ALTERNATIVE markets are not so alternative any more. By manyestimates, they account for well over a third of commercialinsurance premiums. The raison d'etre of alternative markets is toenable qualified insureds to assume more control of, andresponsibility for, their loss exposures. Some agents, brokers andprogram administrators–particularly those with underwritingexpertise and a good book of business–also get involved in thealternative markets as a way to earn additional revenue, althoughthe opportunity is not risk-free.

Alternative markets take on many forms, including captives,rent-a-captives, self-insurance plans and pools, risk retentiongroups and purchasing groups. For this special report, we'vecontacted seven people who are involved with these mechanisms toobtain their perspectives on how they are being affected byeverything from the softening market to New York Attorney GeneralEliot Spitzer, as well as what the future holds for them. Beforereading their comments, however, it might be helpful to brieflyreview the characteristics of single-parent captives, groupcaptives and rent-a-captives, the main alternative-marketmechanisms discussed in this report.

An overview of captives

Agents and brokers sometimes help large accounts createsingle-parent captives, which the account uses to cover its ownrisks, while using reinsurance to cap its losses. Agents andbrokers also are involved in various kinds of group captives. Oneis an agency-owned captive, in which the agency puts up theformation capital, accepts a certain amount of risk and owns anyunderwriting profits and investment income.

There also are member-owned captives, which agents and brokersmay sponsor without taking on any risk or sharing in any profits.Instead, they are compensated by commission and by fees for anyservices they may provide. Meanwhile, the captive's risks andrewards are shared by a (usually homogenous) group of midsizeclients, who also put up the capital to form the group captive. Therequired one-time stock purchase generally ranges from $30,000 to$50,000. The captive members also pay annual premiums, asdetermined by individual underwriting.

In a typical group captive, a captive facility is retained todesign and manage the captive. It arranges for a fronting insurer,generally an admitted or nonadmitted U.S. domiciled insurer, toissue policies to the captive's members. Premiums, less thefronting company's fees and various expenses (commissions,residual-market loads, taxes, “boards and bureaus,” etc.) are thenceded to the group captive, which functions as the frontingcompany's reinsurer and may be domiciled offshore or, increasingly,in states like Vermont and Hawaii. The fronting company usuallyobtains reinsurance above the group-captive layer, up to the limitsof all the policies the fronting insurer issues.

The protection layers of a group captive can be structured invarious ways. One common approach is for each member to have adeductible or self-insured retention for each line of coverageprovided by the group captive. Above this initial retention wouldbe a “dividend” pool, with a size calculated to cover all members'expected losses. Those members whose losses turn out to be lowerthan the projected “loss pick” benefit accordingly. Above thedividend pool is a risk-sharing pool, designed to provide a limitedamount of catastrophe coverage. Most of the risk-taking by captivemembers takes place in this layer. Reinsurance then protectscaptive members from further losses.

Rent-a-captives are specialized captives, usually owned by oneentity, that “rents” individual “cells” of the captive to agents,brokers or program administrators, or directly to insureds. Oneadvantage of rent-a-captives is that they do not require users tocontribute formation capital, although users pay a fee to thecaptive manager that typically runs between 1% and 2% of the grosswritten premiums placed in the facility. Rent-a-captives also aremuch easier and quicker to get into (30 days or less, compared withmonths for an owned captive).

A rent-a-captive uses a fronting insurer, in the mannerpreviously described. It cedes the net written premium, lessexpenses, to the rent-a- captive cell, which acts as the frontingcarrier's reinsurer. The amount ceded, typically 50% to 60% of thegross premiums, becomes the cell captive's loss fund. Aggregateexcess insurance is purchased to protect the cell captive from highclaims frequency, but its attachment point is set well above theamount of money in the loss fund. The difference is the “gap,”which is the layer of insurance for which the agent, broker,program administrator or insureds will be responsible.

Under the rules of statutory accounting, to which U.S. insurersmust adhere, the rent-a-captive is considered a nonadmitted,unapproved reinsurer. (The same holds true for group captives.)Thus, while the insurer will show a liability on its balance sheetfor the potential losses represented by the gap, it cannot show therent-a-captive's contractual obligation to cover those losses as acorresponding asset. Therefore, the rent-a-captive user will haveto post collateral for the gap, typically in the form of a bankletter of credit. This fact has a number of implications,particularly for agents, brokers and program administratorsassuming risk via a captive, as discussed in some of thecommentaries that follow.

