Middle-Market Buyers Eye Captive Option

ABC Corp is a small manufacturer with annual premium of $500,000$300,000 in workers compensation, $100,000 in general lines and $100,000 in commercial auto. Its losses (all lines) have averaged $150,000 over the past five years. It is probably not large enough to take a high deductible and has not found many paid loss retro options.

The group captive program would take about 50 percent of the "ground-up" premium$250,000and transfer it into an "A" fund.

The "A" fund is contractually held separately for the insured and is used to pay claims in the first layer of, say, $200,000 per occurrence.

Ten percent of ground-up premium, or $50,000, would be allocated to a pooled "B" fund.

The "B" fund would be used to pay all member insureds claims in the layer from $200,000 to $300,000.

The member posts additional collateral of one times "A" ($250,000) in the form of a letter of credit.

The combination of all the "A" fund money, "B" fund money plus the collateral is at risk as the carrier will set the aggregate stop loss at two times "A" plus "B."

The remaining 40 percent is the expense load covering fronting, taxes, commissions, third-party administrator fees, reinsurance excess of $300,000 (to statutory for workers comp, to $1 million for general lines and AL) and the aggregate stop cover.

The key to the program is the losses. Here are a few examples highlighting the risk separation and risk sharing that exists:

ABC has $150,000 in losses, which is lower than the $200,000 per occurrence limit. In this scenario, the $150,000 is paid out of the "A" fund, which has a remaining balance of $100,000. Assuming the "B" fund is not exhausted, the balance is available to be returned to the insured after an agreed upon time for losses has elapsed.

ABC has $400,000 in losses, all of which are less than $200,000. This exhausts the "A" fund ($250,000) so the next source of funds tapped is the companys contribution to the "B" fund ($50,000), and thirdly the remaining $100,000 of losses is paid for by the member either by a cash contribution or a drawdown on the LOC. None of the other members contribute to ABCs losses.

ABC has $600,000 in losses, with one at $500,000 and one at $100,000. This example has $300,000 of losses in the first-$200,000 layer which is covered by the members "A" and "B" fund balances, $100,000 in the $200,000-to-$300,000 layer which would be paid for by the "B" fund, and $200,000 in the excess-of-$300,000 layer, which is picked up by the carrier.

The other loss issue is the catastrophe scenario. If there is $10 million in total funds, this puts $1 million in the "B" fund. If this balance is exhausted, the members will first have a collateral call, and if the losses are really out of control, the last call would be on any remaining "A" fund balance. It is important to members that they know they cannot be asked to contribute any more than their premium plus collateral.

So this is the theory behind these programs. The question is do they work, and are they a viable option for middle-market business?

Among the advantages:

Total premium is tax deductible as there is clearly a considerable amount of risk sharing in the program structure.

The downside is capped at two times "A" plus "B." There is no assessment provision and no joint and several liabilities.

Potential for return premium from your own "A" fund and a group dividend from the "B" Fund.

Unbundled services allowing for greater say in loss control and claims adjusting.

Among the disadvantages:

There is a heavy expense load with promoter costs and complex structure accounting.

There are substantial collateral requirements, which will mean pyramiding LOCs, usually for up to the third year.

There are heavier cash flow requirements than retros or deductibles.

Risk sharing of losses could eliminate return premiums.

The potential for reducing premiums by controlling losses is obviously the key advantage, and if the promoter and fronting carrier maintain underwriting discipline there should not be a need for members to be paying out loss calls over and above their "B" fund contribution.

The "B" fund was designed to handle to occasional shock loss that will occur and also to handle accounts where the "A" fund may not cover the single occurrence limit. With the "B" fund and the carrier providing excess over $300,000, it would be major frequency issuesnot shock lossesthat would create problems for these group captives.

We have found that this structure, with its expense load and collateral requirements, may not be the best alternative for accounts with minimal or no losses. These accounts should receive excellent schedule credits or be offered deductible or paid retro plans which have less onerous cash flow and give immediate loss recovery. The accounts that use the group captive mechanism have loss ratios from 30 percent to 45 percent and are often manufacturing or construction risksor in other words classes of risk with a little (rather than a lot of) "hair" on them.

The marketing of these programs has been to promote the "group" component and encourage the members participation in board meetings and committees that have some say on underwriting, claims and investments. This is sometimes enhanced by meetings held in attractive locations such as the Caymans, Mexico and the Bahamas. The reason I question the group motivation is that these programs are still greatly controlled by the fronting carriers and promoters, so member participation may be more perception than substance.

The availability of loss-sensitive programs for the middle market is an exciting outreach of the alternative risk market to smaller accounts. However, the warning I give to participants is to gain a solid understanding of the expense structure and the loss allocation methodsbe sure there are no undue profit margins for some entities to the detriment of your loss fund balances and collateral posting requirements.

If you have the option of active participation on the board and committees, find out how much say the non-promoter board members can have and check the expenses of these meetings to see if they are excessive. Make sure you are comfortable with the quality of fronting carriers and know the reputation of the promoters and their standing in the industry.

A/B fund group captives are an innovative option for middle-market accounts, but the catch-all is "caveat emptor"let the buyer beware! Make sure you understand what your obligations are, the total collateral picture and what the returns can be.

Gary Osborne is senior vice president at USA Risk Group, a captive management company, in Burlington, Vt.

Reproduced from National Underwriter Edition, January 20, 2005. Copyright 2005 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.