Befitting its financial impact on a company's bottom line, large corporations have long had options as to how they secure their required workers' compensation coverage. Employers seeking maximum control and/or cost savings in their insurance programs often select self-insurance or large deductible plans.
Self-insurance programs, while providing maximum control, come with their own set of administrative challenges. An employer must obtain regulatory approval for self-insured status in every state in which it operates. In many states, the application process is fraught with bureaucratic delays, political maneuvering, and irregular rules and regulations. Self-insurers with exposures crossing state boundaries sometimes have problems managing their collateral requirements over such a widely dispersed arena of regulators.
Large deductible workers' compensation plans are popular because they offer most of the advantages of a self-insurance plan, but are typically insured by a licensed insurer, which reduces red tape. Deductibles can range from $100,000 to $1 million per any one loss. Insurance companies charge a deductible premium, which is often discounted as much as 80 percent from the manual premium and the actual cost of claims as paid. Most services are included in the deductible plan on a bundled basis. Because the insurer is statutorily responsible for paying claims, a letter of credit or other acceptable liquid collateral is usually required to secure the insured employer's payments of its share of expected ultimate losses. However, while there are many advantages of large deductible plans, risk financing for the deductible can be problematic.
An attractive alternative to these programs may be a combination of the best from both — a captive/deductible plan. Combining a high deductible plan with captive risk financing provides a fuller solution, more control, greater flexibility, and potential tax savings. Insured companies get more control over their workers' compensation program with large deductible plans through greater retention of risk. The large deductible reduces residual market loadings, premium taxes, surcharges, and assessments. The employer has more incentive to control losses because it directly benefits from favorable loss experience. The insured company also controls more investment income. In addition to the significant economic benefits, a hybrid program is a powerful strategic risk management tool.
Specific advantages of a captive/deductible plan include:
Transfer of liability. With a captive/deductible plan, loss reserves and liabilities are moved from the parent's to the captive's balance sheet. The captive/deductible plan can provide a long-term solution to both current and future insurance issues. Once running, the captive is free to write other lines of insurance. That flexibility may not be important today, but it could be crucial in the future, as the business and/or insurance market changes. The captive also provides stability and leverage against premium increases.
Tax deductions and savings. If structured carefully, a company and its affiliates may be able to take a deduction for premiums paid to the captive. Without a captive, only losses actually paid are tax deductible. Furthermore, the captive can deduct its loss reserves and incurred-but-not-reported losses.
Greater control. The risk manager can better control administration, claims management procedures, and loss prevention programs with a captive. Even litigation and subrogation can be managed more effectively.
Greater flexibility. The deductible can be changed — up or down — in response to market conditions or corporate needs. The captive's ability to place reinsurance directly also adds flexibility to the retention levels and reduces costs. Once the captive is operating, it is not limited to workers' compensation. Conversely, if the company already has a captive that is active on other lines, it can be coordinated with a large deductible workers' compensation plan.
Better allocation of risk management costs. Costs can be compartmentalized, and the risk management department can become a separate cost center with a captive. Some companies actually transfer their entire risk management department and its payroll to the captive, enabling the risk manager to more clearly document the department's bottom line contribution. In addition, the captive makes it feasible to unbundle services. The risk manager can then select the most cost-effective providers of specialized services.
Precise description of expenses. Insurers are usually much more candid about what the deductible premium buys in a captive/deductible plan. The insurer should be able — and willing — to offer details on how much of the fixed cost is allocated to administration, excess reinsurance, premium taxes, workers' compensation boards and bureaus, and residual market loads. If an insurer is reluctant to provide such a breakdown, then buyers would be well advised to take a look at what the competition offers.
Solid risk funding. Deductible reimbursement or loss fund premiums are paid to the captive, which can build its reserves over time. This pool of money assures a solid source of funding for potential losses. Claims and loss adjustment expenses are paid from the captive's reimbursement policy premium funds. This is a better system than simply paying losses from the corporate treasury, where the volatility of a shock loss or series of large losses can adversely affect corporate earnings.
Running the Numbers
An example of how this type of arrangement works: Best Ever Company and its affiliates and subsidiaries take out a large deductible workers' compensation policy with XYZ Insurance. The coverage is statutory for Part A, with $500,000 limits for Part B. The deductible is $500,000 per occurrence. The estimate standard premium would be $2 million. In contrast, the deductible policy's premium is just $540,000. The deductible policy premium is usually billed monthly. Typically, insurers collect a small escrow loss-development fund to cover expected paid losses during the first month of operations.
Best Ever and its subsidiaries form a Vermont-licensed captive called Best America Insurance Co. to insure its workers' compensation losses. Best America Insurance issues a deductible reimbursement policy to insure losses up to $500,000 for each occurrence for Part A and Part B coverage. The reimbursement premium of $1,460,000 (also billed monthly) equals the difference between the standard premium and deductible premium. This goes into the captive's reserves and earns investment income.
Claims charged to the policyholders, Best Ever and its subsidiaries, are reimbursed by the captive, Best America Insurance. Best Ever's liabilities are transferred to Best America's reimbursement policy.
Additionally, Best America Insurance purchases reinsurance directly for a layer of $250,000 excess of the $250,000 for each occurrence. This further limits the captive's risk. By directly placing reinsurance, Best America Insurance and its parent(s) have reduced their cost of excess reinsurance by the amount of ceding commissions normally added on by the deductible insurer. Successful negotiations with the deductible insurance carrier can also limit the amount of security or collateral required.
The savings in direct placement of reinsurance, favorable tax treatment, and greater control can far outweigh the expenses incurred to set up and run the captive. In addition to the economic benefits, it also gives the risk manager a strategic risk management tool. The plan can be a platform for flexible, effective responses to future challenges.
These alternative options are moving into the mainstream as more clients learn about them and seek them out. The broker or agent who helps a client launch an alternative insurance market program gets in on the ground level and gains a lasting edge over the competition.
Michael T. Rogers is chairman and CEO of Risk Services, LLC, in Sarasota. Risk Services specializes in program business for the alternative insurance marketplace. More information is available 800-226-0793 or www.riskcompanies.com.
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