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Captives and strategic planning Captives increasingly are being used to implement ERM programs By Michael J. Moody, MBA, ARM As most people are aware, captives have been a part of the alternative risk transfer market for at least the past 30 years. Captives were first formed to counter some insurance market shortcomings. Whether it was a property insurance issue or a problem with a specialty line of liability coverage, most captives were established to address a specific concern. During this time, the captive market’s growth normally accompanied hard markets in one or more lines of insurance. A market would begin to experience either affordability or in some cases availability problems, and the affected insureds would frequently turn to the captive for help. Most captives, whether single parent or group captive, maintained this single-minded focus. Certainly the advent of the federal risk retention legislation reinforced this single-minded concept. The RRG legislation provided strict guidelines about what the captive should be used for, thereby limiting the available options to its owners. Times change However, a major change in this limited vision of a captive’s usefulness has been occurring over the past decade. Previously, when a hard market ended and the coverage issue abated, captive owners would begin considerations to put the captive in run-off, or just close it entirely. Today, however, most captive owners, some risk management consultants and many captive managers realize that the captive can provide a much larger role in the overall risk management program. In fact, in forward-looking companies, captives are now considered an integral part of the firm’s strategic planning efforts. One area of expansion, according to Robert J. Walling III, principal and consulting actuary at Pinnacle Actuarial Resources, Inc., is “being able to offer value-added coverage to the parent’s strategic partners.” While Walling notes that these types of arrangements have been used for a number of years, today they are seeing the numbers of these types of programs increase. Hospitals and their attending physicians have been able to utilize this approach many times during the recent medical malpractice crisis. He says that hospitals would frequently arrange coverage for the attending doctors through the hospital’s captive. He points out that in addition to the obvious advantage of providing needed coverage for the doctors, there were other benefits to the hospital. First, the hospital was assured that the coverage was in place since it was in their captive. Additionally, the joint defense aspects available from the combined hospital/doctor coverage allowed for a discounted premium—“since there is only one set of defense attorneys, the claims settlement is much more efficient.” And this approach of helping strategic partners is not just limited to hospitals, Walling says. He indicates he is aware of several other industry segments that offer similar types of opportunities to a captive owner’s strategic partners. Among some of the groups mentioned were food producers and farmers, and trucking firms and independent contractor drivers. Benefit buzz One of the most talked about strategic expansion opportunities for captives is employee benefits. Karin J. Landry, managing partner at Spring Consulting Group, says that employee benefits are the most visible area where corporations are attempting to provide strategic advancement for their captives. She says this is only natural because, for many companies, “their biggest risks are people and their related direct and indirect costs.” Captives are frequently pressed into service to help corporations with “issues that are troubling them.” Landry points out that much of the current buzz revolves around the ERISA/Department of Labor (DoL) approved employee benefits such as term life and long-term disability coverage. And, she says, these types of applications have been “a little slow in developing.” But she points out that currently there is significant activity in those employee benefit areas that do not require DoL approval. “Just because there is a lack of DoL approvals, some people think that nothing is happening, and this is just not the case,” she says. “Actually there is a lot happening, but it just does not make the press.” Beyond the obvious employee benefit coverages, there are other human resource opportunities for strategic captive expansion. Landry says it is in “big ticket items like pensions, and retiree health benefits” where activity is starting to heat up. However, this is a captive application that is just beginning to emerge and captives are just starting to scratch the surface of this area. As these areas become more volatile business issues, Landry says, “It is only natural that businesses would look to their captives as a potential solution.” Walling notes that his firm is seeing an increased interest in the pension and retirement planning area from a number of doctor captives. He points out that retirement planning and asset protection are a major concern to these groups and they are looking to their captives for assists in this area. Landry points out, however, that expansion beyond traditional employee benefits could be more difficult. “When you look across the benefits, some, such as group term life insurance, are pretty easy to work with.” Here she says, “You have a predetermined payment when you die, and it’s pretty straightforward.” On the other hand, if you look at a benefit such as retiree medical, it is very complex and difficult to project. “It is also a very emotionally charged issue,” she says. And since corporations are changing the way they now see these benefits, “they have to deal with lots of personal stuff, which goes well beyond the basic risk financing issues.” Other coverage areas Recent large losses in the property area have made consideration of this coverage mandatory for many captive owners. Landry reports that property coverage inclusion, primarily on a cat exposure basis, has had an increasing amount of interest. Other property coverages are also getting a fair amount of attention. For example, business interruption and contingent business interruption risks are getting some additional interest these days, particularly as they relate to wind and flood. Uncertainty over the federal government’s involvement in terrorism coverage at year-end has also resulted in inclusion into a parent’s captive. While there has been a change in the makeup of Congress since the last vote on TRIA, no one still has a good idea about how this issue will be resolved. Certainly the first TRIA legislation passed was much more favorable to being used by a captive’s parent; however, many captive owners are making contingency plans if TRIA is allowed to expire. Enterprising view For a variety of reasons, many organizations have begun moving towards a more holistic view of risk management. This movement, known as enterprise risk management (ERM), will have a profound impact on captives. Many experts believe that a single parent captive is the ideal platform upon which to build an ERM program. Many feel that this is just a natural outgrowth for a captive to take. “Once you get over the barrier to entry, you make the initial capital contribution and take some of the basic exposures,” says Walling. “You develop an internal knowledge base and comfort level with the captive.” And he points out, “Doing incremental increases in exposures to the captive becomes much easier.” Walling says his firm is already starting to see more creative ERM-type risks being considered for the captive. “We’re starting to see how some captive owners are interested in using the captive as a hedge for other risks.” For example, one captive has begun to consider adding raw material risks into the captive. Walling notes that some of the creative approaches to expanded captive utilization have been slow to develop. He thinks that this “has gotten sidetracked with all the problems created around Enron.” Walling says that these types of innovation are now starting to re-emerge, however. “Now they are coming back, smarter then when they left.” Landry also confirms that spring is beginning to see an expansion of the captive beyond traditional property and casualty risks. She points out that owners are trying to take maximum advantage of their captives. They are considering many different approaches since they already have the fixed costs covered. One area that she has seen some interest in is financial risks such as trade credit. This is an exposure that is increasing significantly as companies begin to grow internationally, and the captive could assist in providing coverage, she says. Today’s captive owners are “thinking past the traditional affordability and availability issue,” Landry says. Captive owners are beginning to realize that they have a risk financing tool that has many more applications than originally thought. The future is bright Most captive domiciles have indicated that they continue to have a backlog of captive formations. Additionally, many consultants have also indicated a similar situation. Landry points out that her firm is “still seeing a huge amount of activity in the captive area.” This continued interest in captives is also true for Walling’s group. “Let’s face it,” he says, “captive owners realize that you can be more creative with a captive than in a traditional insurance program.” As a result, people are continuing to look favorably at captive formations. According to Walling, most believe that a captive can provide “an environment that encourages and nurtures innovation,” rather than just having to take whatever is available in the marketplace. Despite this optimistic view of the captive market, the next few years will be pivotal for the captive industry. For the most part, the property and casualty insurance market is soft for the majority of lines. Whether or not captives can take advantage of this current soft market and continue to grow remains to be seen. Certainly, ample opportunities exist for captives to explore creative expansion beyond their traditional roles. In some ways, how captives fair in this new, broader view of risk management will parallel how well the insurance industry fares in this new environment as well. * |
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