Captives and the soft market

Lack of capital hurts new formations

By Michael J. Moody, MBA, ARM

Over the years, captive insurance companies have become an accepted method for risk financing. Today, they are routinely used by corporations that run the gamut in size from Fortune 500 to local restaurant chains. All of these organizations have found that they can better manage their overall risk management program through the use of a captive. However, at this point, conventional wisdom has indicated that a protracted soft insurance market would have a chilling effect on captive use.

However, one study that was completed by mega broker Marsh, Inc., early in 2009 would appear to challenge this assertion. While the study clearly acknowledges that the rate of formations has slowed, it also notes that, “despite the global economic recession and continued soft commercial insurance market, businesses in all parts of the world continue to use captive insurance companies as mechanisms to manage their risks.”

Current market conditions

Without question, the current soft market has been extended much longer than most industry observers had thought. Having to deal with the adverse effects of the financial crisis has been challenging for most insurers/reinsurers. They have to deal with everything from competing with insurers that are “too big to fail,” to investment income that resembles Christmas club account interest. As a result, it was difficult to see how most insurers/reinsurers were going to be able to retain their current rates. But retain them they have, and for most there is little mention of increases in 2010.

For the most part, captive growth in recent years has come primarily from the middle market. And the primary reason for this, according to Scott Addis, president of The Addis Group in King of Prussia, Pennsylvania, is that these accounts “get it.” He points out that these are buyers, “that are beginning to realize that the most cost effective methods of protecting their balance sheets is via the captive approach.” It’s this fact, the “getting it” thing, that has led to the continued acceptance of the captive concept, he adds.

As a result, most current captive owners are well aware of why they came to the captive in the first place. “They have come to realize that their true cost of risk revolves around their ability to control and minimize their claims frequency and severity,” according to Addis. And as a result, he says, “There is a pretty interesting mind shift, going on in this soft market.” Despite the soft market, he says, these buyers “are concentrating on developing strategies that will reduce frequency and severity, rather than simply getting competitive bids for the lowest price insurance.”

Gary Warren, head of Addis’s captive practice, indicates that one of the keys to making the captive concept work is educating the insurance buyer. He says, “By this point, most buyers that are in captives have seen the advantages associated with captives.” Many of them have also survived several market cycles and understand how the captive has benefited them on a long-term basis. “Once they have seen the benefits, there is no reason to go back to the traditional market,” says Warren.

David Becker, president & COO of Cottingham & Butler in Dubuque, Iowa, says that despite the soft market, people that are in captives have remained committed to them. “For those captives that are working well, we have noted that most of the owners are staying with them.” While there may be several reasons for this, Becker thinks that captive owners are also beginning to take a long-term view and, as a result, the owners continue to see benefits of captive ownership regardless of the market cycle.

New formations

Existing captives appear to be holding their own in this market; however, startups have slowed.

Some captive domiciles have indicated that they had growing numbers of startups during 2009. However, when the startup figures are netted with the amount of closures, the actual growth is not quite as impressive. Barring any significant hardening of the commercial market at the end of the year, most industry observers believe that 2009 will be remembered as a year of moderate growth.

Derrick White, president of SRS (Vermont), Ltd., indicates that captive formations today have some major hurdles. Most of these hurdles can be summarized with one word—capital. He says that while there continues to be significant interest in captive formations, particularly in the med mal area, most new formations suffer from a lack of capital.

“Collateral is tight right now; it is as simple as that.” A letter of credit, when you can find one, says White, “is at least twice as costly as it was just a couple of years ago.” That, unfortunately, translates into requiring the owner to have to use cash for capital and surplus. This lack of credit also led to SRS losing two captive clients at the end of 2008. White points out that both were single-parent captives that needed to access the money they used to capitalize their captives. As a result, they were forced to close their captives, just to get the capital out.

Becker agrees that the lack of capital is a problem. He says, “The slowdown in captive formation has less to do with the soft market than it does with collateral issues. Credit availability—or lack of it, to be exact— has been the single biggest obstacle to captive formations that we have encountered.” Becker believes that even if the insurance market should harden quickly, the lack of credit will continue to slow captive formations.

Conclusion

Despite the soft insurance market, estimates still show that over 50% of the commercial insurance market is in some type of alternative risk transfer (ART) mechanism. Captives represent by far the largest segment of the ART market. Growth within this segment has resulted in the total number of captives reaching more than 5,000 worldwide. As a result, many businesses have had the opportunity to see firsthand the benefits available from captive ownership. These benefits typically include cost savings, and even in a soft market, captives can compete favorably with traditional insurers. This is primarily due to savings available to the captive from reduced overhead and related expenses.

While coverage availability is rarely an issue today, affordability is still a problem in some lines of coverage. Captive ownership can allow for signi­ficant coverage improvements, and enhancements can easily be accommo­dated in the captive. In addition, many captive owners are now keenly aware of the benefits associated with being able to better control their risk management program via the captive. The captive typically offers maximum control for owners, as well as an accelerated payoff from improving risk mitigation efforts.

So, while it is obvious that the soft market has taken its toll on the captive movement, it is much less about the captive concept than about the credit availability issue. As Scott Addis points out, business owners are finally “getting it.” Not all business owners, of course, but those that do are committed to developing a long-term course that includes a captive as a key element. And as C&B’s David Becker notes, today’s captive owners are developing strategies that incorporate their captives as a central part of their organizations’ overall risk management programs. And for some captive owners, this risk financing vision is not exclusive to insurable risks. More and more forward thinking organizations are exploring ways to incorporate their captives into their enterprise risk management implementation plans.