John Shea
Tangram Program Managers and Insurance Services

John Shea, president of Tangram Programs and Insurance Services,in Petaluma, Calif., has a dual perspective on the alternativemarketplace. The bulk of Tangram's revenue comes from eightprograms it operates as a typical program administrator. Four ofthe programs use rent-a-captives, making him a user ofalternative-market facilities.

Tangram also provides services to agents, brokers and programadministrators interested in setting up their ownalternative-market facilities. Those services include consulting(on captive feasibility and formation), arranging fronting servicesand procuring reinsurance. Tangram can pro-vide claims andloss-control services through Advance Risk Technologies, a TPA thatShea also serves as president. Tangram assists in the formation ofgroup captives or can refer agents and brokers to rent-a-captivesthat it has worked with.

Shea said he has been involved with captives since the early1980s, when few “Main Street” brokers had any understanding of, orinterest in, captives. Today, he says, “Almost any broker has atleast a working knowledge of how captives and rent-a-captiveswork.”

Interest is particularly high among larger producers, he said.“I would venture to say that half of the large, regional brokers,and certainly all of the alphabet houses, have somebody on staffwho is an alternative-risk expert.”

Why do brokers form group captives or cells in rent-a-captives?The chance to share in underwriting and investment profit certainlyis a motivator, Shea said, but the desire for control is even moreof a driver. By “control,” Shea said he meant not just the abilityto determine such factors as pricing and risk selection but also tocontrol access to a proprietary market. “You wind up with anexclusive market that other brokers are not going to access,” Sheasaid, “and that gives the broker an edge in the market.”

Alternative-market programs tend to be formed for risks that areunderserved or not well understood by standard insurers, Shea said.By creating a captive, a broker often can deliver a better or lessexpensive product than can be found in the open market, he said. Ofcourse, a key attraction for insureds is the prospect of enjoyinglong-term stability and predictability in their insurance costs,rather than seeing those expenses fluctuate with the underwritingcycle.

The first step in assessing the feasibility of a proposedalternative-market program is determining whether it has “criticalmass,” Shea said. It should have $3 million to $5 million ofpremium and, preferably, a homogeneous book of business. “You canput together captives for a heterogeneous book, but it's much moredifficult,” he said. The program also must have an acceptableprojected underwriting profit–at least 5% to 10%, Shea said.

The information checklist for captive formation is fairlystraightforward, Shea said. “You need five years of premium andexposure history, an overview of the exposures and a good marketingplan,” he said. “That's really about it; it's not rocketscience.”

Of course, the agent or broker also must be prepared to investin the program. In the formation of a group captive, the broker andeach insured typically share the initial capitalization costs. Butthe real investment in either a group captive or rent-a-captive iscollateralizing the “gap,” Shea said. If you were to have a $10million (gross premium) program, he said, anywhere from 25% to 40%will be needed to cover expenses, including commissions programadministrators pay to retail agents. The remaining 60% (assumingexpenses are 40%) is the captive's loss fund. Reinsurance kicks inif the fund is depleted, but not until the broker (and sometimescaptive members) has absorbed some losses–the gap.

Shea said the amount of capital required to fund the gaptypically is anywhere from 20% to 50% of the captive's grosspremiums–for example, $2 million to $5 million for a $10 millionprogram. Brokers sometimes do not realize that the gap is not aone-time investment, but has to be collateralized each year(although as losses are developed for each year, the collateralposted for it can be drawn down.)

Contrary to conventional wisdom, Shea said more captives andrent-a-captive programs are formed in a soft market than a hardone. A big reason is that reinsurance usually becomes moreplentiful. That's certainly the case now, he said. “I'm suddenlygetting calls from my friends in the reinsurance market, looking tohelp me put together captive programs.”

Insurers also are more interested in offering fronting services,Shea said. Standard insurers with idle capacity–even those thatpreviously had not been in the alternative-risk business–seefronting as a means for expanding their market share, he said.

