Captive Audience

Through captives, brokers can become strategic partners and not just vendors. Under captive arrangements, clients become stakeholders in their insurance program, allowing them the opportunity to collect underwriting profits.

Traditionally, captives have been a hard-market strategy for Fortune 500 companies, especially when capacity is scarce and prices are high. But today's market is rewriting the textbooks. We are seeing some of the traditional factors that influence a hard market in play, yet overall pricing remains low as companies are slashing fees to secure and retain business. In addition, new captive arrangements are expanding the option to the small and midsized market. However, a look at overall industry experience helps highlight where the market could be going in the near future.

According to the Property Casualty Insurers Assn. of America (PCI), the property-casualty industry's profitability in 2009 increased by 5.8 percent, compared with just 0.6 percent in 2008. The industry's combined ratio, which determines insurer profitability by valuating the claims and expense ratio, improved to 101.2 percent in 2009, down approximately 3.0 percentage points from 2008.

Overall, the property-casualty industry rebounded in 2009 with net income increasing tenfold to $30.6 billion from $3.8 billion in 2008. Improved underwriting results can be attributed to the following:

• 

• Fair pricing and contract terms
• Timely and accurate financial reporting services
• Assistance with banking services (trusts, letters of credit, collateral accounts)
• Expertise in reinsurance contracts, trust agreements and insurance programs
• Location in a domicile that has favorable protected cell laws; a stable and captive-friendly environment with a strong history of successful captive programs, and good local service providers.

One emerging option within the rent-a-captive arena is the ability to share risk with vendors. Under this arrangement, the TPA or other vendor agrees to accept some of the risk and share in potential profits. The approach creates tremendous incentive for all parties to control risk throughout the enterprise while it further increases the sponsoring entities bottom line.

Looking at the big picture

While there are a number of benefits to emerging captive options, such as risk-sharing and rent-a-captives, brokers must look at the big picture and ensure that their clients have the commitment and organizational profile to make a captive arrangement work. The advantages of captives include:

• Risk-sharing captives eliminate barriers of entry; there are no formation costs; virtually any size organization–as well as those with limited capital–can participate in the captive
• Agencies can help their clients turn dollars that were once spent on premiums into profits–a benefit for the client and a valued service line for the broker
• Profit potential for the agency; if the agency takes risk in the program or if the agency creates its own agency captive, they too can share in the profits
• Increased synergies between all participants–client, broker and TPA. Everyone is working together to reduce risk, improve quality and lower costs
• Protection for brokers from the inevitable hard market.

For many organizations, one of the primary advantages of a captive is that it provides the program sponsor with greater control, particularly within claims processing. In traditional insurance programs, clients, especially smaller organizations, have little say in how, why or even when claims are settled. With a captive, the client and captive participants can work together to determine the parameters they believe are best suited for their organization.

In the standard program for a small to midsized group program, the captive takes the first level of risk, typically about $300,000. The captive then has the reserving and settlement authority. The captive is responsible for bringing in attorneys and consultants to settle claims if needed, whereas a large insurer might just pay. The captive managers also develop the anti-fraud and safety programs. The collaboration and coordination has helped captives with aggressive claims management and strong safety programs drive down the average claim cost to about 40 percent of the industry standard.

Such results do take more work and involvement from the client and program manager. Frequently organizations using captives are directly involved in developing best practices and even accident investigations, areas that in the past were often left for the insurer to manage. Claims are typically handled much more aggressively; the focus moves toward behavior-based safety, training, prevention and detection.

Within a rent-a-captive or group arrangement, a strong degree of "peer pressure" exists as everyone is a stakeholder. The best captive programs include quarterly claims reviews where members share results and best practices. For example, one member of the group may have a strong accident investigation program, and another may have expertise in litigation. Together, they can help to strengthen and improve the entire program.

