Practical Benefits of a Middle Market Captive

I have been asked on many occasions why my focus is on the middle market. My desire is to deliver risk financing options, particularly captive based, that were historically only available to larger companies. I want middle market companies to profit from captive insurance solutions so that they can get on with their core business operations with confidence.

With a World facing many challenges from climate change, pandemic, social change, to globalization and coupled with a prolonged hard insurance market the need to provide bespoke risk financing opportunities for medium sized companies has never been more needed. To be able to deliver those options, the captive insurance advisors must be risk focused and work with insurance brokers to gain the optimal benefit.

In this blog I want to focus on the practical benefits that a captive can bring to a middle market company wishing to maneuver their way through an increasingly difficult risk environment.

Coverage

Commercial insurance plays an incredibly valuable role in risk transfer. However, their role can be limited.

• Their insurance policies have exclusions and Self-Insured Retentions (SIR’s) that limit coverage. With a changing world we see SIRs applied where there is perceived heightened risk to such things as wildfire and climate change and this can put a great deal of stress on a company that is not prepared.

• A significant risk faced by many companies with employees in bureaucratic states will have Wage & Hour exclusions on their Employment Practices policies. This can be a significant problem for the employer.

• Developing technology risks are also problematic as the commercial insurers can take several years overcome their bureaucratic ways to respond to a risk that a company can face today.

• Look at the EIFS conditions on a contractors CGL policy and you will see a huge exposure that is left with the Insured for construction Defect.

• And of course, we all saw the way commercial insurers failed when a pandemic hit.

Then we have classes of business where commercial insurance is not available. For example:

• Supply Chain risks. Yes, Supply Chain is available for larger multinational companies, but commercial availability is severely limited when it comes to the middle market.

• Business Interruption is restricted in general when it comes to commercial policies and responds only after a physical loss.

• What about when there is an administrative action from Government, for example, a shut-down order because of a virus.

• How about an interruption to the business that is caused by the something that severely impacts the reputation of the business?

There are many other examples of insurable risk for which commercial insurance chooses not to participate. Luckily, where commercial insurance doesn’t respond, there is an opportunity for a captive insurer to step up and help finance the risk.

Working out what risks to insure commercially and what may be more beneficially placed into a captive arrangement will need coordination between a business’s insurance broker and captive manager. It is important to see brokers and insurance managers as being complementary to a client’s robust risk management program.

Reliance on Commercial Insurance

A good insurance broker will work with a business to evaluate risk tolerance that is reasonable for a portfolio of risk and should also consider how a captive or other risk financing vehicle can help to manage the exposure.

The less that a company has reliance upon commercial insurance the less they are exposed to the cycles of commercial insurance and in particular the punitive hard market.

With commercial policies that are not always there to meet a client’s specific needs and increased premiums with a hard market now may be the time for a business to consider the extent to which they rely upon commercial insurance at all. Certain insurance covers are required by law such as Workers’ Compensation and Auto Liability and others such as property offer very large limits for relatively little money. However, a captive can write certain risks directly and can participate in other commercial risks in the form of accepting the risk associated with large deductibles for Workers’ Compensation, Auto etc.

Again, making the most of this required insurance brokers and insurance managers working together.

Risk Management

Purchasing guaranteed cost commercial insurance allows a company to have a specific outcome: the insurer pays the specified loss and there is nothing more for the company to do. It means that at the outset the equation is set.

However, with a risk financing option such as a captive there is an ongoing dynamic. The participation in the outcome rather than the outset will impact the company’s attitude to risk management over the participation in the risk financing period. The skin in the game and profiting from not having claims means there is far greater focus on loss prevention.

In addition to the benefit of greater loss prevention there is also a knock-on effect of focusing a great deal more on the risks faced by the company and whether the captive can help finance additional risks.

Where there are losses or near misses, the data secured in a formal manner within the risk financing vehicle can greatly benefit the risk management process. That data can be used to measure effective risks management as compared to third parties as well used to identify trends. Data, in the 21st century, is king.

As well as providing regulatory, accounting and other management services a good Insurance Manager will also work to augment an organization's risk management facility by helping to identify insurable enterprise risk, evaluate it and control risk through funding for future risk costs by way of premium. The manager will also manage post loss mitigation.

Cost Allocation

Where a captive responds to the needs of a group of related companies the allocation of losses can be very important. An insurance manager should work with the client to establish this. For example, there may be differing risk tolerances within the individual entities. A captive can help to take on risk and equitably share risk between the many rather than just the one that would otherwise not be able to finance the risk alone. In a strong corporate structure, it may be that a working layer of loss is left with a smaller operating entity and a larger layer of the loss is allocated to the corporate center.

Insurer Third-Party Risks

Under certain circumstances a captive can provide a way to participate in the risks of others. This can be a valuable source of income as well as a way to diversify a portfolio of risk.

For example, a property owner with enough tenants may work with a fronting carrier to provide their tenants with renters insurance and the front can reinsure back to the captive. Other commonly seen arrangements include property damage waiver programs, warranties, and subcontractor default insurance.

Selling insurance to customers and key partners can bring in welcome third-party income but it does have its own issues particularly relating to captive insurance regulations and procurement.

The captive client should discuss opportunities with their insurance manager to see if there are options to cover third party risks.

Premiums

Whilst premiums are required to be established at arms-length the manager will ensure that there is far less exposure to the cyclical nature of insurance pricing typified by commercial insurance.

Retention of Underwriting Result

Lastly, if a company has good captive program and their risk management is strong, they can reasonably expect, over the long-term, to make an underwriting profit. That profit stays within the economic family rather than staying in the corporate pocket of commercial insurers.

A Caveat…

You will notice that, at least compared with my peers, there is no mention of tax as a benefit of captive insurance. Whilst tax can be an important consideration for the establishment of any business, I have specifically not mentioned it because my view is that it is not the role of the independent risk professional. If you want to get the most from your captive get your tax advice from an independent tax advisor and not from your insurance manager.

Overall

When done correctly a captive insurance program can deliver significant benefits that are optimized where the captive owner is committed to risk management and where the insurance broker and manager works together. The captive owner can take control of their risk environment and face the future with confidence.

Want to know more?

If you have any questions regarding the potential benefits you can receive by using captive insurance arrangements as a way to finance the risks faced by your organization, please contact me.

Greg Taylor

CEO

Albion Risk Consulting.