A Soft Market Solution: MGAs and Risk Sharing

Editor’s Note: The following is part two of a discussion of the risk retention options available to managing general agents, the variables which may affect their execution, and the means and modes of analysis. The first part of this article appeared in the May 5 issue of Insurance Journal.

Prior to approaching potential risk-sharing partners a managing general agent (MGA) should conduct a thorough analysis of its active products in order to determine which are best suited for risk assumption. MGAs interested in risk sharing should consider historical performance as the primary characteristic of a product. Since profitability concerns any for-profit organization, lines of business with consistently low loss ratios should be selected for risk sharing to maximize potential underwriting earnings after associated expenses.

After identifying products with the most earning potential, MGAs should consider the current and future size of eligible portfolios. If making a risk sharing decision between two books of equal performance value, though of different sizes, the larger portfolio will most likely make a better candidate for risk sharing since it will attract more interest from potential carrier and reinsurance partners and will enable an MGA to maximize dollar profits. Volume is of particular concern if risk is to be shared via a captive since captives involve a certain amount of fixed expenses which do not vary significantly with program size.

The unique qualities of eligible business classes should also be evaluated. Short-tail lines of business are easier to administer from a risk-sharing perspective and necessitate less restrictive capitalization requirements. Excess capital used to finance short-tail risk can be rolled over more readily from year-to-year since losses on such business tend to develop with relative speed.

Risk assumed on long-tail business, on the other hand, can tie up a risk bearing entity’s underwriting reserves for several years as losses develop, resulting in the pyramiding of capital. For instance, if a carrier partner or a captive regulator requires an MGA to post funds to cover potential losses to risks written during the first underwriting year of an agreement, those funds, or at least a portion thereof, will need to remain accessible until all of the losses associated with year one business develop. Depending on the line of business this could take several years.

Other concerns include the age of a given program and a manager’s experience. It may prove more difficult to find a carrier willing to engage in a risk sharing arrangement with an MGA on a new, untested product offering. A program with controlled premiums and a manager with demonstrated marketplace knowledge can offer a carrier an immediate revenue benefit and the promise of growth or continued performance via access to expertise. These factors can help offset the potential downside of risk-sharing for an insurer — such as the exposure to credit risk by accepting reinsurance from an MGA captive with limited assets — and facilitate the conversion of a basic production-based program into a risk-sharing program.

Carriers’ Concerns

In a soft market, the marketability of controlled business increases significantly despite its decreased actual value. While commissioned producers may be hungry for new business during downward cycles, many carriers are starving. Moreover, boutique or niche market appeal reinforces the relative desirability of specialty program business, providing MGAs with an added advantage. Some specialty lines of business can even be sheltered from overall market trends allowing for the comparative maintenance of rate adequacy in the face of generally softening results. Such dynamics position MGAs to offer existing or new carriers a welcomed top-line boost, a benefit for which many would be willing to pay in the form of improved commissions or other agreement terms.

This being said, when identifying risk-sharing as a program goal, an MGA should first look to its existing carriers for a solution. It is generally preferable — all other things being equal — to maintain the integrity of existing market relationships. Long-term partnerships can afford both parties certain benefits and can facilitate account administration through the continuity of in-force contacts and services. However, some carriers, for a variety of business or underwriting reasons, may be uncomfortable sharing risk with an existing MGA partner or may not feel a given product warrants such treatment. In any case, if existing partners cannot meet an MGA’s risk-sharing, product or underwriting needs, new partnerships should be explored.

MGAs exploring carrier relationships for risk-sharing should first determine the type of paper to pursue. To do so effectively, MGAs should evaluate whether accessing admitted paper for a given product will help maximize returns or if nonadmitted paper will suffice. Admitted products generally take longer to implement because of filing restrictions and are generally more expensive due to the enforcement by state governments of boards, bureaus, taxes, etc., than nonadmitted products. However, admitted products may prove more attractive to prospective insureds and could help solicit more or better business.

Reinsurance intermediaries may be well-situated to provide MGAs with necessary carrier assistance due to their unique position in the insurance marketplace. Such organizations can draw from an insurance company client base and the relationships they maintain with insurance executives to help MGAs meet their unique underwriting and risk-sharing needs. By virtue of their marketplace knowledge they can provide MGA clients with reassurance that the best possible carrier relationships have been explored.

