Captive Insurance Companies Association (CICA) Special Section
SOFT MARKET: FRIEND OR FOE FOR CAPTIVES?
Soft market brings easier reinsurance and fronting
terms, opportunities to clean up balance sheet
By Michael J. Moody, MBA, ARM
At this point in time, it appears that the soft market is in full swing. While some market segments began to show signs of price reductions in early 2002-2003, most of the insurance market remained hard during that period. Then came the record property losses in 2004-2005 and the entire insurance market suffered from a lack of capacity. But today the majority of the property and casualty insurance market is “enjoying” favorable pricing, with little evidence that hardening will occur soon.
Conventional wisdom has typically categorized soft markets as foes to captive insurance companies. Certainly the soft market can be a challenge to the captive industry, particularly group captives and risk retention groups. But in some respects, a soft market may actually aid the long-term prospects for the captive industry. From that standpoint, captives need to view the soft market from two separate perspectives: meeting the pricing competition and assisting with the strategic goals.
Competitive challenges
Without question the current insurance market has put pressure on the captive insurance industry as a whole. However, it typically hits the group alternatives, group and association captives and risk retention groups the hardest. Gary Griswold, director of Captive Operations, SB&T Captive Management Services in Burlington, Vermont, notes, “When you form a group captive in a hard market, everyone is there because of the cost, or possibly the availability of coverage. Obviously, you try to sell them on the fact that you are forming the captive for the long-term, but when the soft market returns, you find out quickly who is there for the long haul.”
Far too often, soft market pricing issues have their origin in basic captive 101 issues. For example, in a perfect world, the expense factors associated with a group captive should be more competitive than most commercial insurers. Commercial property and casualty insurers will have expense ratios that run from about 26% to 30%. A typical captive expense ratio should run around 20%, thereby giving the captive a five point to 10 point advantage over commercial insurers. This comparison is even more profound for risk retention groups that do not require a fronting carrier, where expense ratios typically range between 7.5% and 10% in today’s market, for an overall expense advantage for RRGs of 13 points to 22 points. But, of course, there is little rational pricing that goes on in the commercial insurance marketplace.
And, of course, one of the basic captive 101 advantages is specialized loss control and or loss mitigation programs. This one issue alone may hold the key for group captives. Group captives, particularly homogenous (common risks) captives, should have a risk management program that is its centerpiece. In many instances it’s the risk management program that is responsible for the reduced premiums that its members are able to gain. Many state-of-the-art risk management programs have been started by homogenous captives such as RRGs for their insureds’ specialized exposures, and they typically cannot be found in the commercial insurance marketplace.
Another captive 101 issue is that the captive represents a long-term risk-financing mechanism. Accordingly, there are a number of things that can be included in the contractual relationship between the captive and members. The contractual relationship should be built so as to have disincentives incorporated into the agreement. These would include such things as multi-year cancellation clauses, return of premium that is spread over several years as well. Additionally, the captive should work toward making sure that every member realizes that the captive is a long-term solution and that the purpose of the captive is to take the volatility out of the marketplace. This means both the highs and lows, and should the member leave the captive, future involvement in the captive may be restricted.
The same basic philosophy applies to claims management. Homogenous group captives such as RRGs can afford to invest significant time and effort implementing a specialized claims management program. Within a short period of time, the closed claims data will begin showing the major sources of claims, and then specific programs can be developed to address those issues. Along the way, this recent and relevant loss data will also provide a treasure trove of information about key plaintiffs and defense attorneys as well as expert witnesses that can be used in developing a proactive claims management system. This type of industry-specific information is rarely available to commercial insurers, and even if it were, few would take advantage of it to the extent that the captives can.
Many group captives have also found other ways to provide various value-added services to their members. It might be some new technology that can be obtained more favorably due to group purchasing power or state-of-the-art risk management programs. Sometimes group captives can provide an excellent forum for value-added services. For example, after Hurricane Katrina, many group captives worked with their insureds to develop catastrophe and continuity plans for their members’ operations. This was noteworthy because few, if any, wrote the property coverage for the members. It was an important consideration that members needed help, and the captive filled the bill.
And finally, there is the communica-tion issue. One of the things that some group captives, including RRGs, have found out the hard way is that ongoing communications is one of the keys to a successful captive insurance venture. It is not enough that the organizers of a group captive and/or RRG establish a viable risk-financing program for their members, but they must continually reinforce this message at every occasion because, as Griswold notes, “People’s memories are too short.” Thus one of the factors that can contribute to the long-term success of any group program is the continual communication with the members about the reasons why the captive was formed and why it is successful now.
Opportunistic issues
One of the most opportunistic areas that can be utilized during a soft market is inexpensive reinsurance. Griswold notes that many times group captives that are formed during a hard market have a difficult time obtaining comprehensive reinsurance at favorable pricing. This issue, “frequently puts significant pressure on start-up captives.” Today, however, Griswold confirms that “most reinsurance is cheap and plentiful.” Additionally, he notes that even fronting carriers have relaxed their terms and conditions. He says, “Now fronters are even starting to trawl for new business.” Further, while start-up captives “frequently found $5 million minimum premium requirements, there are no similar requirements today.” Pricing for reinsurance and/or fronting is extremely competitive today, so captives should consider taking advantage of this pricing. Additionally, terms and conditions can be expanded in today’s market. Griswold also points out that pricing concessions for multi-year policies also are available.
Aside from the pricing issues related to reinsurance and fronting, those captives that have not had favorable conditions in the past should consider selling their reserves via a portfolio transfer. Griswold states that selling a captive’s reserves during a soft market can do wonders for cleaning up a captive’s balance sheet. And while pricing is competitive, favorable terms and conditions can also be arranged to shed reserves that were part of the initial start-up.
Right time for a start-up?
Is a soft market the correct time to start a new captive? While there are many points of view on this topic, some believe that a soft market may be the perfect time to consider a captive formation. As Griswold notes above, many captive start-ups must work to rid themselves of high-priced reinsurance and/or fronting contracts. And these can put additional pressure from the start that may not be required from soft market start-ups. And it’s not just the price of coverage. It also includes minimum participation, relaxed underwriting requirements, and other operating issues. Griswold also points out that it is always “good to get several years of solid loss experience prior to the next hard market.” This can help immensely in finding adequate reinsurance in a hard market.
Conclusion
Every soft insurance market takes its toll on captives, and this one will be no different. However, there are strategies that captives can use to lessen the erosion. Existing group captives and RRGs must look at where they are at this place and time. Typically, captives will be formed to meet some difficult market condition, but they must be viewed as long-term vehicles. Members need to realize that the soft market will be only a temporary situation. The captive will provide a long-term solution. Without question, most group programs will lose members during a soft market, but if captives can take advantage of the soft market conditions to maximize their results, they will be affected only minimally.