All this does present a challenge to agents and brokersmarketing an alternative-risk program, Shea acknowledged. “When theclient wants it the most, there is such a huge demand that it'salmost impossible to put together a captive program that makesfinancial sense,” he said. “When the market is soft, on the otherhand, there isn't that much demand from the standpoint of loweringpremiums.”

Tom Kozal
Arch Insurance Group

Arch Insurance Group's alternative markets division works with avariety of captives, all of which are initiated by agents andbrokers, according to Tom Kozal, senior vice president. It hasestablished single-parent and group captives in which the agents orbrokers have no ownership, as well as group captives in which theydo. Arch, however, does not work with a captive that is entirelyowned by an agent, broker or MGA. “We always want the ultimateinsured to be involved,” Kozal said, adding that in the wake ofinvestigations by Eliot Spitzer and others, Arch would require thatinsureds acknowledge in writing that they are aware that the agentis involved in the captive ownership.

For group captives, Arch does not “give out the pen,” Kozalsaid, which in essence means it likely would not form captives forprogram administrators, although Arch does have a division thatworks with program administrators on deals not involvingcaptives.

Kozal said his typical captive client is a midsize regionalbroker interested in putting a number of long-time, preferredinsureds into an alternative-market arrangement. You might havenine insureds and the broker, Kozal said, who each would own 10% ofthe captive's stock. “We have several opportunities like that onour desk right now,” he said. In such arrangements, brokers canprovide a group of superior clients with lower-cost coverage whilethe brokers also share in any underwriting profit and interestincome.

Kozal said some of his business comes to him via captive“wholesalers.” These are organizations that assist agents andbrokers who are interested in creating alternative-market programsbut don't have the necessary expertise. They include independentoperations like Innovative Risk Management and Garnett CaptiveServices, and subsidiaries of larger entities like GallagherCaptives Services (owned by Arthur J. Gallagher) and InnovativeCaptive Services (owned by Holmes Murphy & Associates).

Whether approached by a retailer or a captive wholesaler, Archtypically functions as the issuing insurer and also providesaggregate stop-loss insurance. For those programs that desire touse a rent-a-captive, Arch owns two facilities, based in Bermuda.Kozal added, however, that the rent-a-captives typically are usedby group-owned captives, rather than those in which the agent orbroker also is an owner.

Arch expects a captive to have at least $3 million in premiumthe first year, and a good chance of reaching $10 million withinthree years. “We also are looking for the individual accounts to befairly substantial–ideally, at least $300,000 to $400,000 inpremium,” he said. Typically, the captive insures the three mainliability lines for its members: workers comp, auto liability andgeneral liability.

Kozal said he has yet to see the softening market significantlyaffect the alternative marketplace. While conditions certainly aresoftening “in the more commodity driven lines … the primarycasualty market is still fairly tight,” he said, especially fordifficult classes like nursing homes, contractors and certainmanufacturers.

While agents and brokers primarily come to Arch to form captivesfor their top-tier accounts, their motivation sometimes is to finda way to cover difficult-to-place risks, Kozal said. He said it'sfairly easy to tell when agents and brokers are simply looking fora place to dump a bunch of poor accounts. “Those (deals) aren'tgetting done,” he said.

Kozal said Arch will take on difficult risks–as long as thecaptive is selective. As an example, he cited a captive forCalifornia house-framing contractors. The captive is run by awholesaler, and multiple retail agents access it through thewholesaler. The group has a tight underwriting committee, which,Kozal said, is its key to success. “In fact, that group'sunderwriting is tighter than ours,” he said. Selectivity isessential, Kozal said. “When underwriting difficult classes, youlook to write the best” in those classes.

Rich Turner
Liberty Mutual Insurance Co.

Liberty Mutual prefers to work with homogenous groups of clientswho are large enough to take on risk, according to Rich Turner,Liberty's managing director of sales for alternative markets.

Liberty Mutual usually does not work with programadministrators, Turner said. Rather, all captive opportunities arebrought to the carrier by agents and brokers. Some coordinate withthe carrier in the creation of a group captive or a cell in arent-a-captive but usually do not join their clients in takingrisk. They may, however, provide the captive with loss control,claims or management services on a fee basis. They are not involvedin underwriting. “We don't give out the pen,” he said.

