing the business.

5. Risk Management. This is at the heart of the contingency policy. Companies are faced with many risks from unforeseeable events and it is prudent to take steps to protect themselves against such eventualities. However, there are instances where companies may be unable or do not wish to obtain cover from the conventional market, for instance:
 
a) The conventional market may not offer the cover required. Many companies are exposed to risks that are unique to their specific sector and it is likely that many of these may not be available in the conventional market.
  Examples of this may include the adverse effect of strikes of a company's own workforce, political risk by a company's own government (for example, compulsory purchase), the risk that a building developer may not see a continuous rental stream due to tenant default.
b) The conventional market may exclude certain risks from the policies it issues, policies may contain exclusions that may render them ineffective in the client's view or contain compulsory excesses/ deductibles.
  A contingency policy can be used to cover many types of risk, particularly niche or unusual risks.

6. Tax deferral/ lower rate of taxation. As contingency policy premiums are generally tax deductible, tax deferral benefits will usually be achieved.
 
a) Profit commission will be paid subsequent to the policy period plus a run-off period (say an additional 6 months). Policies can also be issued for a period of 3 or 5 years. This can offer tax deferral advantages.
b) While tax deferral is attractive to companies, it is recognised that some companies will need to preserve cashflow, hence premium instalment plans can be agreed.
We are not tax advisers and we would recommend that clients obtain professional tax advice.

When should a client consider a contingency policy?

It is difficult to define simply when a company should consider a contingency policy, as every company and their needs are unique. In general terms, companies which benefit from the use of contingency policies tend to have common features. These include companies with:

profitable net premium income in the range of £50,000-£500,000;
a Risk Management focus;
loss history which is better than others in the same industry;
low frequency, high severity risks and/ or those that are suitable for excess of loss reinsurance, (a contingency policy retaining the lower levels of risk);
a wish to obtain protection for risks that are not already insured;
understanding and support from senior management.


HOW A CONTINGENCY POLICY WORKS

Assess the risk profile

A client first needs to identify the risks it wishes to cover. This may include deductibles/excesses or new (currently uninsured) risks. Once these risks have been identified, Castletown Insurance Company Limited will work with the client to tailor a policy or suite of policies that would suit its needs as closely as possible. Premiums, limits and policy terms and conditions would be agreed.

Implement insurance programme

The premium would be paid by the insured to Castletown Insurance Company Limited as a single premium at outset or, if preferred, on a quarterly instalment basis. Premiums would be deposited in a segregated account. Claims arising under the programme would be paid out of this fund. Debit notes, cover notes and policy documentation etc. would be issued as normal.

Profit commission

At the end of the policy period, plus an agreed period of run-off, if there are any funds still remaining, then these would be rebated back to the insured or to its nominated payee in the form of a profit commission. The profit commission would be calculated as follows:

* Gross Premium
* Less commissions paid
* Less reinsurance (if any)
* Less insurers administration fee (5% of gross premium, with a minimum fee of £2,500)
* Less claims
* Plus interest accrued

If the policy fund should at any time fall into deficit, the policy provisions include additional premium and claims handling clauses, which may be triggered at certain agreed loss ratios.

The Structure

The overall structure of a policy such as this would operate as follows:

Security measures can be put in place to safeguard funds, including a security fund agreement and charge over the funds to the insured in support of the insurer's obligations.

Example of a suite of three policies

Policy Type Assets DIC/ DIL Credit Strikes
Limit of liability £150,000 £110,000 £75,000
Period 12 Months 12 Months 12 Months
Indemnity 90% 90% 90%
Excess £5,000 £5,000 £5,000
Premium £50,000 £35,000 £25,000

Special Conditions:

1. With no reinsurance, a combined annual aggregate limit of liability may apply.
2. If the aggregate loss ratio across the three policies exceeds 120% (£132,000), an additional premium may by charged at underwriters discretion
3. If claims exceed 100% loss ratio, claims handling charges may be payable.
4. In the event of a claim, if the premium is paid in quarterly instalments, premium acceleration may be applicable.
5. Profit commission applicable at month 18 following expiry of the policy (to allow run-off of the risk).
6. Insurance premium tax will be payable on gross premium for UK companies.

Alternatively, a policy can be agreed that would have a much longer period, say 36 months. In this case, annual premium instalments could be agreed and the policy would carry a premium acceleration clause if the claims exceeded premium received. The effect of a 36 months policy would offer a number of benefits including the maximisation of tax deferral benefits and consistency in premium pricing over a longer period.

 

STEPS IN IMPLEMENTING A CONTINGENCY INSURANCE PROGRAMME

As most companies considering forming a captive insurance company or participating in the underwriting of its own risks have well developed Risk Management disciplines, a captive or contingency project usually involves the risk manager and the company's broker or insurance adviser. The initiative is often driven by a combination of the Risk Manager and Finance Director as these programmes may have a significant bearing on the balance sheet, in protecting its assets and minimising the effects of adverse events.

We are able to work with brokers and advisers, as well as directly with client companies if required. We have a wealth of experience in structuring captive and contingency programmes.

Contingency programmes are tailored to suit each client. If the business is accepted as reinsurance, Castletown may offer a programme via its reinsurer, Ilex Global Reinsurance Limited.

 
Also see:
Captive Insurance Companies