Home computers used to cost thousands of dollars. Caribbean islands once were the exclusive playgrounds of the super-rich. And captive insurance companies for many years were beyond the reach of all but the Fortune 500.
That was then; this is now. With the emergence in recent years of options like rent-a-captives and agency-owned captives, middle market independent agents now can offer their clients the spectrum of benefits available through a captive structure--without the financial, administrative and regulatory challenges that once barred all but the mega-brokers from this lucrative playing field.
In a two-part series on the new face of captive insurance, we'll explore the widening range of choices available to independent agents and their clients. In this month's segment, we'll define key terms, describe the structure of various captive alternatives and explain how they can allow both agents and clients to share in underwriting and investment profits. Next month we'll take a closer look at the states that have laws permitting captive formation and present the views of some experts in this rapidly expanding market.
To navigate the captive landscape, it's useful to have a roadmap. Let's start by defining some common terms, using information provided by the South Carolina Department of Insurance, one of several states that permits the formation of captives.
What is a captive?
A captive is an insurance company that primarily insures the risks of its owner and is actively managed by the owner and/or insureds. Captive insurance companies are generally formed as an alternative to self-insurance. The assets of the captive are typically owned by the insured. Captive insurers can take a variety of forms.
* Single parent: Captives that underwrite only the risks of the parent and its subsidiaries.
* Diversified captives: Captives that write unrelated risks in addition to the parent's business.
* Association captives: Captives that underwrite the risks of members of an industry or trade association. Liability risks such as medical malpractice are frequently insured in this way. A similar structure is the group or multi-owner captive.
* Agency captives: Captives formed by insurance agents or brokers to allow them to participate in high-quality risks that they control.
* Rent-a-captive: A captive that provides access to captive facilities without the user needing to capitalize its own captive. The user pays a fee for the use of the captive facilities and will be required to provide some form of collateral so that the rent-a-captive is not at risk from any underwriting loss suffered by the user.
* Special-purpose vehicles are used in risk securitization. These are reinsurance companies that issue reinsurance contracts to their parent and cede the risk to the capital markets by way of a bond issue.
* Fronting arrangements are used by smaller captive insurers. The smaller captive acts as a reinsurer accepting the risks of its parent, which have been insured by a licensed direct or primary insurer and then ceded to the captive. The fronting company will generally charge a fee for its services and may require a letter of credit to guarantee the captive's ability to pay claims.
Why use a captive?
The various captive structures offer the insured (and often the producer) some significant advantages; these are outlined below.
* Cost control: A captive may help reduce insurance costs by charging a premium that reflects the parent's loss experience rather than that of a group. Further, the insured can enjoy a higher level of control over claims and defense costs, as well as realizing savings from loss control efforts. Finally, under certain circumstances, premiums may be tax deductible.
* Increased profits: A captive can retain premiums and loss reserves and realize the returns from both underwriting and investments, as well as realizing investment income on contributed capital.
* Cash flow: With a captive, premiums and investment income are retained within the insured group. A captive also may be able to offer more flexible premium payment plans that would provide a direct cash flow advantage to the parent.
* Stability of coverage and price: Captives can be an attractive alternative when the commercial insurance market is unable or unwilling to provide coverage for certain risks, or when the insured deems the quoted premium to be excessive. With a captive, the insured is significantly less vulnerable to market cycles and is better able to predict costs.
* Custom coverage: With a captive, coverage can be increased or tailored to meet the insured's specific needs. In addition, the insured may have access to more capacity than would be available in the commercial market.
* Risk retention: Establishment of a captive helps the insured address concerns about inadequate discounts when it assumes higher deductibles for the risks it retains.
* Risk management: Forming a captive forces the company to focus on the parent's risk management programs. An effective program may allow the parent to realize profits by reducing costs.
* Access to the reinsurance market: By using a captive to access the reinsurance market, the insured can more easily determine its own retention levels and structure a more flexible program.
* Writing unrelated risks for profit: A captive may insure the risks of its parent and the risks of third parties. A captive generally sells insurance to the customers of its parent. For example, a retail business may sell warranty agreements to its customers.
* Tax benefits: The formation of a captive may provide some tax benefits to the parent.
Haven in a hardening market
In an article titled "The Role of Captives in a Tightening Marketplace" in the November 2000 issue of Rough Notes, Bermuda-based captive specialist Peter Mullen points to the increasing availability of captive solutions to middle market independent agents and their clients as the commercial insurance market hardens. Mullen, who is president of Artex Underwriting Managers, a unit of mega-broker Arthur J. Gallagher, explains why the number of agency-owned captives has increased significantly in recent years. "The captive in this case is owned and funded by the agent, who in turn will keep all of the underwriting profit and investment income from the program. Under the right circumstances, an agency captive brings a tremendous amount of control and additional profit to the agent."
A key advantage of the agency captive structure, Mullen points out, is that the agent can manage the business in the program while a firm like Mullen's takes care of taxes, SEC issues and other details. Another benefit is the ability to purchase services on an unbundled basis from third-party specialists such as fronting companies, reinsurers and third-party claims administrators. This approach, he notes, offers a level of flexibility and control not available in the standard market, where the insurer provides all the services and sets all the prices.
High praise for rent-a-captives
At the Consultative Brokerage Summit cosponsored by Rough Notes in March 2000 and reported in the May issue of the magazine, John M. Foehl, Jr., of Tillinghast-Towers Perrin described the rent-a-captive as an affordable and profitable opportunity for middle market agents. This approach, he noted, has three advantages that make it particularly attractive to middle market risks: low or no startup costs, low annual operating costs and flexibility. Like Peter Mullen of Artex, Foehl points to the benefits of stability, control and financial incentives available to agents and clients through a rent-a-captive.
For the middle market agent who is seeking to establish him/herself as a trusted adviser to clients, Foehl says the rent-a-captive is the quintessential win-win situation. First, it allows the agent to provide additional value to clients and aids in the transition to risk manager. Second, it's an excellent way for the agent to solidify relationships with clients by allowing them to share in the control of their risks. Finally, it's a proven way for agents to create new sources of revenue in cooperation with the rent-a-captive.
Onshore opportunities growing
Although most rent-a-captives and agency-owned captives now are operated in offshore locations like Bermuda and the Cayman Islands, a growing number of jurisdictions in the United States have captive laws that allow for the establishment of these facilities within their borders. From the granite cliffs of Vermont to the palm-lined beaches of Hawaii, more states are recognizing the advantages of welcoming captive formation that traditionally has taken place offshore. Next month, in addition to examining offshore captive structures, we'll explore in more detail the options available to agents and their clients who choose the domestic route to establishing a captive. *