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IV. The Pluses and Minuses of Captives

August 1, 2002
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By John A. Wright, CPCU, CIC
IV. The Pluses and Minuses of Captives by John A. Wright, CPCU, CIC During times of rising insurance premiums and difficulty in finding insurance coverage at all, insurance buyers have looked at captive insurance mechanisms as a possible saving option (see sidebar for an explanation of terms used in this article). The problem is that these concepts can seem at times mysterious and overly complicated, and can be perceived as the "magic bullet" that will solve all insurance-purchasing problems.

No doubt there has been significant movement into captives over the past 15 to 20 years, with market-share projections indicating that the captive premium volume exceeded 50% of total risk-bearing premiums in the United States. As always, though, it is critical to balance the advantages of captives with their downside. Just as insurers fail because of mismanagement or improper utilization of capital, captives have suffered the same fate.

It is important always to keep in mind that a captive is strictly a risk-financing technique designed to pay claims and expenses on behalf of its policyholders. Some of the litigation trends that have contributed to the crisis for healthcare facilities, particularly in Florida and Texas, will not be mitigated by alternatives such as captives. Captives do not inherently eliminate exposure to litigation and claims, although members' increased focus on loss control and risk management can improve outcomes (as would be true of insurance programs, as well).*

Nevertheless, there are many advantages to captives. They are designed to be a long-term solution for providing insurance coverage that is not entirely dependent upon insurance company swings in the marketplace. The ability to dampen the external factors that affect insurance companies' decisions on how they allocate their risk-based capital to maximize shareholder return can provide more stability to captive policyholders over time. Captives can be structured in a very focused approach to provide tailored services on clearly defined issues that are prioritized by the policyholders themselves. The traditional captive approach involves selecting providers based specifically for their expertise within their specialties . Beyond this, claims services, loss-control services, legal defense and captive services can be evaluated and negotiated separately. Captive insurance
companies might seem
to be a way out of the
liability insurance
crisis, but a careful
approach is justified.
The financial aspects of captives can be beneficial to the policyholders, as well, since the underwriting profit and investment income on cash balances, including loss reserves, are credited to policyholders' accounts. The premiums charged by captives are not market driven (some policyholders suspect that the insurance industry is overcharging current premiums to cover prior years' shortfalls, to recover those losses as quickly as possible), but rather are actuarially driven by analysis of the captive parti-cipants' financial situations.

If homogeneous captives are formed, the potential of partnering with facilities having similar missions and attributes can lead to the growth of best-practice intangibles within the group. In long-term care, the focus can be upon such appropriate issues as resident standards of care, rather than upon a marketplace search for premium reductions. Facility management and employees can develop a commitment to loss prevention and safe practices that can evolve into a stakeholder mindset. Specific compliance programs can be developed, understood and im-plemented across the captive group to achieve common objectives.

Despite these advantages, there are precautions to observe in evaluating the captive alternative.

First, part of the difficulty in forming a captive is establishing a large enough critical mass of policyholders with good loss and exposure data to establish actuarial confidence in the predictability of outcomes for claims. Typically the starting point for forming a captive is in the $5,000,000 premium range, even though some have launched programs with as little as $3,000,000. The lower the premium, the higher the risk in forming a captive because of the statistical confidence of the potential outcomes.

Another thing to remember is that most captive programs focus on casualty and workers' compensation lines of coverage rather than on property and umbrella liability coverage. The basic idea is to assume losses within the working layer of exposure (i.e., that portion that is predictable) and reinsure losses outside the normal range of expectations, while earning investment income on reserves held for future claim payments.

The attraction of underwriting profit is strong in forming a captive, but there is no guarantee of such profit, and past performance does not predict future results with certainty (especially when legal trends are unpredictable). Profits are not realized immediately, but over the long-term life of the captive; usually underwriting profits are not returned to policyholders' accounts for 3 to 5 years, minimum. This requires ongoing capitalization of each policy year until underwriting profit begins to offset this obligation.

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