Curious about Captives? Our Alternative Risk Experts Tell All!
In hard markets like we’re in today, insurance premiums can rise regardless of a company’s safety record, financial strength, or loss history. That’s why many businesses are seeking out alternative markets (or alternative risk) that don’t ride the waves of the commodity market like traditional insurance does.
1. First, can you explain the concept of alternative risk?
RV: Traditional insurance is a first-dollar policy. Which means you pay premium and the insurance company takes the risk and pays the claim. They also reap any underwriting profit that comes out of that insurance policy.
With alternative risk, you’re taking on some of the risk—and you’re sharing in that risk with the insurance company. So alternative risk is really just the difference between a first-dollar policy and the insured taking some sort of loss retention and trying to recoup a portion of the underwriting profits along with the insurance company. There are many different types of alternative risk: large deductibles, self-insured retentions, and captives—which are the most popular.
2. Since captives are our focus, can you explain how they work as a type of alternative risk?
TC: If an insured or group of insureds is looking to flee to the haven of a captive, generally they’re doing it for one of two reasons: #1. Because of what they do. Their work could be inherently dangerous, which could lead to heavy losses, making it a challenge for them to find an insurance company willing to offer them coverage. That’s one end of the spectrum.
Then, there’s the other end of the spectrum: #2. Companies with strong finances, companies with excellent controls, companies that have an outstanding loss record. That’s our model.
When you’re in a traditional market, there is obvious market cyclicality. In a hard market, everyone’s rates can go up 10-20% with little regard for actual losses. In soft markets, rates can go down 10-20% in a similar way. So if you want to stabilize your rates, control costs, and remove some of that market cyclicality, a captive could be an ideal long-term solution for you.
RV: At its core, a captive is simply the way we can enable our insureds to be their own insurance company. It’s the vehicle we use to transfer the risk from ourselves to the members of that captive. We still issue a regular insurance policy to each individual insured. Then, the captive—which is the reinsurance company—takes that risk from us.
There are 3 different types of captives. One is the group captive, which is probably the most commonly known. The second is a single-parent captive. For those insureds that are large enough, they don’t have to share risk with anyone else. In a group, you’re sharing it with the other members. Single-parent captives take on all their own risks. The last one is an agency captive. You can also throw association captive in there. In that type, none of the members are taking the risk; it’s the agency (or association) providing the insurance that’s sharing the risk with the fronting carrier.
3. How does risk sharing work in a group captive?
RV: You want to have similar-sized insureds in a group because you don’t want one large company determining the experience or pricing of the captive. Lines of Business in a captive are normally General Liability, Automobile, and Workers Comp. Typically homogeneous captives—a type of group captive where members are all in the same industry—are a better risk option than heterogenous ones (members in differing industries) because the potential losses are the same.
TC: It’s important for members in a group captive to realize they’re all sharing risk with one another. Let’s say you have a pretzel guy and a roofer in the same captive; the roofer could have a $500,000 loss, but the pretzel guy could have zero losses. Guess what, the pretzel guy will still be paying part of the roofer’s loss because captive members share in absorbing the losses of the group. So, to Ric’s point, it’s better for the pretzel guy to be part of a homogenous captive with companies like his.
4. What costs are involved with forming or joining a captive?
TC: Captives are inherently more expensive, initially. There are more frictional costs. Think about it, you’re basically paying to start up an insurance company. You have to do things like business plans and feasibility studies to the state. There’s a cost associated with setting up a captive. It’s an insurance company, so you have to provide surplus. If you’re a million dollar company and you add $300,000 to hard costs, it’s not affordable. There’s got to be some scalability, some size, to the business. We typically say you need to be at least a $3 or $4 million company, or the economics just don’t make sense. If you have that size, a strong balance sheet, and the right long-term objectives, your company would make a great captive candidate. And over time, the frictional costs should be offset by a lower total cost of risk.
For existing captives, you still need to typically pay something to have access to that captive, namely captive access fees. Again, you’re renting surplus, you’re renting capacity, so there’s a cost associated with that. You also have to do quarterly tax reporting, accounting reporting, and annual statements. There’s also ongoing management and regulatory compliance that go with operating any insurance company.
RV: What Tony is describing, figuring how to set it up and get it registered with the Department of Insurance, all the way up to the maintenance and filing of taxes, that’s all done by a Captive Management Company. They’re the people who help with all the state stuff. Because the actual members in the captive, the ones sharing the risk, they’re not insurance people. They wouldn’t know how to do this.
