Managing Surging Insurance Costs With A Captive
2020 was recognized as one big cataclysmic event for the insurance industry, with billions in losses being reserved on the balance sheets of property and casualty insurance companies. The industry was already coming off historical losses just two years previously from Hurricanes Irma, Harvey and Maria. The following year saw a profusion of wildfires and the industry now continues to face the aftershocks of the pandemic.
According to Fitch, COVID-19 related claims are estimated at $23 billion and will continue to grow until the multiple impacts of the virus are under control. All of these losses had the dual effect of reducing insurance capacity while driving up premium rates. As 2022 draws to a close, renewals are up across all lines of coverages and all industries are impacted. Renewal increases are averaging 10 percent to 25 percent, but can exceed 100 percent for more difficult risks.
These increases have companies taking action as they seek to find cost-effective solutions for their insurance spend. The most popular alternative option has been the establishment of a captive. Captives have been around since the 1950s and, even in 2011 according to a survey conducted by Insurance Journal, at that time accounted for half of all property and casualty premiums. While popular among the Fortune 100s, with 90% reporting captive participation, middle market companies now represent the fastest growing segment of the market.
Why form a captive?
A captive is an insurance company set up by its owners to self-insure against the owner’s subsidiaries’ or related entities’ specific risks. These structures can be designed for a single corporation or a group of companies. They can be utilized to cover a wide range of risks, including most casualty exposure, property, terrorism, cybersecurity, and even employee benefits. The captive operates like a commercial insurance company and is subject to state regulatory requirements, such as financial reporting, capital/solvency support, and reserve adequacy including an annual actuarial opinion. Why would a company want to own their own insurance company? The reasons are many:
• Increased cash flow
• Coverage tailored to meet your needs
• Reduced operating costs
• Greater control of claims
• Funding and underwriting flexibility
• Incentive for loss control
• Capture underwriting profit
• Potential tax benefits
• Price stability over your insurance program
• Investment income
• Flexibility in managing risk
While all of these are important, a few stand out when a company looks to form a captive. First is the ability to capture the potential underwriting profit that otherwise would accrue to their commercial provider. When a company is in the commercial market, the company pays its annual premium with no prospect of receiving compensation for a better than average loss ratio. With a captive, the company pays the annual premium, but at the end of the policy period the earned underwriting profit is returned to the company. Underwriting profit is determined by premium minus expenses and any claims payments.
Secondly, with a captive the coverage is tailored to meet the company’s specific needs. As many are discovering upon renewal in the current market, companies are not only facing increased premiums, but also are encountering underwriting restrictions. With a captive, the company can determine types of coverage and coverage limits that best fit its needs. Captive premium pricing and coverage limits are determined through an independent actuary.
Another other key advantage is the potential tax benefits. The annual premium can be eligible for a tax deduction. The captive must be structured properly to qualify for a premium tax deduction and this can be achieved through proper tax advice during the formation.
There are a number of different types of captives that can be utilized to achieve the company’s goals: group, association, segregated cell, pure, and risk retention group, to name a few. The company has the ability to select which captive structure best fits within its company financial goals and risk management strategy.
How a captive is created
Forming a captive is not typically a difficult process. Hiring a captive manager or captive consultant will provide you the advice and assistance required to get through the formation and obtain the license to operate. One of the first decisions is the selection of a domicile in which to license the captive.
There are a number of domiciles to choose from both within the U.S. and offshore. The three domiciles with the largest number of captives are the Cayman Islands, Bermuda and Vermont. Vermont is the largest U.S. captive domicile, although there are others to choose from, such as Arizona, South Carolina, Delaware, Utah, Tennessee and North Carolina, just to name a few. There are several aspects to take into consideration when selecting a domicile, including the capital requirement. Most domiciles require a 3-to-1 investment. For example, on a $1 million premium, the captive would be required to carry $300,000 in capital. In some cases, the capital can be provided posting a “letter of credit” in lieu of cash. The domicile’s regulator will make the final determination regarding capital requirements.
When forming a pure or stand-alone captive, having selected a captive manager, there are additional decisions to be made. The captive manager is critical and fundamental to structuring the insurance program to be written by the captive and will assist in engaging the actuary to prepare the feasibility study necessary to submit to the selected domicile as part of the license application.
Your captive manager will also assist in the selection of the various vendors required to operate the captive. Once you’ve chosen your captive manager and actuary you will need to engage various professionals familiar with captive insurance companies to assist with tax and audits, reinsurance (if needed), and claims, often including a third-party administrator (TPA).
Stand-alone or group captive?
If the company decides to join a group captive, those service providers engaged by the group captive will be used. This can make the transition to placing part of your insurance program through a captive less complex. But important distinctions between a stand-alone and a group captive need to be observed, since joining a group captive can also come with its own limitations.
If the company forms its own captive, it owns the captive outright. This is not the case with a group captive. If your organization is not able to achieve risk distribution internally, joining a group captive is a viable solution. However, it must be understood that when participating in a group captive the insured company would share risk within the group. If your company works hard at maintaining a very good loss experience, you may not want to share risk within a group captive where the other participants do not share a similar loss history. You may consider an alternative to owning your own ‘stand alone’ captive if the premium corresponding to the risks you wish to insure through a captive aren’t sufficient to warrant or cover the expense of running a pure captive. In these circumstances participating in a group captive could be a good option.
Captives provide a company with an alternative, for some or all of their insurance program, to the traditional commercial market space, which is prone to potential premium increases and underwriting uncertainties year to year. Captives allow companies to insulate themselves from the traditional market conditions and offer greater risk management control.
While captives may not be the answer for all companies to navigate current commercial market conditions, they can present an attractive alternative for some companies seeking alternative ways to finance their risk.
