Captives May Not Be 'Time Bombs,' But Buyers Must Beware Minefield

A mini-brouhaha erupted earlier this month over a quote in a Wall Street Journal article about alternative risk financing, suggesting that “captives are a time bomb waiting to explode.”

The president of the Captive Insurance Companies Association, Carl Modecki, didn't take that blow lying down. He lashed back at the employer of the quote's source with a letter demanding “an immediate retraction.” He argued, quite correctly, that “the use of a captive, in and of itself, is not inherently riskier than purchasing insurance in the open market.”

The author of the juicy quote was Donald Watson, who at the time of the Journal interview was Standard & Poor's managing director for insurance. (He left S&P shortly thereafter–not because of his quote, but to accept a new position as enterprise risk manager at ACE Ltd.)

Mr. Watson has for years been one of our most reliable and insightful sources, particularly on reinsurance. He is truly one of the bright lights in this industry. But was he on target about captives being a “time bomb?” Yes and no.

S&P had the same measured response to CICA's letter. In an interview with NU, Robert Partridge, who is taking over Mr. Watson's responsibilities as managing director of S&P's insurance ratings group, said Mr. Watson's quote “needed some clarification.” He went on to explain that captives “in and of themselves can be as efficient and as effective as primary insurance companies,” but he added that this was only the case “if they're well run and well managed.”

Exactly the point. We agree with Mr. Partridge that “there is nothing structurally wrong with captives as a risk mechanism,” but we also second his caveat about competence in managing self-insurance vehicles.

Before the capacity crunch began, an entire generation of risk managers (and brokers and underwriters, for that matter) was raised in a seemingly bottomless soft market. Coverage was readily available, cheap and broad. There wasn't nearly as much incentive to go to the trouble and expense of starting up a captive or establishing some other self-insurance vehicle.

Now, however, as buyers have their backs against the wall, desperate to keep insurance costs under control, many might rush into captives or self-insured retentions. That's laudable–risk managers should take control of their own destiny, instead of leaving themselves at the mercy of the market.

However, the key is to know what you are doing. For example, will buyers who are used to paying “X” for coverage, seeing their renewal quote soar to “Y,” mistakenly believe they can self-insure the coverage themselves for the same “X” they paid an insurer last year or the year before? Not in this roller coaster stock market, they can't. And if reserving isn't responsibly handled, a captive could come up short when faced with a claim. Plus, reinsurance is much harder to come by.

Perhaps that is what Mr. Watson meant by his “time bomb” analogy. In any case, brokers who take their clients into the new world of captives and self-insurance had better make sure they are prepared for a worst-case scenario, because insurance is a minefield for those who accept risk for a living.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, August 26, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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Captives May Not Be 'Time Bombs,' But Buyers Must Beware Minefield

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