Large agents and brokers may bring the carrier existing captivesfor which they already provide required services. Small ones, onthe other hand, may have one or more clients interested in formingcaptives, Turner said, but not the resources or expertise to createthem. In that case, the insurer prepares feasibility studies andworks with the agents and brokers to set up and manage captives inappropriate domiciles, he said.

The carrier does not work with captives that are owned 100% byagents and brokers, and in which they retain any underwritingprofits. “I think agency-owned captives in general have taken a bigturn backward,” he said, citing the Spitzer investigation. “Youalso have a number of brokers that by their charters are no longerallowed to participate” in such captives, he added. He said therelatively few insurers still working with agency-owned captivesrequire full disclosure to captive participants.

Turner said he saw a sharp increase in interest in captivesduring the hard market. Even as the market softens, he saidcaptives remain attractive for difficult-to-place risks. Forinstance, Liberty Mutual has created captives to insurehomebuilders' completed operations exposures. “The client is reallylooking to take risk, because the cost of buying the coverage isalmost as large as the policy limits,” he said.

Turner said valid reasons for a business to get into a captiveinclude a desire to control all elements of a risk managementprogram and a belief that the traditional marketplace is wayoverpriced for the participant's liability exposure. A bad reason,on the other hand, is a desire to reduce premiums when one alreadyhas a competitive quote from the traditional marketplace. “What youreally are looking for is a client who says, 'I have done somethingthat obviously has changed the risk factors of my operation, whichis not being recognized by the traditional marketplace,'” hesaid.

Property exposures aren't as well-suited to captives asliability exposures, Turner said, since losses tend to be paidimmediately, meaning there is less time to earn investment incomefrom the loss fund. Captives also are ill-suited for catastrophicproperty exposures, he added. “Captives tend to be most attractiveto predictable risks with high frequency and low severity.”

From an agent's or broker's point of view, one of theattractions of a captive is that a client who goes into one is nolonger interested in shopping its account every year, Turner said.The ability to offer clients captive services also differentiatesagents and brokers from competitors that can offer only traditionaltransfer-of-risk products, he said. Captives are “hands-on”products for insureds, Turner noted, which means the agent orbroker will be more involved with a client's senior management,fostering a deeper relationship. The agent also can offer a numberof fee-based services to lower losses–and the clients will beinterested, he said, “because it's their captive.”

As the market softens and traditional insurers sometimes cutrates below expected loss costs, it becomes harder to set upcaptives for the most desirable risks, Turner said. Nor willcaptive participants necessarily benefit from from smaller “gaps”in such a market, he said. In past soft markets, insurersreinsurers narrowed the gaps by dropping their attachment pointsfor stop-loss coverage, Turner said–and sometimes got burned in theprocess. “I'm not sure what's going to happen in this marketplace,”Turner said. “My guess is that there is going to be morediscipline.”

Greg Lang
Munich-American Risk Partners

While the soft market may be slowing the growth ofalternative-market programs, there continues to be strong interestin them, according to Greg Lang, Munich-American Risk Partner'ssenior vice president for business development and marketing. “Wecontinue to see many new agents coming in and taking risk for thefirst time,” he said.

Munich-American works primarily with program administrators orother wholesalers on the formation of captives or rent-a-captivecells. Thanks to program administrators' underwriting expertise intheir niches, these books of business typically havebetter-than-average loss ratios, Lang said. “Our theory is, Why notshare in some of the fruits of your labor (by partaking infavorable underwriting results), rather than just earn commission?”Munich-American normally looks for homogenous books with $10million or more in premium volume, although Lang said there areexceptions.

Munich-American can issue policies for a captive, work with aprogram administator's existing carrier or ar-range for theservices of a fronting carrier. It can provide aggregate excessinsurance for a program administrator's captive as well as offerthe services of two Bermuda-based rent-a- captives. The program maycover a single line of coverage, but Munich-American also canarrange alternative-market programs for multiple lines, Lang said.On any given program, the company may or may not arrange for claimsservice, captive management services, or even a fronting carrier,he said. “We're very comfortable with the unbundling ofservices.”

In evaluating captive opportunities, Munich-American looksclosely at program administrators' financials to gauge theirability to take on risk. It also looks at their programs' trackrecords to ensure they have been maintaining tight underwritingstandards. “If the program has grown more than 200% during threeyears of a softening market, that could be a red flag,” hesaid.

