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PROGRAM CAPTIVES: EYES WIDE OPEN

PROGRAM CAPTIVES: EYES WIDE OPEN

PROGRAM CAPTIVES: EYES WIDE OPEN
August 26
13:36 2021

PROGRAM CAPTIVES: EYES WIDE OPEN

Opportunities beckon, but don’t rush in

By Joseph S. Harrington, CPCU

Agents and brokers have been showing intense interest over the past decade in creating captive insurers for supporting program business. Among other things, by sharing premium as a de facto reinsurer of primary carriers, captives can provide their owners with more revenue for investment, and hence greater overall returns, in a low interest rate environment. They can also help stabilize underwriting capacity for the lines of business an agency or brokerage seeks to write.

“It’s a super busy time in captives,” said Robert Gagliardi, head of captive management for AIG. “The hard market definitely drives interest in finding capacity.” Gagliardi made his comments as a panelist in a May 2021 web seminar available on the website of the Target Market Program Administrators Association (TMPAA). (Quotes from the seminar in this article have been edited for brevity and context.)

All of this comes with risks and costs, of course, and those risks and costs are present from the moment a captive is established, well before its owners are likely to see the rewards.

In essence, “you’re building an insurance company,” said panel moderator Jeremy Hitzig, former CEO of Distinguished Programs who founded a new venture, Starfish Specialty Insurance, in June 2021. Hitzig noted that, while insurance carriers typically have significant assets, program administrators are usually “balance sheet light.”

“Every business requires capital,” said Gagliardi, “and understanding the long-term nature of captive capital is very important, because of the potential for negative cash flow in place of the commission you’re used to receiving without any risk.”

Walk before you run

Thus, although bullish on the prospects for using agency captives to support program business, the panelists cautioned viewers to rigorously evaluate the pros and cons of creating a captive vis-à-vis alternative approaches, and to avoid being over-ambitious when first creating the captive.

“We always recommend ‘walk before you run,’” said panelist Carol Frey, vice president of business development for Great American’s alternative markets, which writes primary business for agency captives.

“Many times, we have large clients that want to come in and reinsure 100% of the book,” she said. “They don’t always understand that this creates huge collateral requirements. While they’re very willing to take on risk, that commitment needs to be balanced by the amount of capital they have.

“We normally say, ‘start smaller, start with a smaller quota share, build some surplus, and build confidence with your captive over time,’ as opposed to taking on a heavy risk assumption early on.”

Given the substantial commitment of time and money required to establish an agency captive, “the feasibility study becomes critical upfront,” explained Gagliardi. “You need to determine if the captive is going to make sense. To do that, good data is key. You need to be able to rely on information you have gathered over the last five to 10 years to make a projection about the performance you can expect.”

Frey noted that Great American looks for indications that a prospective program is both economically sound and structured to produce stable profitability over time.

“The whole point of sharing risk and profit is to write business in a captive that is going to be profitable in the long run,” she said. “So, we look at rate adequacy, we look at the market, and we look at how this program fits in a particular industry, and whether it is a growth industry.”

Speaking as a program administrator, Larry Chasin, CEO of PAK Programs, emphasized that a producer seeking carrier support for a program captive needs to project confidence in the proposed enterprise. “Confidence is very important,” he explained. “It’s very important to have confidence in what you’re writing, that you can achieve scale, and that you can take a pop without crashing.”

To that end, Chasin finds that a commitment to accept risk has a profound effect on prospective partners. “I can sit at a table with my insurers and with reinsurers, and we’re partners,” he said. “I’m selecting risks, and I’m paying losses before anyone else is. I have to pay before they pay.

“That’s pretty powerful when I’m trying to sell a program to insurers. We’re putting our money where our mouth is; we’re owning our results, and we’re going to live and die by our decisions.”

Structure and domicile

Producers considering whether to establish a program captive benefit today from a growing range of viable options for forming a captive and selecting its domicile. That’s good news, but it makes a complex decision even more complicated, and captive organizers are urged not to lose sight of the fundamental purpose of a captive—assumption of risk—while evaluating other potential benefits, such as tax advantages.

There are essentially two options for forming a captive, said Gagliardi.

“Most people think about setting up their own captive to become a subsidiary of theirs, a new corporate entity,” he explained. “That’s the most common structure, and that’s how most captives have been formed for years.”

Also, he added, there’s the so-called “rent-a-captive” approach, also referred to as a “protected cell” or “segregated account” captive. Under this approach, a program would utilize the structure and services of an existing captive framework but retain its own premium and risk.

This approach “is like [renting] an apartment,” Gagliardi noted. “The captive [structure] is already set up, you don’t have to build anything, and your risk would be segregated from the other participants. You’re walled off from each other. It’s a pretty efficient way to start up, and it allows you to try out [a program captive] to see if it works for you before forming your own captive.”

As for choosing a domicile, offshore locations are still prominent, but several states in the United States have recently enacted legislation to attract captives and to extend incentives to agency captives. Today, “there’s so many domiciles here in the U.S. to choose from,” said Frey. “That wasn’t always the case.”

She added, “From a carrier perspective, we’re more interested in making sure that a domicile has really good governance [standards], that it is committed to the captive business and wants to make sure everything is being done right.

“We really don’t get into [discussions] with clients on where they want to put their captives. We’re more [concerned] about who and where the collateral is going to be coming from. That’s the most important thing for us.”

Plan for the long term

It’s not easy to establish a program captive, and it’s not easy to walk away from one.

“You really can’t decide one day that you’ve had enough of the captive participation and say, ‘I just want my collateral back,’” said Hitzig. “While that’s technically possible, you could negotiate an early commutation or some other transfer, the more likely scenario is that you’ve got to be prepared to wind it down over a period of years.”

“Sometimes there are a lot of carriers that simply don’t want to commute anything,” added Frey. “Sometimes captive owners experience sticker shock when they first see a commutation price. That’s not unusual, because there are probably still a lot of open claims and IBNR that carriers are attempting to price for.”

Frey recommended that captive sponsors seek provisions in their contracts with carriers and reinsurers allowing them to seek a commutation price, perhaps 36 or 42 months after the first program year.

“Generally speaking, the more maturity you can achieve in any program is probably going to be to your benefit,” she noted.

The author

Joseph S. Harrington, CPCU, is an independent business writer specializing in property and casualty insurance coverages and operations. For 21 years, Joe was the communications director for the American Association of Insurance Services (AAIS), a P-C advisory organization. Prior to that, Joe worked in journalism and as a reporter and editor in financial services.

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