Typically, a captive insurance company is formed to solve a specific risk management concern. Many times, captives are formed during a hard insurance market when premium rates are on the rise, or when a company is unable to find the type of coverage it wants in the traditional insurance or financial marketplace.
Typically, a captive insurance company is formed to solve a specific risk management concern. Many times, captives are formed during a hard insurance market when premium rates are on the rise, or when a company is unable to find the type of coverage it wants in the traditional insurance or financial marketplace.
But as with all things in life, time passes and situations evolve. Perhaps changes in the insurance market have made the desired coverage available. Through focused safety measures and claim mitigation procedures, the captive owner may have improved its loss experience thereby reducing its insurance costs. There may have been acquisitions or divestitures at the parent level that have significantly increased or decreased insurance exposures. Perhaps there has been turnover within the risk management or finance functions, and much of the institutional knowledge of the captive programme has been lost.
Whatever the situation, you can be certain that today’s environment is not the same as it was when the captive was formed. For a mature captive, it makes sense to periodically assess the functionality and financial effectiveness of the existing programme, as well as to consider additional lines of coverage for the captive. As a colleague of mine once said, a captive may not quite be “a many splendid thing”, but it is a very flexible risk management tool that can be utilised in a variety of ways to benefit the parent organisation.
This periodic assessment of the captive’s operations has many names—captive audit, utilisation review, etc—but I like to think of it as a ‘captive tune-up’. Like a fine automobile, a captive can bring its owner years of satisfying performance, but to keep it operating at peak efficiency, a professional needs to regularly look under the hood and make sure everything is working properly and performing to its full potential. The tune-up is a chance to review the objectives of the parent and determine if there are areas where the captive can better respond to evolving insurance needs and corporate strategies. Determining how often to conduct a tune-up will depend upon the complexity of the parent organisation, but as a general rule, we recommend every five years.
In many ways, the tune-up is a type of SWOT (strengths, weaknesses, opportunities and threats) analysis:
Strengths: what is our captive doing well? How do we expand on these areas?
Weaknesses: what has not been going well? Do we have any operational issues that are hindering the captive’s growth and development?
Opportunities: does the parent have problems that the captive may be able to address? Are there changes in the market that make coverage through the captive more attractive?
Threats: are there regulatory changes that present a threat to the captive’s business?
Once the initial broad assessment of the captive and its current operating environment is completed, the review should move into more detailed questions regarding:
Domicile: does the current domicile remain the best fit for the captive? This analysis should include a review of the allowable business in the domicile, the costs relative to other domiciles, and political support for the captive industry.
Taxation: does the current captive structure optimise the tax position of the parent company for state, local, and federal purposes?
Service providers: have there been any service issues with the captive manager, fronting company, auditor, tax specialist, legal counsel, actuary, or third party claims administrator? Are the service fees competitive in the marketplace?
Current programme structure: does the current programme reflect the optimal retention for the parent company? Based on current market pricing, would there be additional savings by retaining a lesser or greater amount in the captive? Clearly, this is an area to be reviewed in the tune-up, but ideally it has also been evaluated during each renewal of the programme.
Future programme structure: what other programmes should be considered for the captive? This is an area that can make up a significant portion of the tune-up report that should include an evaluation of: current corporate insurance programmes not included in the captive and any existing uninsured exposures; and the potential to assume business into the captive from affiliates, business partners and employee affinity programmes.
There are a number of non-traditional areas where using a captive is being considered by experienced captive owners. For example, there is a significantly increased interest in cyber risk as companies become more aware of exposures surrounding information security. Banks and hospitals are particularly sensitive to cyber risk due to both the amount of personal information they hold that must be kept private and their dependency on electronic data.
Often, the existing general liability, errors and omissions and/or crime policies do not adequately address the risks associated with an increasingly digital world. Even specialised cyber insurance policies may not provide all of the protection that a company seeks. A captive can craft a customised policy to allow the parent to provide coverage and to fund for potential claims related to:
Network business interruption;
Wrongful disclosure of personal information or protected health information;
Failure to guard against threats such as hackers, viruses, worms, etc; and/or
Costs related to restoration or re-creation of data or software.
Another area where captives have continued to emerge in recent years is employee benefits, specifically medical stop-loss. The enacting of Obamacare created significant uncertainty for most businesses in the US as to how healthcare expenses will be paid. So while the Department of Labor may have suspended the ExPro process for approving the funding of Employee Retirement Income Security Act (ERISA)-regulated benefits through a captive, interest in using a captive to help fund employee benefits costs may be at an all-time high. For a company that self-funds its medical plan, a stop-loss captive programme can help provide specific and aggregate insurance protection for the owner. In many cases, medical stop-loss is provided on a group basis, however, individual owners can optimise their self-insured retention and cash flow through the use of their captive.
Mergers and acquisitions are events that can often result in new exposures for organisations. Captive owners can turn to their captive insurance subsidiary to help them handle exposures that they have not faced before. Perhaps an acquisition results in new territories or jurisdictions where the parent company does business, and the captive can expand its existing coverage to these new locations. During an acquisition, the captive can also be used to assume the risk of any coverage gaps in the target company’s historic insurance programme.
For manufacturers, we are also seeing interest in using the captive for product recall risk or for various extended warranty products. These coverages can each provide benefits to the parent company but must be carefully reviewed to ensure that they will be treated as insurance products.
When evaluating any new coverage for the captive, the risk appetite of the parent is a major consideration. While the economic analysis of a programme may indicate that using the captive would result in long-term underwriting income, if the parent company is uncomfortable with the risk due to its potential volatility or some other uncertainty, then self-insuring through the captive will not ultimately occur.
Any changes to the captive structure may increase the capitalisation required in the captive, as well as the costs to operate the captive. Therefore, the consideration of a new programme must include the cost of capital that will need to be committed to the captive to support the new coverage.
Ultimately, the tune-up report should include:
An evaluation of the captive’s performance in meeting the objectives of the business. This evaluation should include both the case for the continuation of the existing captive and a counterpoint discussion on the potential disadvantages of having a captive with commentary on alternative risk structures;
A review of the original business plan of the captive compared to current writings, illustrating historical growth of premium, losses, retentions, capital/surplus, and retained earnings;
An operational analysis describing the data flows and internal controls within the captive, as well as an overview of all service providers and the roles they play in the overall delivery of services;
An outline of potential new risks together with underwriting considerations that could be written by the captive, including the rationale to do so and the potential opportunities for the parent company. In addition, commentary should be made on those opportunities that were identified but ultimately not recommended for inclusion in the captive and why; and
Additional capitalisation needed for the captive’s expansion, if necessary.
Ownership of a captive insurance company can provide many benefits. A captive, however, does require regular maintenance if the owner wants to enjoy maximum operating performance. A ‘captive tune-up’ can provide the owner with tools that ensure that the captive will continue to perform well for years to come.
