A captivating possibility

Our clients have posed this question countless times to our team at Commercial Insurance Associates LLC (CIA): “Our company has not had claims; why are our insurance premiums increasing?”

Because insurance is typically a top-three expense on a profit and loss statement, more companies have wondered, “What can we do about it?”

As insurance professionals, we always respond with, “Look no further than a captive.”

What are captives and how do they work?

Captives are a way to escape the ebbs and flows of the standard insurance market and stop paying for the losses of bad operators that are being passed through as increased premiums year in and year out.

Three types of captives are most common.

Single-parent/pure captives are the most widely used captive structures today. This is an insurance company owned by a single insured entity. It provides some risk financing or risk transfer for corporations. In most cases, it is not permitted to write insurance for parties other than for the insured entity that owns it.

Typically, these types of captives are used by larger companies to insure against property and casualty risk and to provide employee benefits. They typically are tax-advantaged.

Insureds or corporations that own these captives typically need to capitalize them so that they have sufficient funding to bear risk.

The next option is a rental captive, which is capitalized already by a corporation, captive manager or insurance company. It allows an insured company the ability to transfer risk to the captive by paying a premium.

Unlike with a single-parent/pure captive, no upfront capitalization costs are required; however, the annual continuous cost to a company is higher.

Group captives are the third option, and they are either homogeneous captives or heterogeneous captives.

Homogeneous captives are comprised of member companies from the same industry. Because all members have similar insurance and risk management needs, coverage and loss control can be tailored to each captive’s specific industry needs.

Heterogeneous captives are comprised of member companies from diverse industries that can range from scrap metal recyclers to libraries. The resulting risk diversification and spread of risk are why our agency highly recommends heterogeneous captives.

Business owners who want to join a captive need to be safety-conscious, accountable and have a strong balance sheet. Losses, safety culture and corporate culture are heavily scrutinized during the underwriting process, and only the most well-ranked businesses are accepted.

What do captive costs pay for?

New member costs include an “A” loss fund, “B” loss fund, reinsurance, claims administration, loss control and other operating expenses. Collateral also is required in the form of a letter of credit or cash, which can be paid out in three equal installments over three years.

The “A” fund provides for frequency losses of up to $100,000. These losses are small, low-cost frequency events that members are required to pay to the loss bucket, with prefunding determined by the captive.

The “B” fund provides for more serious losses ranging from $100,001 to $500,000. This layer is considered the “Black Swan” event fund. The “B” fund pays for catastrophic claims should they occur and also is subject to risk sharing in the event that other members’ funds have been exhausted.

Captives are fronted by A.M. Best “A”-rated insurers. Any loss over the “B” fund loss limit will be paid out by the reinsurance markets.

If a member company were to exceed the actuarial projections, a stipulation for assessment is built in. This helps for two reasons: ensuring adequate funding and creating an incentive for members to focus on loss prevention and claims management.

Privacy is an added benefit of the fronted insurance paper; when certificates of insurance are issued, they do not reference the captive, so no other company will know that your company is a member.

Advantages of captives

CIA has put dozens of our clients into captives, and the success rate has been phenomenal. Our clients love captives for a variety of reasons.

Given the rigorous underwriting process, captives can be incredibly economical, saving a company money on its auto liability, general liability and workers’ compensation programs. The underwriting method allows the captive to estimate the total amount of losses accurately and charges a commensurate premium.

In addition to saving on liability and workers’ compensation, based on CIA’s data, long-term captive members have been able to improve their claims experience. The reduction of losses and premiums also has resulted in below-market pricing for umbrella and excess liability layers in the standard insurance marketplace.

Captives employ third-party administrators who are assigned only to the specific captive. These administrators are restricted on the number of claims they can handle, which is usually up to 50.

Unfortunately, in today’s post-COVID-19 age, the workforce has been slow to return, leaving companies short-staffed, including standard market claims adjusters who are forced to juggle up to 200 claims at a time. Standard market adjusters are slow to respond and quick to pay out, which leads to larger-than-necessary losses.

Members of a captive work every step of the way to help keep claims costs down and fight claims that are identified as fraud. They are given an online portal where they can check on the status of a claim, day or night, 365 days of the year.

Captive members are provided with a loss control program tailored to their business. An annual, two-day risk control workshop focuses on relevant issues facing environmental, health and safety experts. Risk control webinars are provided monthly that review safety, loss prevention, claims management and more. Personal loss control consultants also are assigned to members to provide a full audit of safety programs, review early return-to-work programs, conduct mock department of transportation audits, provide mock Occupational Safety and Health Administration site visits and many other safety-related tasks.

Turning a liability to an asset

Standard insurance market premiums are considered a sunk cost for well-run, safe businesses because they have no incentive to continue safe practices with their premiums going up year after year.

Captives are wonderful in the sense that they are truly an investment, and members can receive tax-advantageous dividends after three years. The dividends can be distributed into a trust for personal reasons, reinvested into the businesses or applied to future premiums. Year over year, companies in our captive programs have outperformed the S&P 500 in investment income percentages, another great benefit of being a captive member.

Captives are an outside-the-box method to escape the standard insurance market. They provide well-run firms with benefits such as cost savings, risk management and return-on-investment income.

The author is director of mergers and acquisitions at Commercial Insurance Associates LLC of Brentwood, Tennessee. He can be reached at cskufca@com-ins.com.