Dip your toe into the risk pool
For a business with a large deductible workers’ compensation plan, how can a captive be useful?
Karl Huish: In the US, many middle-market and large businesses have a high deductible workers’ compensation plan, where the business retains the first $100,000, $250,000 or more of every claim. However, even though workers’ compensation risk represents the individual risks of hundreds or even thousands of individual employees, the current view is that this spread of risk by itself is insufficient to meet the necessary risk distribution to have a valid captive. While it is conceivable that the ‘risk units’ theory of risk distribution could, in the future, broaden to encompass workers’ compensation risk, that isn’t where the interpretation is today.
So many US businesses, large and small, can have a significant liability on their balance sheets—future workers’ compensation claims—and no way to efficiently discharge that liability until the claims are paid. Simply having a captive and transferring the liability to your captive isn’t enough for most businesses that don’t have several operating subsidiaries—there needs to be a source of third-party risk to meet the risk distribution test.
TJ Scherer: To solve this problem, the company must participate in an insurance pool where there is a sharing of risks between many businesses. Some large brokers, including Marsh and Aon, developed pooling mechanisms for their clients. In these pools, clients could pool their risks together and transfer that pooled risk to each captive, so that the captives would each have unrelated risk, and potentially qualify as an insurance company for US federal tax purposes. This may allow the company to deduct insurance premiums paid to the captive. Large businesses have had this option for many years.
However, until a few years ago, there wasn’t a similar solution for small and middle-market businesses, say a business with $400,000 to $7 million or more in annual workers’ compensation losses.
What are some of the benefits of pooling?
Huish: For example, if you own some stock in just one company, even if it’s a very good company such as Apple, that stock can go up and down quite a bit and have a lot of volatility. However, if you own stock in 10 companies, especially in different industries, they all tend to balance each other out. As the saying goes, don’t put all your eggs in one basket.
The alternative risk industry does this by utilising insurance risk pools—accomplishing some basic diversification. Businesses thrive on predictability. They want to be able to predict from month to month and year to year what their revenue and expenses are going to be, and the likes of insurance losses are not very predictable. Participating in a risk pool is a good way of smoothing out those losses to make them more predictable.
Scherer: If you go from a guaranteed cost product to a high deductible there is a lot of benefit taking on that risk yourself. However, one of the drawbacks is that smooth cash flow isn’t always there because of the volatility, so joining a risk pool offers the best of both worlds.
Is this where the Artex Exchange solution fits in?
Huish:Yes. A couple of years ago, Artex built a solution for those middle-market businesses called the Artex Exchange (AEX). The solution is a pooling mechanism that allows middle-market businesses to share a layer of their workers’ compensation risks. There are several benefits to this. First, pooling risks reduces the variability of losses for any single company—it acts as a risk dampener, which is precisely why companies pool risk.
Second, the pooled risk is an unrelated source of risk, which can help support the captive’s position as an insurance company for US federal tax purposes. Some AEX participants already have a captive, and use the AEX to help qualify that captive as an insurance company or diversify their captive’s underwriting portfolio. In other cases, the company might want to form a captive, but can’t determine how the captive can qualify for insurance company treatment. AEX solves that problem, allowing the company to form a captive and achieve the same type of benefits as larger businesses.
With a captive in place, the company now has a central organising entity for risk management programmes, and an efficient way to create reserves for future losses. Of course, the captive doesn’t need to be limited to workers’ compensation risks. Many other types of risk can be included in the same captive.
Has the programme been successful so far?
Scherer: We think it has been successful. We started in late 2012, and so our first full year was in 2013. So far we have 10 clients, with $25 million in annualised premium, and we believe the growth is just about to kick off.
There are a lot of clients that we have approached, or prospective clients, who believe the programme sounds really good, and who have shown interest but do not want to be the first to join. However, now that we have been going successfully for four years, we think there will be a lot of businesses interested in joining.
We feel the programme has met everybody’s goals including the risk shifting and sharing, and maintaince of the pool. The AEX pool is not meant to be a profitable line of coverage. It is meant to facilitate the captive as a risk management tool. With a captive in place, the business can, over time, expand the uses for the captive and look at general liability, auto liability, property, and other risks unique to the business. For all of our AEX clients, it has met that goal.
