RSK Review Podcast
John Capasso, CEO of Captive Planning Associates, tells Gert Cruywagen, host of RSK Review Podcast, why captive insurance companies are finally coming into their own – and how the pandemic has played a role in exploring alternative means of risk transfer.
Captive insurance companies fall within the ambit of alternative risk finance, and they are good risk management vehicles, precisely because they can cover certain risks that the commercial market has either mispriced or will not cover. Alternative risk finance complements traditional insurance well – commercial carriers typically handle large losses, with captives helping the insured to control their at-risk monies.
The four ‘Cs’
There are four ‘Cs’ at play when it comes to risk management – coverage, cost, capacity and control. Over the past couple of years, control has proved to be the biggest reason to use a captive. Many risk managers come to us for greater control of their money and the adjudication of claims. Risk managers know what should be settled and what should be litigated, but some uncaring commercial carriers simply want to get claims settled as quickly as possible to meet certain statistical benchmarks. It doesn’t help to settle for $10 000 but pay $100 000 in legal fees.
Sometimes it makes sense to retain the risk in the commercial market, depending on whether the markets are hard or soft. You need to look at how you utilise capital and what return on investment you expect. It sometimes makes more sense for a business enterprise to invest in a new product or line of business because the rate of return is greater than on the potential savings associated with financing its own risks. In addition, certain types of risks are better suited for the traditional markets and would actually be more of a detriment to the company for the captive to pay the claim than for a commercial insurer to pay it. You can therefore decide on the amount of exposure in your balance sheet and be nimble enough to move between captive and commercial insurer as circumstances change. However, take a long-term view as you go through cycles of availability of capital, and how you plan to utilise that capital. You also need to understand the limitations of a captive – it’s not always best to transfer risks to a captive and you have to assess the frequency and severity of claims.
We regularly see renewal quotes whereby the frequency of claims results in a large increase in annual premium, so we undertake studies to determine the expected frequency and what the dollar threshold might be. That gives one a good indication of what should be insured by a captive.
If you want to insure directly with a captive, do you need a fronting carrier? The answer may depend on several considerations including the particular line of coverage, financial responsibility laws of the jurisdiction, contractual requirements between parties, and insurance regulations that require policy issuance by admitted insurers only. A captive can use an admitted carrier to both front, with a portion of the risk ceded to the captive and reinsure the captive for losses above specific or aggregate limits. A captive can also directly issue a policy to its parent, maintaining a certain threshold of risk and then reinsure the rest. One can save a lot of money in fees by changing the equation from retail to wholesale insurance. This is one of the primary benefits of having a captive.
Captives can be wholly owned, standalone insurance companies, or cells in a protected cell structure, or even an incorporated cell company. One can also consider group captives, which are formed when a group of individuals or entities come together to jointly own a captive. In the US, we often see captives wholly owned by their parent company that will forego tax-deductibility of insurance premiums paid to the captive because risk mitigation is the more important consideration. On the other hand, tax-deductibility of premiums paid to a captive can be a great benefit and one in which many owners and operators explore. One such strategy might involve a company increasing its commercial policy deductibles while utilizing a captive to issue deductible reimbursement policies which, if done properly, will both minimize cost and maximize benefit.
Captives are tremendous assets to companies that know how to manage their balance sheets, from a perspective of contingent liabilities that business have to plan for. A contingent liability is not tax-deductible until it’s paid – and perhaps it is never paid – so being able to transfer that liability from the balance sheet to the captive is a way to improve a company’s financial strength as well as its performance metrics. This will expand its ability to borrow money, extend lines of credit, and so on.
If you can use a captive to exchange your at-risk dollars, it can benefit management by reducing or flat-lining potential increases from a commercial carrier. We see this commonly in workrs’ compensation and professional liability risks, where we analyse frequency and severity for the purpose of determining the most economically advantages scenario to retain risk while decreasing the overall cost of risk to the organization. In the long term, there is a flattening of any increase, particularly if you set a proper benchmark. From a budgeting perspective, this helps the C-suite as they can budget for the long term. They should also be able to educate everyone in the business to help to identify potential areas of claims arising through no fault of their own. The entire risk management process is then appreciated by staff. It takes years of training and communication, but it can be achieved.
Captives in the time of Covid-19
The coronavirus pandemic has made it clear that captives can play a crucial role in the sector. The commercial insurance market does not cater for everyone, particularly in an environment in which governments insist people take responsibility for their own risk. One need only look at business interruption – some states in the US have passed legislation to the effect that carriers should cover this during the pandemic, although it has been excluded from contracts. This is giving rise to litigation. Captives can provide a lifeline where contractual exclusions and limitations come into play, as we saw during the 2009 influenza pandemic and Ebola crisis.
Even though a captive cannot cover an organisation for business interruption in its entirety, it is possible to cover certain policy exclusions and thus agree upon a limit per occurrence and to an aggregate, which we have seen in practice with some of our clients whose business has been affected by various interruptions. We have spoken with many clients that have already been denied business interruption coverage from their commercial insurers but may have coverage options from their captive – although we have cautioned that it will take time to assess the magnitude of the interruptions and determine the monetary amount of the claim.
I think more business enterprises will turn to captives now as a backstop, not only from a claims-paying perspective, but in order to be well prepared for changes and uncertainty while building a surplus that will help a business stay afloat in times of distress. For example, using loans to make payroll or find an alternative supplier if one experiences supply-chain problems. A captive can be used as a vehicle to help businesses survive tough times. I don’t think the pandemic is the last crisis of this nature we’ll see – and captives will again be at the forefront.
Covid-19 has also hastened something of a migration to microinsurance or limited-duration insurance. With the gig economy and the advent of blockchain technology, the purpose of insurance is changing – independent contractors like people in the construction or music industries would want insurance by the hour, by the day, or by the event. It is a good alternative in the developing world, which does not have quite the same sophistication as leading economies.
I am hugely optimistic about captives, at a time when carriers are looking to expand themselves and create appropriate vehicles for their policyholders. More people than ever are using captives to fill the gaps.
- John Capasso is CEO of Captive Planning Associates, a New Jersey-based boutique captive management firm specialising in providing innovative, alternative risk solutions to closely-held family-owned businesses and large corporations. A global expert in captives, Capasso is a member of the Captive Insurance Company Association as well as the Self-Insurance Association.