Should SMBs use captive insurers to manage risk?
Here's what insurance agents and brokers should know about captives and the small and midsize business market.
There is a mystique — and more than a few misconceptions — about captives.
The most common myth is that captives are only suitable for organizations that generate large premiums and have sophisticated risk-management and employee-benefit programs.
Captives defined
Broadly defined, a captive is an insurance company established with the objective of insuring or reinsuring the risks of its owner (a single-parent captive) or owners (a group captive).
Captives are either domiciled onshore or offshore and are regulated by and subject to the laws of the domicile of incorporation. Single-parent captives typically work better for larger firms. With group captives, however, expenses are disseminated across multiple participants, lowering the cost of entry for smaller organizations. There are many types of captive structures and lines of property & casualty and employee-benefit coverages written in captives, which makes this risk-financing solution a viable option for companies of virtually any size.
Regardless of size, all companies can use the following guidelines to determine whether a captive would be an appropriate solution.
Benefits of a captive
Captives have the potential to deliver significant advantages to owners, the most important of which is control. Captive owners have direct involvement and influence over the captive’s operations, including underwriting, claims management, loss prevention and corporate governance and investing.
A captive also insulates a firm from the cyclical swings and uncertainties of the commercial insurance marketplace. This advantage, coupled with the fact that captive operating costs are nearly always lower than those of conventional insurers, results in more stable program pricing over time.
Additionally there is a far greater return on loss-prevention and claim-mitigation investments. If actual losses turn out to be better than projected, owners can recoup — via dividends or reduced future premiums — a greater percentage of those savings than they could from traditional insurers.
When not to use a captive
There are certain fundamental predictors of success. If one or more of these is missing, a captive is likely not a viable solution. Captives work best for firms that share the following characteristics:
- There is a senior management “champion” who is actively involved and who is willing to invest meaningful time in the captive’s ongoing day-to-day operations.
- The firm’s commitment is long term (it’s not cost effective to jump in and out of a captive to “game” the pricing cycles of the conventional insurance market).
- The firm has an appetite for and experience in retaining risk and has an average or better-than-average loss history. Although captives are often structured to provide excess insurance or reinsurance to protect against unexpected large claims, culturally risk-averse firms will be more comfortable with traditional insurance.
- The exposures insured in the captive should be reasonably predictable. Low-frequency/high-severity catastrophe risks are poor candidates for captive coverage.
- The firm is committed to building and maintaining robust loss-prevention and risk-mitigation programs.
- The firm has a stable operating history and strong financials.
Evaluation process
On a broad level, the roadmap to evaluate and ultimately create a new captive — whether a single parent or group structure — is the same: Perform a feasibility study, engage a team of service providers, get the captive licensed in the selected domicile, establish operating protocols and procedures, capitalize the facility, and, finally, begin operations.
There are also important differences between single-parent and group structures. Because only one company is involved in decision-making with a single-parent, starting the feasibility process tends to be simpler; the process does become more complex, however, as evaluation and establishment progresses.
Once a single-parent captive is up and running, the owner will be required to commit significant time to operational oversight.
Conversely, establishing a group captive involves more time upfront sourcing, educating, and organizing suitable, like-minded partners. Once the group is assembled and decides to proceed, individual participants’ time investments in feasibility and implementation steps will often prove less than that of a single-parent owner.
A far more likely scenario for a company considering participation in a group captive is that the facility will have already been created by a sponsoring organization, which assumes responsibility for most day-to-day operations. And, information comparable to that of a traditional insurance company submission: historical losses and exposure data for the contemplated lines of coverage, the most recent interim and audited financial statements, and, critically important, detailed evidence of aggressive risk-exposure-mitigation programs.
Conventional wisdom characterizing captives as risk-financing options solely for large companies is simply incorrect. For firms that satisfy the requisite success factors, captives can be a great alternative to traditional insurer solutions. Even if a captive is not a fit for a firm today, it may be one in the future. There is often a multiyear learning curve about the value of captives, and many firms compare captives against conventional insurer alternatives for several renewal cycles before finally electing to go the captive route. The best advice for companies is to always keep captives on their risk-financing radars.
Paul Tamburri (Paul.tamburri@relationinsurance.com), West Coast risk management practice leader, and Josh Watney (Josh.watney@relationinsurance.com), vice president, are alternative-risk-financing specialists at Pan American Insurance Services, a Relation Company.
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