Turning Premiums into Profits in Today's Market

There is an important adage that should have special meaning to brokers: if you live by price, you will die by price. In today’s market, property and casualty insurance has become a commodity and often brokers are charged merely with finding the lowest price possible for their clients. Such an environment leaves little opportunity for real growth, innovation, or long-term relationships.

Alternative risk strategies – especially new captives, rent-a-captive and risk-sharing options – can play an important role in helping brokers open new markets, reshape their programs and provide true value-added services to clients. Through captives, brokers have the opportunity to become strategic partners and not just vendors. Under captive arrangements, clients become stakeholders in their insurance program; the clients – not just the insurance companies – have the chance to receive underwriting profits.

How Captives Fit in Today’s Market

Traditionally, captives have been a strategy used in hard markets by Fortune 500 companies, when capacity is scarce and prices are high. Today’s market is rewriting the textbooks to an extent. We are seeing some of the traditional factors that influence a hard market in play, yet overall pricing remains low as companies are slashing fees to secure and retain business. In addition, new captive arrangements are expanding the option to the small- to mid-sized market. However, a look at overall industry experience helps highlight where the market could be going in the near future.

• According to the Property Casualty Insurers Association of America, in 2009, the P & C industry’s profitability increased by 5.8% compared to just 0.6%  in 2008. The industry’s combined ratio, which determines insurer profitability by valuating the claims and expense ratio, improved to 101.2% in 2009, down approximately 3.0 percentage points from 2008.
• Overall, the P & C industry rebounded in 2009 with net income increasing ten-fold to $30.6 billion from $3.8 billion in 2008. Improved underwriting results can be attributed to the following:
  • $9 billion less in catastrophe-related losses
  • $12.5 billion in prior accident year favorable loss-reserve development
  • Net investment gains increased by 19% up to $39.5 billion from $33.1 billion
• With the present overabundance of insurer’s surplus capacity in the market place (the U.S. P&C Industry’s surplus increased 9.4% to $519.3 billion over the past year and increased an additional 5% first qtr 2010 to $540 billion, per the Insurance Information Institute), prices continue to be soft.  However, despite, these strong gains, industry analysts note that the ongoing slowdown in the economy and effects from the financial crisis continue to impact overall results.
  • The $28.3 billion in net income for 2009 is half of the 2007 income of $62.5 billion.
  • Per A.M. Best, for the first time in history, Net Written Premium (NWP) decreased for a third consecutive year. From 2008 to 2009, NWP decreased 4.2% to $426.8 billion.
  • Excess capacity and lower net written premium will continue to put pressure on U.S. P & C carriers to be flexible and creative in order to meet top line and bottom line goals.

Rent-a-Captives Take Root

A rent-a-captive company "rents" its capital, surplus and legal capacity to the insured parties that want the benefits of a captive without actually participating in ownership or management. A rent-a-captive or protective cell company structure can be offered to single entities or to groups. The participants avoid the capital requirements normally required to form a captive, making entry and exit easier. To take part in a captive, an organization needs to have a minimum of $1 to $2 million in premium as well as a retention amount large enough to sustain payment for one major loss of $250,000. The number of participants covered by a captive varies by industry. A high hazard industry with higher average size premiums might require a lower number of participants; a lower hazard industry, like real estate, might require more.

Rent-a-captive fees are usually based on a percentage of premium ceded to the captive and range from 1 to 3% of premium. This allows a more predictable expense ratio relative to the size of the program, and is desirable for start ups and smaller programs of less than $10 million in premium. When program premium is unpredictable or uncertain, and when the fixed costs of owning a captive become higher than the normal expense ratios, a rent-a-captive can become a viable option.

There are trade-offs to consider. Organizations that enter into a rent-a-captive arrangement no longer can select vendors, such as accountants, auditors, actuaries and TPAs — those services will be provided by the rent-a-captive. On the plus side, organizations do not have the burden of seeking out and contracting with these services, which many have minimum fee arrangements that drive up fixed costs. Because the interests of all parties in a rent-a-captive are better aligned and they offer the ability to bundle key services through experienced vendors, program participants can also secure the benefit of economies of scale and related cost savings.

Such relationships must be created and entered into carefully. Look for companies that offer:

• Experience and a proven track record in developing effective risk management programs and managing claims;
• Fair pricing and contract terms;
• Timely and accurate financial reporting services;
• Assistance with banking services (trusts, letters of credit, collateral accounts);
• Expertise in reinsurance contracts, trust agreements and insurance programs; and
• Location in a domicile that has favorable protected cell laws; a stable and captive-friendly environment with a strong history of successful captive programs, and good local service providers.

One emerging option within the rent-a-captive arena is the ability to share risk with vendors. Under this arrangement, the TPA or other vendor agrees to accept some of the risk and share in potential profits. The approach creates tremendous incentive for all parties to control risk throughout the enterprise while it further increases the sponsoring entities bottom line.

Looking at the Big Picture

While there are a number of benefits to emerging captive options, such as risk-sharing and rent-a-captives, brokers must take responsibility for looking at the big picture, and ensure that their clients have the commitment and organizational profile to make a captive arrangement work. The advantages of captives include:

• Risk sharing captives eliminate barriers of entry; there are no formation costs; virtually any size organization – as well as those with limited capital – can participate in the captive.
• Agencies can help their clients turn dollars that were once spent on premiums into profits; a benefit for the client and a valued service line for the broker.
• Profit potential for the agency; if the agency takes risk in the program or if the agency creates its own agency captive, they too can share in the profits.
• Increased synergies between all participants – client, broker and TPA. Everyone is working together to reduce risk, improve quality and lower costs.
• Protection for brokers from the inevitable hard market.