Because group captives share the risk along with the profits, they also must be charged with a high level of selectivity. Participants in the program should be chosen based on several key steps, including:

• Strong entrepreneurial philosophy–A management team that wants to get involved in all aspects of the business.
• The nature of the participant's industry–It is possible to mix industries within a group or rent-a-captive program, but the overall characteristics of the group must be similar. For example, it is not recommended to mix a company in the retail industry with one from trucking as the nature of the risk is too diverse.
• Shared safety and claims management culture–Because the actions of one company will impact all others, each organization must share similar goals and commitments to programs. A commitment to safety and loss reduction is key.
• Willingness to change and adjust to meet the needs of the group–Flexibility and a commitment to helping the overall group drive down costs are important attributes.
• Risk history to date–Clearly, any company can lower its risk, but until a company shows that commitment, it probably should not be included in a group
  captive model.
• Strong hiring practices-In today's market, employers can and should be more selective to ensure all employees have the skills and ability to learn tasks that will help improve safety.

When risk partners are chosen carefully within a group, average loss ratios can be lowered significantly. For example, one risk program for a captive for small to mid-sized franchisees was able to drive its loss ratio to 16 percent, compared with the average of 45 percent to 60 percent for most of the industry. Some captives have been able to drive loss ratios even further (see "Captive success" sidebar).

Potential drawback

However, for some, the very factors that may benefit some organizations can be considered negatives by others. Captives require strong involvement from their sponsors. In traditional insurance programs, the company simply turns over all aspects to the insurer with little involvement other than occasional reports.

Captives are not a strategy for short-term savings. They require a commitment, time and work from the sponsoring organization.

Brokers and plan sponsors must remember that there is risk. Poorly managed programs, or those with the wrong mix of participants, can lead to significantly greater risk that could negatively affect an organization's bottom line.

In today's market, where carriers actively court business, it is difficult to turn away from the aggressive pricing programs they offer. The more value-added services a broker can offer, and the more programs that match the needs and personality of the client, the more likely the broker will be able to secure and keep clients.

Steps to success and real-life examples

Because a captive is in effect a "mini insurer," there are a number of programs and processes that must be implemented. Strong management is vital to the success of a program, as is selecting vendors and partners that share the commitment to better outcomes and lower costs. Group and rent-a-captives will need to provide:

• Strong TPA services for claims management
• Innovative and effective safety programs
• Medical cost control
• Case management
• Accident investigation
• Aggressive subrogation
• Fraud detection
• Litigation management
• Tax preparation and filing
• Regulatory research and review.

An example of how captives work in real-world settings is evident in the experience of a restaurant franchise in southern California. There was a grease fire at one of the restaurants participating in the captive. Rather than simply paying the claim, loss control worked with claims to identify the cause of the fire. They went to every store in the chain and collected data, including all vendors used for cleaning. It was discovered that a cleaning contractor did not properly clean the vents. The captive was able to have the claim subrogated to the contractor's insurer. This intense review not only protected the captive's funds, it provided a valuable safety lesson that was shared with other program participants, potentially preventing further claims.

Captives, and especially rent-a-captives, must have a strong reinsurance partner whose role is to assume a defined share of the group's risks. Finding the right reinsurance partner helps provide the security and assurance clients need to proceed with captive arrangements. Although reinsurers are not subject to the same state regulations as primary insurers, they must have the strength and a minimum of an A-rating to provide the protection the captive needs.

Captive participants also must provide proper program oversight. Captive managers should demand quarterly reports and analysis from their vendors, and meet frequently to review findings, identify problems and share best practices. Remember that within a captive, every participant can provide added value.

Viable options

Despite current economic uncertainties, captives are viable options for agents and brokers, helping to create more meaningful and lasting partnerships with their clients and to distinguish their product offerings from competitors. A well-managed captive program can reduced risks, lower costs and create greater revenue to the organization's bottom line–valuable benefits in today's marketplace.

Rick Stasi, COO of Alternative Risk, a national claims and risk management service provider, is responsible for overall operations of the company's alternative risk programs. Stasi can be reached at rstasi@avizentrisk.com.

Everett Newman is a managing partner with United Alternative Risk Solutions LLC, an affiliate of United Agencies. United Alternative Risk provides captive formation and program management services on a national basis. Newman can be reached at enewman@unitedagencies.com.