Is the lack of available insurance coverage holding you captive?
The year 2020 has challenged us all in unique ways. It has called for modifications in the most fundamental aspects of life and business operations. While companies struggle to remain solvent due to risks previously unconsidered, many have looked to insurance policies, grasping at any possibility of coverage. The COVID-19 pandemic has challenged business interruption insurance1 and transformed how we view workers' compensation coverage.2 Cyber liability has taken on new levels of exposure as people work from home, school is held online, and retail converts to no-touch operations.
Companies are realizing what their current insurance does and does not cover throughout all these uncharted events. Many have recognized a gap in insurance coverage they wish would have been filled. But from where? Mainstream insurance companies may not yet provide coverage to meet these specific demands, such as pandemic insurance. Even if these unique coverages exist, some companies find certain types of losses could be handled internally within one’s own captive for less money than the commercial insurance market. This combination of coverage unavailability and future uncertainty encourages companies to look for solutions in captive formation.
Could a captive provide otherwise unavailable insurance coverage?
Captive insurance companies are typically formed to insure traditional insurance exposures of a parent company or a group of risks, but they can be used to shield a company from almost any type of insurance risk to which it is exposed.3 This could include new and emerging risks or those unique to a company and for which no mature or broader traditional insurance market exists, such as warranties, financial exposures, and pandemic insurance. Further, captives provide an opportunity for companies to spread the cost of low-frequency/high-severity events over time as years with few or no losses increase surplus.
The COVID-19 pandemic is a key example of a low-frequency/high-severity event resulting in significant business losses to large and small companies alike. Pandemic coverage is a unique risk for which the traditional insurance market has little to offer; very few insurers offer pandemic policies and projected losses are difficult to estimate. Most companies are discovering that their commercial package business interruption coverage will not cover the losses related to this pandemic.
Society is now relying heavily on new and emerging technologies to work remotely, access distance learning, and provide contactless deliveries. The digital world is growing exponentially and contains its own group of emerging risks. The traditional insurance market often reacts slowly to emerging risks due to lack of historical data. The commercial insurance market is also heavily regulated, adding further hurdles for innovation.
When considering a captive to insure unique and emerging risks, two key obstacles need to be overcome. The first is developing insurance policy terms for the coverage, and the second is setting the appropriate premium for the coverage.
For traditional insurance risks, the policy terms, definitions, and procedures are well-established; however, for unique and emerging risks, the coverage and policy issues need to be defined. The following questions should be answered:
- What risks and types of loss are covered?
- What triggers a claim? How is an incident defined?
- How is the date of loss determined? In the case of a pandemic or another scenario where losses are spread over a period of time, this may not be obvious.
- What are the coverage limits, and how do they apply?
- How is the amount of loss determined?
- Are there any exclusions that need to be specified?
Ideally, premium calculations for any insurance coverage are based on a large database of relevant historical data. However, for unique and emerging risks, this is rarely an option. Companies must work with an actuary to find relevant information on which to base their rates. This information may come from internal histories or external industry sources for similar risks.
There will likely be uncertainty in the rates and they must be monitored closely and adjusted as necessary when actual claim experience emerges. While there might be a temptation to set rates conservatively in the face of this uncertainty, the captive will need to be able to demonstrate to its domicile regulator that its insurance policies include risk transfer for accounting purposes. Insurance risk transfer must include uncertainty in both timing and value of claims. Companies should verify that redundant coverage is not simultaneously provided by existing insurance policies, such as a business interruption endorsement for virus and disease provided by some commercial package policies.
Similar to the way the September 11, 2001, terrorist attacks increased the availability of terrorism insurance, COVID-19 has heightened awareness of the need for pandemic insurance coverage. Just as the world evolves with technology, the insurance needs of businesses also evolve. In addition to the propulsion of various technologies caused by the pandemic, there are additional emerging insurance risks such as those related to automated cars, smart home technology, city bike and scooter rentals, climate change, riots, and cyber liability. Captive insurance companies could be a solution for providing coverage wherever traditional insurance markets lag behind.