For many organizations, one of the primary advantages of a captive is that it provides the program sponsor with greater control; particularly within claims processing. In traditional insurance programs, clients – especially smaller organizations – have little say in how, why or even when claims are settled. With a captive, the client and captive participants can work together to determine the parameters they believe are best suited for their organization.

In the standard program for a small to mid-sized group program, the captive takes the first level of risk – typically about $300,000. The captive then has the reserving and settlement authority. The captive is responsible for bringing in attorneys and consultants to settle claims if needed (whereas a large insurer might just pay). The captive managers also develop the anti-fraud and safety programs. The collaboration and coordination has helped captives with aggressive claims management and strong safety programs drive down the average claim cost to about 40% of the industry standard.

Such results do take more work and involvement from the client and program manager. Frequently organizations using captives are directly involved in developing best practices and even accident investigations, areas that in the past were often left for the insurer to manage. Claims are typically handled much more aggressively; the focus moves toward behavior-based safety, training, prevention and detection.

Within a rent-a-captive or group arrangement, there is also a strong degree of “peer pressure” as everyone is a stakeholder. The best captive programs include quarterly claims reviews where results and best practices are shared. For example, one member of the group may have a strong accident investigation program, and another may have expertise in litigation. Together, they can help to strengthen and improve the entire program.

Because group captives share the risk along with the profits, they must also be charged with a high level of selectivity. Participants in the program should be chosen based on several key factors, including:

• Strong entrepreneurial philosophy – A management team that wants to get involved in all aspects of the business.
• The nature of the participant’s industry – It is possible to mix industries within a group or rent-a-captive program, but the overall characteristics of the group must be similar. For example, it is not recommended to mix a company in the retail industry with one from trucking as the nature of the risk is too diverse.
• Shared safety and claims management culture – Because the actions of one company will impact all others, each organization must share similar goals and commitments to programs. A commitment to safety and loss reduction is key.
• Willingness to change and adjust to meet the needs of the group – Flexibility and a commitment to helping the overall group drive down costs are important attributes.
• Risk history to date – Clearly, any company can lower their risk, but until a company shows that commitment, it likely should not be included in a group captive model.
• Strong hiring practices – In today’s market, employers can and should be more selective to ensure all employees have the skills and ability to learn tasks that will help improve safety.

When risk partners are carefully chosen within a group, average loss ratios can be lowered significantly. For example, one risk program for a captive for small to mid-sized franchisees was able to drive their loss ratio to 16%, versus the average of 45 to 60% for most of the industry. Some captives have been able to drive loss ratios even further. (See sidebar.)

Potential Drawback for Captives

However, for some, it is the very factors that may be benefits to some organizations that can be viewed as negatives to others. Captives do require strong involvement from their sponsors. In traditional insurance programs, the company simply turns over all aspects to the insurer with little involvement other than occasional reports.

Captives are not a strategy for short-term savings. They require a commitment and again, time and work from the sponsoring organization.

Brokers and plan sponsors must remember that there is risk. Poorly managed programs, or those with the wrong mix of participants, can lead to significantly greater risk that could negatively impact the bottom line of an organization.

Of course, it must be acknowledged that in today’s market, where carriers are actively courting business, it is difficult to turn away from the aggressive pricing programs offered. The more value added services a broker can offer, and the more programs that match the needs and personality of the client, the more likely the broker will be able to secure and keep clients.

Steps to Setting up a Successful Captive

Because a captive is in effect a “mini insurer” – there are a number of programs and processes that must be implemented. Strong management is vital to the success of a program, as is selecting those vendors and partners that share the commitment to better outcomes and lower costs. Group and rent-a-captives will need to provide:

• Strong TPA services for claims management
• Innovative and effective safety programs
• Medical cost control
• Case management
• Accident investigation
• Aggressive subrogation
• Fraud detection
• Litigation management
• Tax preparation and filing
• Regulatory research and review

How captives work in real world settings can been seen in the experience of a restaurant franchise in Southern California. There was a grease fire at one of the restaurants participating in the captive. Rather than simply pay the claim, loss control worked with claims to identify the cause of the fire. They went to every store in the chain and collected data, including all vendors used for cleaning. It was discovered that a cleaning contractor did not properly clean the vents. The captive was able to have the claim subrogated to the contractor’s insurer. This intense review not only protected the captive’s funds, it provided a valuable safety lesson that was shared with other program participants, thus potentially preventing further claims.

Captives, and especially rent-a-captives, must have a strong reinsurance partner. The role of the reinsurer is to assume a defined share of the group’s risks. Finding the right reinsurance partner helps provide the security and assurance clients need to proceed with captive arrangements. Reinsurers are not subject to the same state regulations as primary insurers, however, they must have the strength and a minimum of an A-rating to provide the protection that the captive will need.

Participants in the captive must also ensure they provide proper oversight for the program. Captive managers should demand quarterly reports and analysis from their vendors; and should meet frequently to review findings, identify problems and share best practices. Remember that within a captive, every participant can provide added value.

Viable Option for Uncertain Times

Despite current economic uncertainties, captives are viable options for brokers and agencies. Captives enable brokers to create more meaningful and lasting partnerships with their clients and to distinguish their product offerings from competitors. The result of a well-managed captive program will be reduced risks, lower costs and greater revenue to the organization’s bottom line — valuable benefits in today’s marketplace.