Will Cheaper Insurance Undermine Captive Growth? Soft market should not be only consideration for buyers
The hard property-casualty market of the last three years brought triple-digit rate increases in some lines of coverage and capacity shortages in others, sparking the formation of many new captives. A return to a softening market, however, might soon make captive formation less appealing.
Although captives take market share away from traditional insurers, the reinsurance market benefits as the captive market expands. In addition, the growth of the captive market opens opportunities for traditional insurers to offer services such as claims and captive management.
Besides forming captives to obtain coverage that may not be available or affordable in the traditional market, organizations use them to reduce the overall cost of risk, control cash flow, gain flexibility in coverage design, gain direct access to the reinsurance market, and incur lower taxes. Since 2001 these advantages have spurred captive growth in three primary areas: traditional primary casualty risks, other p-c risks and employee benefits.
Traditional risks such as workers' compensation, commercial general liability and auto liability are often insured through captives. However, today they are also increasingly being used for property, business interruption, directors and officers liability, errors and omissions coverage, environmental liability, employment practices, and various financial risks.
Employers' increasing use of captives to insure employee benefits at lower cost is being driven by a Department of Labor requirement that employers use a qualified insurer and reinsurer (in this case, the captive operates as the primary insurer to access the reinsurance marketplace) to secure long-term disability, group term life and medical stop-loss coverage.
As pricing pressure eases, however, companies will need to weigh the pros and cons of using a captive, bearing in mind that in a soft market, commercial insurance policies can often be less expensive. The following strategies may be used simultaneously:
Continue to self-insure present exposures.
Some companies will continue to insure their existing exposures through the captive, even though less costly short-term solutions are available in the traditional market.
For example, a company that insures employee benefits in the captive may decide to keep its p-c risks there as well, in order to keep enough premium in the captive to obtain the accelerated federal tax deduction. Coverage design may also be more favorable in the event of a loss due to specially designed policy provisions.
Optimize existing insurance exposures.
In a soft market, the parent and its subsidiaries may stop writing new business in the captive. Here, the strategy is to efficiently run off old claims at or below reserve levels, optimize investment returns, and transfer selective runoff exposures to a third party through a loss portfolio transfer.
The goal is to keep the lines of business that are doing well, while selling nonperforming lines. Many insurers can be competitive in bidding for runoff claims since they believe their claims operations give them the opportunity to settle claims below projected claim case reserves.
Stop insuring renewals and run off existing policies.
Alternatively, the captive could be placed in a dormant status, and some lines of business could go back to the commercial market. This "dormant" strategy takes advantage of commercial insurers' aggressiveness in the soft market by negotiating premiums that are below the cost of the captive operation.
Dissolve the captive.
Dissolution is usually a last resort when the company doesn't foresee any benefits to having a captive and doesn't want to continue paying annual operating costs and committing capital to the captive facility.
The company will have to negotiate the dissolution with the domicile regulator. Elimination of the captive may also leave the parent with risks that remain uninsurable in the commercial market.
In choosing among these alternatives, the key is to obtain a clear picture of both near- and long-term market forecasts and select strategies appropriate to the organization's tolerance for both risk and volatility.
A long-term solution may be inappropriate for a short-term problem. For example, dissolution may not be the right answer if some risks can't be covered, or if the cycle is expected to be short and shallow.
Bruce Zaccanti, bruce.zaccanti@ey.com, is a senior manager in Ernst & Youngs Insurance and Advisory Services practice. Peter Rossow, peter.rossow@ey.com, is a manager.
Reproduced from National Underwriter Edition, August 19, 2004. Copyright 2004 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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