Why should companies choose risk pooling?
Huish: Sharing risks in one form or another has been around for hundreds of years, dating back to Lloyd’s of London. Risk pooling is used in so many different areas. At Artex we manage different types of risk pools. For example, there might be municipals, cities and towns that will get together and do a risk pool for their general liability risk, property risk or auto risk. Captive insurance companies also use risk pooling for several reasons. The top reasons are to reduce variability of risk and to qualify as an insurance company. To put it in simple terms, businesses really, really want to avoid an extremely large, unanticipated expense, especially something that rises to the level of what is called ‘balance sheet risk’.
Scherer: The risk is still there, but now all the risks from many companies are being shared by many captives. The nature of portfolio diversification is that for some years, your own company’s losses will be low, but others may be high. The next year, it might be the reverse. The pool has the effect of smoothing out these losses for each participating company.
Can pooling provide any relief for existing liabilities?
Scherer: Yes. By forming or having an insurance company, the insured can transfer its existing risk to the captive through a reserve transfer, sometimes called a loss portfolio transfer. This provides the insured with a cleaner balance sheet, less in reserves, and a tax deduction for the premium payments. Since many companies would not have the ability to do this without a pooling mechanism, AEX can provide the solution.
Does pooling change the current programme at all?
Huish: Risk pooling doesn’t change the existing programme for the business, however, sometimes companies put off risk pooling because they think it involves change, when really it doesn’t. Risk pooling is just an overlay—it fits right on top of the existing programme. With AEX, the company keeps its large deductible programme in place, including the broker and excess carrier.
Do you think some have been put off by the potential changes?
Huish: I think businesses need more explanation and education on captives. Some businesses are willing to go through that process of learning and others think it will be too complicated. Many good solutions take a little bit of education to get there. But once the business understands it, watch out. They get very excited about the benefits that a captive can bring.
A lot of businesses learn about one type of captive and then believe the same rules apply to all captives when in fact there are many types of captives. We have to re-educate risk managers about alternative risk and what a captive really means, and that takes some patience on their part. This especially occurs when you have a new programme such as AEX. Now that our programme has been around for a couple of years, risk managers are more willing to engage and I can see it having good growth in the future.
Has there been an increase in movement to pooling from other alternative risk solutions?
Scherer: Companies using a large deductible are using a type of alternative risk. A large deductible is a great start, but if the company is willing to take the risks of that deductible, there’s more that can be done. One answer, we feel, is to join a workers’ compensation pool and utilise a captive. Companies are always looking to move on to the next level. So, many clients that are on a high deductible are looking at other options, and forming a captive is one of those.
Huish: A large deductible is only one type of alternative risk but clients see a lot of benefits from it. One benefit to the company is purchasing less insurance, and saving money on all of the overheads associated with commercial insurance. Businesses are forming their own captive insurance companies so they can have their own risk manager vehicles and be able to pay those premiums up front into their captives.
Imagine a middle-market business, with workers’ compensation losses that will be $5 million or so. However, it cannot take a tax deduction for those until it actually pays the claims, so the business ends up having a large liability stuck on its balance sheet.
One way to fix this problem is to create your own captive insurance company and transfer that liability to your captive. But to have a legitimate captive insurance company in the US you have to have a sufficient amount of unrelated risk and that’s where the pool comes in and provides that.
What about additional benefits?
Huish: Most large deductible programmes require a letter of credit (LOC) or other collateral. AEX may permit the business to reposition the collateral to the captive, thereby freeing up substantial after-tax cash for business use or shareholder distribution. Also, some carriers will also accept a ‘Reg. 114 Trust’, which can be a cheaper and easier alternative to an LOC, and can generally only be entered into by insurance companies, including captives.
Scherer: Further, with AEX providing unrelated premiums to the captive, the business may be able to transfer additional direct premiums to the captive, outside of AEX, for other retained risks, such as general liability, auto, property deductibles, prior years’ comp retentions or other self-insured risks. This can result in a significant financial and risk management benefit.