Knowing there are risks that are challenging to underwrite or expensive to share with a carrier does not have to limit a firm’s or groups options for risk management, nor does a prospective firm need to engage a top-heavy syndicate where 40% of premium dollars result in expense costs. For those firms with stout hearts, clever advisers and an urge to have closer management of risk there are captive insurance schemes. And there just might be tax savings, too.
Patrick Kelahan is a CX, engineering & insurance consultant, working with Insurers, Attorneys & Owners in his day job. He also serves the insurance and Fintech world as the ‘Insurance Elephant’. image source
The less than ideal outcomes of claims related to Covid-19 and systemic risk has caused consideration of alternative risk financing to become mainstream fashionable, and in some aspects required for continuity of lines of business. Few reading this article need to be reminded that traditional indemnity insurance has been found to not be a viable option for systemic risk like a viral outbreak is. Systemic risk flies in the face of the law of large numbers (other than large numbers of firms suffered similar losses at the same time) in that ssystemic risk is not differentiated by geography, industry sector, size of firm, etc., anathema to prudent underwriting.
The default ‘insurer’ for a systemic risk event becomes government, not an ideal circumstance for any economy. Companies looking for options where a respective insured can exact tighter administration of coverage, can pare down expenses, and can leverage insurance investment in terms of tax-benefited expense and claim payments are looking to captive arrangements, but certainly need to tread carefully.
“Captives are not for the faint of heart; they require an ongoing commitment to risk management and mitigation.” Hale Stewart, JD
Captives have been in the US market since the early 1950’s when Frederic Reiss, “father of captive insurance,” coined the phrase from his client’s operation of mines which produced output solely for the client’s use. (Wikipedia – “Captive Insurance” )
Captive insurance plans are self-retained risk where the insured becomes the insurance company, or associated with a closely held insurance company, providing risk coverage for the parent group. The greatest difference between strictly self-retained risk and a captive- captive plans are forms of an insurance company, provide tax-benefited handling of costs, allow use of insurance premiums/reserves as basis for other financial transactions, allows ceding of risk to reinsurance companies, and provides the insured greater control over how claims are handled. Not financial snake oil by any means as captives need to be licensed, and are regulated within the operating jurisdiction to ensure adequate capital is in place to pay claims and meet minimum surplus requirements. Most captives insurers are domiciled within jurisdictions that have become expert in hosting such arrangements, including interesting spots like Guernsey, British Virgin Islands, Vermont, Malta, Gibraltar, Singapore, among several others. The legal forms of captives run a full gamut- MGAs, reinsurers, industry captives (collectives of like firms), association captives (formed by trade associations or single members, owned by the parts of the whole), agency captives where agents or brokers form captives to address unique customer needs, and so on.
What all captives must consider in the US- the formation and operation of the captive cannot stray far from the stated use of the vehicle- risk management. Many smaller captives formed as Section 831(b) P&C captives were designed to transfer unlikely risks which then allowed the captive to accept premiums, seldom or never have claims to pay, and the premium funds would transfer back to the forming company on a tax-free basis. The US Internal Revenue Service of course has upset that party and has taken action against many of these micro-captives as tax issues.
Europe has a long history with captives of similar nature as the US, and many firms have used the formation of captive insurers as a means to manage risk, have a hedge against volatile commercial insurance rates, have closer management of claim costs, and have entrée to the reinsurance markets. Of late and with the advent of Solvency II regulation captives have encountered unequal burden in meeting the bureaucratic requirements of Solvency II. The irony is- Solvency II changes were promulgated to ensure that carriers maintained sufficient capital/reserves to protect the carrier’s customers in terms of claim payments. If one considers that a captive lives to serve its sponsor company alone the very purpose of Solvency II becomes moot. European captives are now jumping through admin hoops to convince regulators that the captive is operating in its parent’s best interest.
While this article is not a deep dive into the potential benefits of captive forms of insurance companies, one can see that firms with substantial insurance premium portfolios are candidates for captive formation, as the parent firm can craft its insurance to address coverage gaps the commercial market has. Business interruption cover is an ideal example of a benefit a captive could hold for a parent company, if the numbers work properly. A million dollar policy with a $100K premium that covers BI losses, with risk ceded to a reinsurer clearly provides immediate financial benefit to the parent company from tax favored handling of the premium payment. If the captive is designed to address the needs of a pool of like firms, has reinsurance and is well-managed then there is an option for pandemic BI cover. It’s not the big picture answer, but it sure can be for the right group of insureds. Any high-risk, high premium exposure, e.g., malpractice insurance or environmental cover may be a good basis to form a captive. There are MGAs like Elite Risk (Jeff Kleid) who with a captive managing firm are creating systemic business interruption options for companies where BI or event cancellation cover is almost always a probable maximum loss circumstance.
Conversations with captive insurance legal experts like Matthew Queen find that new applications of captives are being brought to the market every day. As Matthew recently stated,
“In the modern Covid-19 environment, rolling outbreaks and unforeseen business interruptions are now a part of life. Captives can and should be used in conjunction with other risk mitigation measures to minimize exposure to this risk. A cell captive, for example, could provide tax-deductible financing for a large deductible commercial business interruption policy for a business of virtually any size. The trick is to find creative managers that can manage the risk distribution issues.”
Hale Stewart and I have had numerous discussions regarding captives, and as a long-standing expert in the field Hale expresses caution among the self-retention exuberance. Hale’s suggestion that a ‘gatekeeper’ premium amount of $100K is a good measure of a parent’s enthusiasm and ability to reasonably support a captive is good advice. The options remain for SMEs who individually may not have those resources, however in combination with similar firms may take advantage of the many collective forms a captive can take.
There are organizations that exist such as VCIA (Vermont Captive Insurance Association) that can be great resources for better understanding of benefits and uses of captives (their conference August 11-14,) and other individuals including colleague and alternative risk financing expert, Dr Marcus Schmalbach of RyskEx, another regular captives discussion partner. Marcus is taking alternative risk financing to other levels and vehicles through his latest venture.
Captives- freeing risk management from traditional insurance bindings (pun intended).
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