Munich-American expects program administrators to accept asignificant amount
of risk in their captives and rent-a-captives. For a $10 millionprogram, the “gap” for a program administrator might work out to $1million above expected losses. In the softening market, however,Lang said, the size of gaps may be coming down a bit as reinsurersbecome “a little more aggressive with their aggregate attachmentpoints.”

Like Tangram's John Shea, Lang noted that program administratorshave to collateralize the gap and sometimes don't initiallyunderstand they have to do so every year, as new business iswritten, a phenomenon Lang referred to as the “stacking” ofcollateral. He said they also do not always fully grasp that incasualty lines, where losses can take several years to fullydevelop, the unused collateral for a given program year might notbe returned to program administrators as quickly as they mightexpect. As premiums shot up in the hard market, so did collateralrequirements. Now that premiums are leveling off or even falling,one consolation is that collateral requirements are dropping too,Lang said.

As did some other people contacted for this report, Lang saidthe Spitzer investigation into broker practices has discouraged theformation of group captives owned 100% by retail agents. Withoutadequate disclosure, such arrangements can have an inherentconflict of interest, in that agents could put their interest inearning underwriting profits ahead of their responsibility to gettheir clients the best deal. Captives owned 100% by programadministrators or other wholesalers present no such conflict, hesaid, since unaffiliated retail agents and brokers bring them theirbusiness.

Roger Greiner
Markel/SMART

Specialized Markel Alterative Risk Transfer was founded in July2003 as the platform for the Markel Insurance Group to producealternative risk business, according to Roger Greiner, president.It targets large individual commercial risks, public entities andhomogeneous casualty insurance programs, he said.

Greiner said most of the unit's clients have been programadministrators, although it also works with retail agents andbrokers, reinsurance intermediaries, third-party administrators andinsurance consultants. For program administrators, SMART has helpedcreate group captives and rent-a-captives for habitational risks,restaurants and taverns and assisted living facilities, among otherclasses, he said.
Under the usual scenario, an admitted or nonadmitted Markel companyissues policies for the program, Greiner said. Actuaries thendetermine a program's “working layer,” where most of the lossesoccur, and cede part of it to the captive on a quota-share basis,he said.

Suppose, for instance, most losses amounted to $250,000 or lessfor a captive or rent-a-captive providing $1 million of generalliability coverage to its members. The issuing company might cede25% of the $250,000 working layer to the captive, he said, whileretaining the rest of the exposure. If the total expected losseswithin the working layer were $2 million, then the captive would beresponsible for 25% of them, or $500,000. That would be thecaptive's “gap,” Greiner said, which the program administratorwould be expected to collateralize. Then a Markel company mightretain 100% of the losses within the remaining $750,000 layer ofthe $1 million policies, he said.
Besides sharing in the underwriting profits (or losses) of theircaptives, program administrators are paid commissions based onwhatever functions they may perform for the insurer, Greiner said,which could include rating, quoting, and binding business, andbilling and collecting premiums.

SMART also helps program administrators who operate purchasinggroups, which are entities authorized by federal legislation thatenable multiple, homogenous risks to buy certain kinds of liabilityinsurance from traditional insurers on a group basis. SMARTprovides insurance for the purchasing groups from one of the Markelcompanies, Greiner said, which issues a single policy to the group.The program administrator or wholesaler then issues certificates tothe group's members, affirming their status as insureds.

Greiner said SMART works with retail agents and brokersprimarily on group captives or single-parent captives arranged fortheir clients. The captives generally are created to coverage thegeneral liability, auto liability, and occasionally, specialty orprofessional liability exposures of middle- market accounts.Workers comp exposures are not accepted. Single-parent captives areused for accounts that pay at least $3 million to $5 million inpremiums, Greiner said. Retail agents and brokers generally do notshare risks in these captives, he added, but are paid commissionsfor business placed in these captives, just as they would be forbusiness placed with any insurer.

Excess public entity business is another target market. “As longas there is significant risk-taking on the part of the accountitself, SMART will provide the excess capacity beyond their SIR,”Greiner said. Recently it began working with public entities thatshare their risks in legislatively created pools. “We write areinsurance treaty behind the pool to support an excess layer thatthe pool might need to provide capacity to its members,” hesaid.

