IV. The Pluses and Minuses of Captives

IV. The Pluses and Minuses of Captives
by John A. Wright, CPCU, CIC
During times of rising insurance premiums and difficulty in finding insurance coverage at all, insurance buyers have looked at captive insurance mechanisms as a possible saving option (see sidebar for an explanation of terms used in this article). The problem is that these concepts can seem at times mysterious and overly complicated, and can be perceived as the “magic bullet” that will solve all insurance-purchasing problems.

No doubt there has been significant movement into captives over the past 15 to 20 years, with market-share projections indicating that the captive premium volume exceeded 50% of total risk-bearing premiums in the United States. As always, though, it is critical to balance the advantages of captives with their downside. Just as insurers fail because of mismanagement or improper utilization of capital, captives have suffered the same fate.

It is important always to keep in mind that a captive is strictly a risk-financing technique designed to pay claims and expenses on behalf of its policyholders. Some of the litigation trends that have contributed to the crisis for healthcare facilities, particularly in Florida and Texas, will not be mitigated by alternatives such as captives. Captives do not inherently eliminate exposure to litigation and claims, although members’ increased focus on loss control and risk management can improve outcomes (as would be true of insurance programs, as well).*

Nevertheless, there are many advantages to captives. They are designed to be a long-term solution for providing insurance coverage that is not entirely dependent upon insurance company swings in the marketplace. The ability to dampen the external factors that affect insurance companies’ decisions on how they allocate their risk-based capital to maximize shareholder return can provide more stability to captive policyholders over time. Captives can be structured in a very focused approach to provide tailored services on clearly defined issues that are prioritized by the policyholders themselves. The traditional captive approach involves selecting providers based specifically for their expertise within their specialties . Beyond this, claims services, loss-control services, legal defense and captive services can be evaluated and negotiated separately.

Captive insurance
companies might seem
to be a way out of the
liability insurance
crisis, but a careful
approach is justified.
The financial aspects of captives can be beneficial to the policyholders, as well, since the underwriting profit and investment income on cash balances, including loss reserves, are credited to policyholders’ accounts. The premiums charged by captives are not market driven (some policyholders suspect that the insurance industry is overcharging current premiums to cover prior years’ shortfalls, to recover those losses as quickly as possible), but rather are actuarially driven by analysis of the captive parti-cipants’ financial situations.

If homogeneous captives are formed, the potential of partnering with facilities having similar missions and attributes can lead to the growth of best-practice intangibles within the group. In long-term care, the focus can be upon such appropriate issues as resident standards of care, rather than upon a marketplace search for premium reductions. Facility management and employees can develop a commitment to loss prevention and safe practices that can evolve into a stakeholder mindset. Specific compliance programs can be developed, understood and im-plemented across the captive group to achieve common objectives.

Despite these advantages, there are precautions to observe in evaluating the captive alternative.

First, part of the difficulty in forming a captive is establishing a large enough critical mass of policyholders with good loss and exposure data to establish actuarial confidence in the predictability of outcomes for claims. Typically the starting point for forming a captive is in the $5,000,000 premium range, even though some have launched programs with as little as $3,000,000. The lower the premium, the higher the risk in forming a captive because of the statistical confidence of the potential outcomes.

Another thing to remember is that most captive programs focus on casualty and workers’ compensation lines of coverage rather than on property and umbrella liability coverage. The basic idea is to assume losses within the working layer of exposure (i.e., that portion that is predictable) and reinsure losses outside the normal range of expectations, while earning investment income on reserves held for future claim payments.

The attraction of underwriting profit is strong in forming a captive, but there is no guarantee of such profit, and past performance does not predict future results with certainty (especially when legal trends are unpredictable). Profits are not realized immediately, but over the long-term life of the captive; usually underwriting profits are not returned to policyholders’ accounts for 3 to 5 years, minimum. This requires ongoing capitalization of each policy year until underwriting profit begins to offset this obligation.

The investment income that is illustrated in captive feasibility studies should be reviewed carefully. The funds that need to be held in reserve are usually required to be liquid and in short-term instruments. Typically, captives with cash balances of less than $20,000,000 perform beneath the market indices of insurance company portfolios, because those companies’ flexibility to diversify funds is not available to the smaller organizations. Any investment income projection of more than 3% in this financial market would be an aggressive assumption for a captive.

The start-up costs involved in aggregating loss data, performing an actuarial feasibility study and implementing a policyholder selection process can be substantial. The key to cost-efficiency is to evaluate who your partners will be. What are the requirements for participation? What are the demographics of the group? Is there a comfort level among the participants in sharing common goals and values? The answers are important-usually there is a “joint and several” liabilities agreement among the participants within a group captive, to meet the captive’s financial obligations. It is important to make sure that everyone is on the same page in terms of expectations of the captive and the goals and objectives to which everyone is committing his/her organization.