5. If it’s more expensive upfront, what are the benefits of joining a Captive?
RV: Within 3-5 years, you should start seeing dividends paid from the captive assuming it was profitable. Your total cost of risk for the first three years is going to be more than you’d pay in the standard market. But over time as you see dividends, that should come down—hopefully below the standard market—because you’re doing better than the standard market.
TC: There are tax advantages, as well. Ric mentioned typically after three years, captives can declare dividends. That’s underwriting income. So if you’re earning underwriting income years 1, 2, and 3, and you’re not paying dividends out until year 4, that’s a very nice income tax deferral mechanism. While there are inherent tax advantages, we always tell people to consult with their accountants.
RV: Another advantage, which is softer, is control over claims. You know more about your claims and have more say over them because you’re having quarterly meetings. The second piece is coverage options. If you’re taking $250,000 in loss retention and you want a brand-new coverage that only goes up to $50,000 in limit and it’s something that’s never been done in the industry before, I’ll be ok with that as the insurance company. It’s entirely in your layer, you’re trying to create something new. Because you’re taking the risk, you have the option to pursue more expansive coverage.
6. Are there any challenges that companies should be aware of when considering a captive?
TC: Funding is paramount. That’s probably the most vulnerable part of being in a captive. You have to make sure there’s enough surplus loss funding to support potential losses—which can be a real challenge for those captives just getting started. But over time, that variability should even out. They should also have excellent historical data, like premium, losses, and exposures. That information helps us determine a loss forecast and individual pricing components.
RV: Another important thing to understand is that a captive doesn’t imply lower rates. That’s a misconception. Just like any insurance company, sticking to your underwriting discipline is the most important thing you can do. You’ve come up with this box of “like” people that you know you want to share risk with. Then, someone comes along with a little heavier exposure, don’t do it. You have to be true to the guidelines for how you started your captive.
TC: It’s not about lower rates. It’s about stabilizing your costs and being in control of your own destiny. Let’s say you’re a commercial auto fleet, and you’re using telematics in your vehicles. You have internal and external cameras installed. You’re spending real money to ensure you’re creating a very safe environment. Guaranteed over time, you’re going to do better than the norm in the industry. So that’s an example of how you can control your own destiny. It’s having the ability and confidence to do so. And we’ll help you.
7. Is marketing a captive different from marketing a traditional insurance product?
TC: The first and most obvious way is the ramp-up time for captives, which is significantly longer than other types of insurance placements. It could take a year or two, sometimes longer, because there’s such a big financial commitment. There’s collateral to be posted, multiple contractual agreements, and a major mindset change.
RV: People can grasp the benefits of starting a captive very quickly, but the harder part is telling them, “OK, it’s going to take six months to talk to the DOI and get all these things set up.” People think it just happens overnight, but it takes time to form a captive.
TC: Education is so key. First, it’s understanding the economic and intellectual commitment; then, it’s understanding the time commitment involved.
RV: The other piece of it, and this falls more into the sales process, is that the client is taking the risk since they’re the insurance company. They have skin in the game, so it’s a different client profile. They’re a much more sophisticated buyer.
TC: And the distribution method is different, as well. We don’t market to the end insured. We’re usually talking to the captive managers and reinsurance brokers who have clients that fit the captive profile.
RV: A lot of these conversations happen at specialized captive conferences. It’s not only the captive managers who attend, but also the people who create the infrastructure for captives, like financial companies, operations people. There are CPAs who can talk about tax implications, regulatory people. It’s kind of its own little world.
TC: Yes, conferences like CICA and VCIA. There are about 6-8 of these conferences that rotate throughout the year. All the different captive professionals attend. That’s where we can make connections and have the important conversations. They’re our primary source for marketing captives.
8. How does a company go about forming or joining a captive?
RV: If you want to join a captive, talk to your insurance broker. You’re still represented by the same people throughout the process. They will do the work for you. It’s still very similar to the traditional insurance process.
TC: As Ric said, talk to your broker first. You need representation, period. Then there’s the Captive Manager, who is the conduit between the captive candidate and the state. As the insurance company, we’re the third leg of the captives stool. We enable you to legally form a captive. We provide the licensing, certificates of authorization, and A.M. Best rating. We look at ourselves as your risk-sharing partner. You might be great at making widgets, but you’re not an insurance company so it’s our job to help you operate successfully. All three of us have mutual interests, and it’s this shared interest that really distinguishes captives from the traditional market.