A number of mid-sized organizations have recently begun to explore the ART market for possible solutions to their own hard market woes.
Group captives
The wave of the future?
By Michael J. Moody, MBA, ARM
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A number of mid-sized organizations have recently begun to explore the ART market for possible solutions to their own hard market woes. |
Although we have not seen a full-blown hard market yet, there certainly have been pockets of hardness for certain industries since the millennium began. And for most businesses, a certain stiffness has replaced the extended soft market of the last decade. Commercial insurance buyers have greeted this market change from several different perspectives. The majority of Fortune 1,000 corporations looked to their captives to handle risks that were no longer attractively priced in the traditional insurance market. Nearly all of these large commercial risks already were prepared to move to the alternative risk transfer (ART) market, thanks to steps taken during previous hard markets. However, a number of mid-sized organizations have recently begun to explore the ART market for possible solutions to their own hard market woes. For many of these companies, the group captive alternative is gaining increasing interest.
Group basics
The renewed interest shown by middle-sized commercial accounts in captive insurance companies has led to significant growth in the group ART arena. For the past three or four years, various groups of insurance buyers have been banding together to establish viable solutions to today’s hard market. A captive insurance company is one that is owned and controlled by its insureds. Its major purpose is to insure the risks of its owners, who are also the primary beneficiaries of any underwriting profits. Group captives are ART programs that are established and controlled by two or more insureds. The insured groups, which may be either homogeneous (similar types of businesses) groups or heterogeneous (unrelated types of businesses), band together to form a captive insurance company. Within the group captive classification, there are several successful business models that include:
• Association Captive—a group captive that is formed by an association so that it may offer insurance coverages as part of its membership benefits. Participation in the captive is typically confined to association members.
• Risk Retention Group—a group captive that is authorized under the federal Risk Retention Act of 1981/1986. RRGs must be limited to insured owners who are engaged in the same businesses or activities. Thus, homogeneity is mandatory. Coverage provided is limited to liability related exposures.
• Rent-A-Captive—a group captive where the insureds “rent” their required capital and surplus from the captive owner.
• Protected Cell Captive—a specialty rent-a-captive company that ensures separation of risks among program insureds. The legal separation of accounts includes the insured’s assets, as well as any reserves or dividends that may be available.
All of the above forms of group captives have been used in the past to provide a viable insurance market for their owners. However, over the past few years, the most popular group option has been the risk retention group (RRG). According to the 17th annual survey of RRGs conducted by the Risk Retention Reporter, growth over the past two years has soared. The survey indicates that RRG formations are increasing at a pace six times faster than the rate in 2001. As a result, in both 2003 and 2004, there were about 58 new RRG formations, compared to only seven in 2001.
While many industry segments have taken advantage of the favorable federal legislation associated with the RRGs, it was the health care industry that grew the fastest. Currently, the Risk Retention Reporter shows a total of 177 RRGs nationwide, and of that number, 77 are health care RRGs. Other industry groups that have found that RRGs offer a feasible alternative are property development firms, transportation, construction, and groups with a professional liability exposure (i.e., accountants, lawyers, insurance agents, etc.).
Dress for success
While there is no single, magic formula that assures group captive success, a number of factors can provide a good foundation for the long-term viability of the group alternative. More than 20 years ago, risk management consultant Tillinghast documented 10 factors that were important to maintaining a group program. The intervening 20 years have served only to confirm the importance of the factors that are summarized below.
Many of the factors directly or indirectly revolve around underwriting. These include such things as careful risk selection, so that each member pays an equitable premium that is based on prudent actuarial estimates. This factor is closely aligned with prudent funding, which requires that adequate levels of capital and surplus be committed to the captive. Regardless of the specific details of the bylaws, there must be risk sharing since it is essential that the participants agree to share the losses of the others. While the degree of risk sharing is typically dictated by the availability and affordability of reinsurance, it is important to maintain some element of risk sharing. One of the expectations of any group captive operation is that it will, at some point in the future, show a favorable bottom-line return. Accordingly, it is also important to establish a profit allocation methodology early in the formation process in order to maintain participant support. The final underwriting-related factor deals with homogeny of interest. Time has shown that shared needs lead to a clearer understanding of risks.
Other factors that should be considered include establishing a risk management approach to the captive operations. From a strategic standpoint, the captive should be the focal point for an overall commitment to a proactive risk management program. Additionally, the captive must be viewed as a long-term solution to the member’s risk financing needs. As a result, the captive’s organizational features must be established to take advantage of this long-term view. The captive should be able to reduce the expense factors for the members. It must take advantage of the elimination of some expense items (e.g., boards and bureaus, guaranty fund expenses, reduced advertising, lower commission expenses, etc.). Finally, there must be a sense of urgency—not panic, but urgency. Further, the captive concept must have the strong support of the sponsoring organization. Without the strong political support, few captives could survive the formation process.
It is important to point out that each group captive will have it own unique personality. And while the 10 factors noted above may not be incorporated in each captive, the more factors that are included, the better the chances are that it will be a long-term solution for its owners. Another important factor to success in the group captive arena is to align yourself with quality third-party vendors that will work with your group to establish a long-term, strategic risk financing mechanism that will best serve the insureds’ needs.
Conclusion
At this point, it is obvious that captives and, more important, group captives, will continue to be a part of the risk management landscape for some time to come. Past events, such as the cyclical nature of the insurance business have continued to foster this trend. And it’s this cyclical nature of the traditional insurance market that has allowed many prudent insurance buyers to see that there is a better way to approach risk financing. While large organizations recognized the value of captive insurance companies years ago, it is only recently that mid-sized corporations have seen the value of this creative ART method.
This leaves middle-market brokers in a precarious position. At this point in the evolution of group captives, middle-market brokers can either embrace this movement and establish or develop relationships with appropriate group captives and selected vendors and make this option available to their client base, or they can wait until another broker presents this alternative to their clients and risk losing the business. Forward looking, middle-market brokers will recognize this as an opportunity and be able to grow their business with group captives as a strategic component to their overall market program. *
The author
Michael J. Moody, MBA, ARM, is the managing director of Strategic Risk Financing, Inc. (SuRF). SuRF is an independent consulting firm that has been established to advance the practice of enterprise risk management. The primary goal of SuRF is to actively promote the concept of enterprise risk management by providing current, objective information about the concept, the structures being used, and the players involved.