Reinsurance brokers may also be able to assist an MGA captive and its eventual carrier partner in procuring reinsurance for a program venture. This dual servicing capability may help consolidate workload and perhaps even offset some of the costs associated with risk-sharing.

With this in mind, if an MGA intends to issue policies through a captive entity, a fronting carrier may not be necessary for some programs. While this will allow a captive owner to avoid the costs of fronting, which can be substantial, the feasibility of this method represents primarily a function of the savvy of existing and prospective insureds. A new program written directly on a captive’s paper will also likely need reinsurance coverage. This could prove difficult to obtain on the open market due to reinsurers’ security concerns or premium limitations.

Feasibility Analysis

The conventional agency business model does not account for risk beyond the limited range of intrinsic business risks associated with production-linked business. If the management team of an MGA remains risk averse and unwilling to compromise an agency’s fundaments, risk sharing will be simply infeasible. However, if management seems willing to diversify an MGA’s earnings potential through the assumption of underwriting risk, a variety of analytics (actuarial, financial, legal, risk/reinsurance, etc.) will need to be sought in order to accurately gauge the feasibility of a risk-sharing project, especially one that involves the formation and maintenance of a captive insurance entity. This may seem problematic considering most MGAs do not maintain comprehensive analytical staff, yet through outsourcing an MGA can obtain detailed budgetary estimates and actuarial forecasts to assist with the implementation of a workable risk-sharing solution.

In the absence of internal expertise, MGAs should seek external support from an experienced advisor or representative such as a captive manager or reinsurance intermediary. Such entities offer MGAs access to a variety of external resources via a primary contact. Depending on the particulars of a risk-sharing project, such entities can also arrange or conduct most of the relevant analysis an agency interested in risk-sharing may require.

The results of relevant analyses can then be used to compile a quantifiable business plan, proposal or submission for the related risk-sharing opportunity. Such a proposal should also include a list of general business goals and aims, estimates for future growth and a survey of the competitive marketplace in which the program will operate. Once completed, a business plan for a risk-sharing venture replete with verifiable analytics and objectives will serve as an invaluable tool to attract new carriers, attain preferential program terms, place reinsurance and convince captive regulators of the viability of a project.

Unless an MGA is able to dedicate a portion of its workforce to the oversight of a captive entity, it will need to retain a captive manager to conduct the ongoing services a captive demands. Many captive managers offer unbundled services, allowing an MGA to select only those it needs most. Ordinarily, MGAs retain captive mangers to deploy their primary functions, such as periodic accounting, dedicated investing and legal and regulatory oversight, though most offer an assortment of other claims, risk control and underwriting services.

Conclusion

Captives are conventionally conceived as hard-market solutions. In fact, non-insurance organizations historically created captives as a manner of avoiding excessive insurance costs when premiums rose unsuitably high. Conversely, during a soft market a captive can help an MGA make up for revenue shortfalls due to rate softening and can also poise an MGA over the long-term to take substantial advantage of a hard market once one arrives.

The potential soft-market benefits of risk sharing extend beyond the mere potential for increased profits. MGAs with risk-sharing capacity demonstrate faith in their own underwriting capabilities and attract more willing and less restrictive carrier partners. Shifting the traditional carrier and program manager relationship from a one-sided appointment to a mutual partnership creates a new dynamic. This can position MGAs to align interests with and gain access to the resources of experienced partners, diversify their balance sheet, increase the marketability of their business, expand the reach of their existing programs, grow through the negotiation of improved agreement terms and leverage earnings potential through the creative application of risk-sharing techniques.

Nevertheless, while the possibility of sharing in underwriting profits is certainly titillating, it comes with the possibility of sharing in underwriting losses. Thus, any risk-sharing venture should be approached with attentiveness, due diligence and a degree of circumspection so as to avoid any undue risk taking.

Alex Bernhardt, ARe, AIS, works for Guy Carpenter & Co. in Seattle, Wash. Peter Taubenheim of Guy Carpenter also contributed to this article. Phone: 206-621-2924, E-mail: alex.bernhardt@guycarp.com.