Does a captive make sense financially?
Companies looking to form a captive insurer usually find themselves in one of two scenarios; a company using the commercial insurance marketplace may believe it is being overcharged, or it may be unable to find a desired coverage. The latter occurs when a company requires coverage for unique or hard-to-place risks, when a company struggles to place unattractive layers of coverage, or when a company’s industry is avoided by the commercial insurance market. A captive can also provide access to additional reinsurance markets that might not otherwise be available to the parent company. In these cases, the formation of a captive might be the answer.4
It is likely that a company with significant insurance risk already retains some portion of its losses through a self-insurance or large deductible program. It is important to note that, unless the proposed captive insures a different level of losses or different exposures altogether, retained losses will be identical under either option. An actuary is often asked to review losses at various retentions in order to help determine optimal layers of coverage supplied by the captive.
Although difficult to quantify, tangential benefits such as the centralization of risk management data and the creation of a separate subsidiary to measure the cost of risk related to self-insurance can be a benefit to the parent company and a valuable management tool.
Outside of losses, a company also should consider potential additional expenses, anticipated savings, and long-term objectives. For example, a captive will most likely incur additional expenses associated with planning, underwriting, and implementation beyond the current program structure. Typical additional costs include captive management fees, premium taxes, accounting and audit fees, actuarial fees, an annual board of directors meeting, and regulatory examination fees.
In contrast, a successful captive is designed to save money by recapturing underwriting profits as well as any corresponding investment income that an insurer would have earned. It is also possible for savings to be enhanced in more specific ways. For example, if the captive writes a narrow class of risk and hires claim specialists who are experts in that class of risk, outcomes may be superior to what the commercial market achieves.
Single parent versus group captives
Companies with significant amounts of insurance risk can look into forming their own captive, of which they would be the sole parent. As these captives cover only the parent’s losses, single-parent captives heavily rely on information and data currently known and understood by the company. In the case where a company may not be big enough to form its own captive, a group captive may be formed where risk is pooled among members. Usually a group captive includes companies from the same industry with similar levels of risk. A group captive can be helpful in sharing the expense of running the captive. However, incentives should be implemented to encourage all members toward quality risk management.
Third-party insurance
Captives can also be used to write coverage for companies outside of the parent, or third parties.5 In this way, a captive insurer could be used as a potential profit center.
The biggest advantage of writing third-party business through the captive is that it may provide a tax advantage compared to a captive that is only writing the risks of its parent. When writing outside business, a captive may defer taxes on all unpaid claim liabilities subject to IRS rules on discounting, much like an insurance company. This amount could be significant, depending on the limits and coverages being written. The captive would also collect fees for writing outside business to help offset its costs. In addition, if the business proves to be profitable, the captive would be making money as opposed to just saving money.
Writing insurance for third parties comes with its own additional set of risks. Ultimate losses associated with the business may not be known for several years, at which point it may be difficult to recover unanticipated losses and mitigate their impact on the captive’s profit margin. Thus, it’s important to stick to familiar coverages and industries and to have an actuary help price and review any outside business.
Conclusion
In 2020, we have seen companies and industries forced to reevaluate conventional techniques and procedures. Survival to this point is testament to how quickly they have been able to adapt to a rapidly changing landscape. How will the insurance industry fare with all the newly uncovered risks? Who will thrive? It may be time for your company to consider using the captive insurance market to insure previously unfilled gaps in coverage.
1For more information, see https://us.milliman.com/en/insight/COVID-19-business-interruption-coverage-and-the-physical-loss-or-damage-requirement.
2For more information, see https://us.milliman.com/en/insight/If-you-contract-COVID-19-at-work-is-that-a-compensable-workers-compensation-claim.
3For more information, see the video at https://www.captive.com/captive-videos/video-pages/insuring-unique-risks-captive.
4For more information, see the video at https://www.captive.com/captive-videos/thought-leaders/joel-chansky.
5For more information, see the video at https://www.captive.com/captive-videos/video-pages/writing-third-party-business-captive.