Despite a softening market, Greiner expects a steady gain inbusiness. “We're looking for controlled, profitable growth, wherewe can build relationships over a long period of time,” hesaid.

Daniel T. Keough
Innovative Captive Strategies Inc.

Innovative Captive Strategies (ICS) was created in 1999 as anaffiliate of Holmes Murphy & Associates, a large privately heldregional insurance broker in Des Moines, Iowa. Dan Keough, theorganization's president, said ICS initially was formed to giveHolmes Murphy the ability to offer captive services to its ownclients. It has since expanded its scope to provide such servicesto other agents and brokers. ICS typically works with retail agentsand brokers having $10 million to $100 million in revenue, Keoughsaid, but to date has not worked with MGAs or programadministrators.

While ICS has at times worked with 100% agency-owned captives itmore frequently works with member-owned group captives, Keoughsaid. They tend to be created for homogenous middle-marketbusinesses that use them mainly to insure common liabilityexposures, including auto liability, workers compensation andgeneral liability. ICS also helps form single-parent captives forlarge businesses, he said, those paying $2 million or more forinsurance. Such a large business also might use a rent-a-captive toseparately insure unusual or difficult-to-place risks, headded.

ICS functions as a consultant and facilitator ofalternative-market programs, generally taking no risk itself,Keough said. An agency might approach ICS, for example, for help increating a member-owned group captive for contractors, Keough said.ICS would prepare the necessary feasibility studies, presentproposals to potential fronting companies and excess insurers, andarrange claims management and other services if necessary.

Most agencies come to ICS by referral, Keough said. Theseagencies have close working relationships with clients they placewith traditional insurers, he said, and they also want to beinvolved in their clients' alternative-market programs. An agencyworking with ICS typically sits on a captive's board and on itscommittees, and sometimes shares its risk, he said.

Keough said agents' interest in captives and similararrangements increased during the hard market, as insureds soughtalternatives to the higher premiums and reduced coverage offered bytraditional insurers. “Customers wanted more control,” he said.That is still a motivating factor, he said; another is EliotSpitzer. The New York attorney general's attack on contingencycommissions has led some agents and brokers to wonder whether theyeventually might disappear under pressure from regulators ormiddle-market clients. As a hedge against that possibility, someagents and brokers are looking for revenue options that createvalue for clients and in which all charges are transparent.“Captives met both those criteria,” he said.

Christopher Payne
Aon Alternative Risk Underwriting

According to Christopher Payne, now is a good time for agentsand brokers to explore alternative-market options with theirclients. Payne is president of Aon Alternative Risk Under- writing,which is part of Aon Underwriting Managers. ARU facilitates thecreation and operation of agency-sponsored, insured-owned groupcaptives. A typical group captive might provide workerscompensation, general liability and business auto insurance for 10to 50 midsize clients, paying an average of $700,000 in annualpremiums. Aon Alternative Risk usually arranges these captives forsponsoring midsize and larger brokers, and occasionally for smalleragents.

Payne said the number of available fronting markets has expandeda bit, as insurers that had pulled back during the hard market nowentertain new opportunities. Reinsurers also are more interested ingroup captives, he said. Some formerly might not have taken thetime to grasp the difference between them and program business, “inwhich an MGU might try to write a few thousand doctor's offices,”he said, but that's no longer the case.

Pricing for reinsurance and other components ofalternative-market programs also are softening a bit, along withthe market in general, he said. Because of Hurricane Katrina, groupcaptives insuring property exposures aren't going to see areduction in reinsurance costs any time soon, Payne said, but onthe other hand, “I think there's a lot of capital out there, so Idon't see this turning the market.”

Payne said that when markets soften, some new players willbecome “reckless” with pricing, “but I think the more intelligentbuyers will see past that and say, 'Look, this is still a lot moreattractive than what I've paid historically.'” Also, he said, suchaccounts will continue to be drawn to the concept of controllingand investing in their own insurance programs, rather than “writinga check to somebody.”

All in all, Payne said, today's market offers agents and brokersa low-pressure environment in which to talk about group captives toclients who are interested in opting out of a cyclical insuranceindustry and large enough to finance their expected losses.