Another issue to consider in participating in a group captive is the logistics of participation. For example, usually there is a common expiration date that could require a midterm cancellation of an organization’s fully insured program. If so, are there cancellation penalties? What are the claims-reporting provisions-are there coverage gaps or changes in terms and conditions? Can property coverage be obtained on a stand-alone basis at the same level of cost? Can all the filings for governmental agencies be met through a captive mechanism?

The cost of defense for losses is generally treated as a supplemental expense not included in the loss amount for fully insured programs. It is important to factor that into the perception of what an insurer is actually paying, rather than simply looking at the amount of incurred loss on a claims report. Under a captive mechanism, the responsibility of funding the defense cost is included.

The expenses within the cost structure of a captive traditionally range from 30 to 40% of the premium. The balance of the premium is used to pay claims and earn investment income. Components of the expense include the fronting fees to an issuing insurer, reinsurance (specific and aggregate), captive management fees, underwriting expenses, actuarial services, claims handling, taxes and loss-control services. The ability to set a premium that will retain sufficient net amount after expenses to cover the expected incurred losses of the group is the ultimate driver of success.

Because the potential gains are realized only over the long haul, long-term commitment by the policyholders is essential. If the captive mechanism is looked upon as a short-term marketplace solution, to be used only until insurance premiums drop below captive costs, success is unlikely.

There are further considerations to evaluate in today’s marketplace. The same reinsurance marketplace that is driving up insurance companies’ premiums for healthcare facilities will impact the fixed expenses and the capital requirements of captives. Reinsurance companies are also looking to provide much higher attachments to projected incurred losses. Because reinsurance is necessary, totally withdrawing from the insurance marketplace and all of its concerns via the captive option is simply not feasible right now.

The traditional fronting relationships in which an insurance company “rents” its policy to a captive for a small fee are coming under regulatory scrutiny and, as a result, the availability of the “pure fronting” relationship is shrinking. Most insurers are looking to participate in this exposure through both underwriting disciplines and premium sharing; the overriding concerns here are the credit risk of captives and the reinsurance receivables to which fronting carriers are exposed. The resulting added cost of insurer participation will further decrease the potential savings for captive participants.

The key in considering a captive is to balance as objectively as possible the potential advantages and disadvantages-the solution that a captive approach can bring against the risks of participation. Keep in mind that for many entities, the ability to transfer risk to a third party (i.e., an insurer) rather than forming their own insurance operation is still feasible. True, captives can be a very effective tool for risk financing, but very careful analysis and a clear understanding of all the issues surrounding the transaction are critical to the ultimate success of the venture. NH

John A. Wright, CPCU, CIC, is a principal with Johnson, Kendall & Johnson, a regional insurance brokerage firm based near Philadelphia. He has acted as a lead consultant for Fortune 500 corporations and multinational companies on risk management and alternative-funding program feasibility. For more information, phone (215) 968-4741.

* Note: The taxation issues and the deductibility of premiums and expenses will not be dealt with in this article. This is a very complicated area that should be addressed with attorneys and accountants experienced in this area.

Commonly Used Terms
Some of the basic terms used when discussing captives:

captives. All types of captives are insurance companies that are owned by their policyholders; usually created to insure their own exposures to loss.

domicile. A domicile is where a captive is licensed and formed. Popular offshore domiciles include Bermuda, the Cayman Islands and Ireland, to name a few. Onshore domiciles are states with enabled captive legislation to operate within state borders. Vermont, for example, is very active in captive regulation and oversight, and many states allow captives. The reasons for choosing specific domiciles range from tax issues, types of coverage allowed, experience of and with regulators, capital requirements, investment restrictions, etc.

fronting insurance. Insurance policies are issued on behalf of captives through licensed insurance companies to meet state filing requirements and financial responsibility requirements. The fronting insurer is ultimately responsible for paying the claims through its policies and relies on reimbursement of funds from the captive and its reinsurance.

group captives. Two or more policyholders that are unrelated to each other can own group captives. Also, heterogeneous or homogeneous policyholders can own group captives. Captive participants do not have to be in similar operations to join together in a captive. There are pros and cons to either approach.

reinsurance. This provides insurance for losses in excess of those the captive can sustain, both for specific losses and aggregate losses (total losses paid out during a policy period for the captive).

risk-based capital. Captives are required to have financial capital beyond premiums. They are stand-alone insurers and must comply with regulations to ensure that funds are available to meet the ultimate obligations of the policies issued on behalf of the captive.

risk retention groups (RRGs). These are groups formed as a result of the “Liability Risk Retention Act” passed in the mid-1980s. These groups are limited to providing insurance for liability coverage and do not include property, workers’ compensation or other noncasualty coverage. One reason RRGs are formed is that they can be direct-writing insurance companies with lower fixed expenses, since a fronting insurance carrier is not required to issue policies. Also, special and unique coverage not available in the insurance marketplace can be provided through an RRG, since RRGs are not subject to state-rate and form-filing rules.

single-parent captives. These are owned by one company and insures that company and its subsidiaries’ exposures.

John A. Wright, CPCU, CIC

Topics: Articles , Facility management , Risk Management