There are a number of reasons to create a captive insurance program including cost (premium and expenses) containment, control over claims management, tailored coverage and capacity accumulation (underwriting profits and surplus). All of these variables are integrated (bundled) into a basic professional liability policy which when purchased by a policyholder, is generally considered a “traditional” policy.
Under a traditional insurance policy there is very little risk sharing, such as a deductible or self-insured retention and all services are provided by the insurance company. For the policyholder, there is virtually no leverage in determining premium except when an insurance intermediary, such as an agent or broker, can create competition amongst representative markets.
As an alternative, the decision to start looking at a captive insurance solution (a non-traditional policy), is when premiums charged are unjustifiably higher year-to-year. Sometimes that is the cyclical nature of the insurance markets, but often enough it is that the policyholders’ underwriting profit inures to mainly benefit the carrier and not the policyholder(s).
How does group captive insurance function?
A group captive is formed by bringing many similar (or dissimilar, as the case may be) to act together. Most prospective group captive policyholders will not be large enough form a captive by themselves. By aggregating many firms of similar size (a range), however, they can form a large enough “risk pool” to provide funding of anticipated losses while allocating for variable expenses (claims adjusting, captive management and loss control, for example), reinsurance, taxes, fronting fees and commissions. Professional services such the use of an actuary, legal and auditor are “must haves” as the captive will be regulated as an insurance company, which require annual financial solvency tests and audits. The captive manager provides oversight of the captive, essentially acting as the “eyes and ears” of the captive domicile’s regulators, in addition to securing reinsurance services and providing regular financial reports to the captive owners/members.
Directors and Officers
A board of directors will be established to provide governance of the captive. The board works with the captive manager. The number varies, but at a minimum, it is usually 3. At a minimum, there is one annual shareholder meeting required. A slate of officers is also created to help execute the captive’s plan and operations. Engagement and participation of the captive shareholder/members is key to the success of the captive. Accordingly, there should be meetings conducted on membership, loss control, risk management, underwriting, and more.
Benefits of a group captive
Group captive programs can provide the members with greater control and leverage over their traditional policies resulting in a smoother year-to-year renewal process. As shareholders, they could accrue tax deferred benefits such as underwriting profits and investment income. Importantly, underwriting will be based not only upon the group’s overall expense, claims and risk management controls, but each member will be underwritten individually. The outcome is a significant return-on-investment (ROI) opportunity. As to claims, the focus is on protecting policyholder/members, especially when fighting a fraudulent or suspicious claim.
Risk sharing among members
A group (or association) captive can be organized in a number of ways, but in every case there is an element of risk sharing among members. Each member, while individually underwritten, is not only assessed a premium but is required to contribute capital and/or collateral to help support the captive. Usually the obligation to contribute capital/collateral is done during the first 3 years of a new policyholders acceptance, but assessments due to adverse loss development under some group captives isn’t uncommon.
Loss funding for policyholder/members is typically done using both an individual account (“frequency fund”) and a “shared” level among all members. Claims borne by an individual are first paid through the member’s frequency fund until exhausted (including the members capital/collateral). Any claims in excess of the individual’s frequency account are shared by the rest of members, usually on a pro rata basis. Of course, any claims in excess of both frequency and shared levels would be covered under the captive’s reinsurance cover, up to the stated amount.
Underwriting profits and dividend distributions to members
While there can be several variations on how profits are distributed (after all of the claims have been paid for the policy year), most group captives distribute profits based on an individual’s performance (money left in their frequency fund) and then through the profitability of the captive’s “shared” level. In some cases, a members’ frequency fund can be depleted but the member will remain eligible for a profit sharing on the shared level. Each year stands alone, so a “bad” year is isolated and does not affect prior or future years.
Membership eligibility focuses on having a strong commitment to professional risk management controls and documentation practices. Companies with better than average loss histories and ability to contribute capital/collateral are good candidates. Minimum premium size will be dependent upon the total expected size of the group captive.
To begin due diligence on the feasibility of a captive, there has to be enough expected premium generated from the collective members so that a carrier that is prospectively providing coverage also offers to share risk with the group captive and would be interested in providing reinsurance and issuing a policy. This is very important.
I would suggest that polling the prospective members as to what they pay for their professional liability premiums (on a 3 year average) would be a good starting point. If there is a reasonable expectation that a collective incumbent premium of $3-4 million+ is identified I would then suggest that a “feasibility study” be undertaken by the prospective group members. The results of the study, which is based upon the group’s loss history and premiums, provides loss forecasts and funding of claims under both an expected case and an adverse policy year.
The forecast is usually 3 or 5 years, with 5 years being the most desired. The cost of a captive feasibility study, which includes the services of both an actuary and a captive management firm, such as ours, is variable, but in a case such as the West Shore, I would estimate $15,000 – $20,000. Most of the work is collecting the loss histories of the members and making sure they are currently valued before submitting to the actuary.