Captive insurance marketplace: A 2011 update

Appeal broadens to mid-sized agents serving mid-sized clients

By Michael J. Moody, MBA, ARM

Today, captive insurers make up the largest percentage of the alternative insurance market, and many large and small companies have taken advantage of them over the past couple of decades. Despite the continuing soft market, according to Dennis Silvia, president of Cedar Consulting, "The captive market is as active as it has ever been."

Part of the reason for this continued growth, he points out, is that many corporations are viewing captives as a method to further their long-term strategic plans.

Len Crouse, principal at The Towner Management Group, and previously the deputy commissioner for captives in Vermont, also notes an increased level of activity with regard to captives. "Corporations today are looking at captives to see how they can enhance the organization's bottom line."  Crouse remarks that corporations are particularly interested in finding ways to improve their profitability while advancing their long-term goals.

Creatures of a hard market

For the most part, the captive industry was born out of the cyclical hardening that occurs in the traditional insurance marketplace. To this day, Crouse notes, "In hard markets, captives really thrive and formations move much quicker."

Hard markets, however, are no longer the key factor driving captive formation. Particularly, over recent years, pricing in the traditional insurance market has been difficult to understand. Projected first-quarter losses in excess of $52 billion (already more than the whole of 2010, when the total was only $40 billion), and mounting loss figures coming out of Japan, would suggest movement to a harder market. As Silvia observes, "If the market can do this without increasing its rates, it would be mind boggling." Many industry observers have noted that insurance carriers are beginning to run out of short-term fixes such as redundant reserves and that there is declining support for many of the other rationales used to explain the continuation of the soft market.

Despite the prolonged soft market, many corporations have chosen to pursue captive formation. Crouse points out that, as a former regulator, "I have always believed that a soft market is an excellent time to set up a captive." This is a time when reinsurance and fronting are plentiful and a corporation can take its time in determining the feasibility of a captive. Then the corporation can complete the formation process in an orderly fashion, "rather than with the urgency that typifies a hard market formation," Crouse says.

Middle market accounts rule

One exceptional aspect of the current captive movement has been the dominant role played by middle market accounts. Early captive formation was initiated primarily by Fortune 500-type entities.  Today, Crouse notes, "It is the mid-cap and small-cap companies that are the big drivers."

A major reason for this involvement by smaller organizations is that, as the captive movement has matured, it has developed many unique approaches for group captive arrangements. This is most frequently seen in the increasing use of risk retention groups (RRGs) over the past 25 years. RRG formation accounts for much of the growth in group captives over the past five or six years.

Crouse notes, however, that the course for RRGs has not always been smooth. "Since passage of the federal legislation (the 1986 Federal Liability Risk Retention Act), they have had to battle some state insurance departments and the NAIC, just to pursue their legal rights as provided by the federal government," he remarks.

The real problem, according to Crouse, "has been that the federal act created the law, but did not provide for enforcement of it." Over time, this has created some real hardships for startup RRGs. Crouse comments, however, "We are hopeful that the GAO study that is currently under way will document the abuse by state insurance departments" and will assist RRGs in remaining a viable approach for smaller organizations to participate in the captive movement. Crouse adds that it is just a handful of states that have chosen to implement fees, notification procedures and the like, in clear violation of the federal RRG legislation.

Another concern voiced by some industry observers is the proliferation of new captive domiciles that has occurred over the last half dozen years. But, as Crouse notes, "There is no way to prevent it." He points out that these states are looking at establishing new captive domiciles from an economic development standpoint, based on the success of states like Vermont.

Some states, Crouse observes, don't realize that it takes a long time to make a captive initiative profitable, and it should always be viewed from a long-term perspective, he says. Many states believe the old saying, "If you build it, they will come," and nothing could be further from the truth. Simply enacting favorable legislation is not enough anymore, according to Crouse; the most important task is to find "a staff that understands the difference, from a regulatory standpoint, between captive operations and traditional insurer operations."

More choices for smaller accounts

Smaller corporations are showing increased interest not only in group captive options such as RRGs, but also in cell captives and rent-a-captives (RACs). Many experts initially believed that cell captive structures and RACs would serve as a stepping stone for corporations to get comfortable with the captive concept, and that corporations then would move on to form their own single-parent captive. For the most part, however, this has never materialized. In fact, many cell captive owners and RAC participants are happy to remain in these structures. A key reason is that cells and RACs have matured and become able to accommodate the needs of their members. As a result, cell captives, many of which are now moving to the protected cell arrangement, and RACs are still attracting and retaining members.

Another alternative to which smaller accounts are gravitating is the 831(b) captive, so named for the section of the Internal Revenue Code that provides favorable tax treatment for smaller insurance companies.

According to Silvia, "There is a great deal of interest in these today." He adds, however, "This can be a mixed blessing." Some of the interest in 831(b)s "is being driven by the investment side of the house, rather than the risk management side." These captives are typically structured as wealth management mechanisms and "have little or no insurance aspects incorporated within them." As a result, Silvia says, "They become financial planning tools rather than insurance companies."

Silvia cautions, however, "You can't just throw the 831(b) baby out with the bath water." There are many legitimate uses for these captives, and if they also provide a tax advantage, so be it. Crouse adds: "Each domicile has its own view of 831(b)s; some like them and others don't." In general, Silvia says, "If you start out trying to solve a risk management issue, you should be okay."

Another issue that continues to generate a lot of buzz in the captive community is employee benefits. Although discussions of this topic have been going on for years, Silvia notes, "There appears to be a viable model that is finally emerging." Most industry experts believed it would be an AD&D/term life approach that would have to move through the Department of Labor approval process. Instead, Silvia says, the focus is on employee health coverage, and this approach forgoes the burdensome DOL approval process.

A group captive, Silvia explains, can be used by several employers that self-insure employee health coverage.  By banding together, they can purchase stop-loss coverage at significantly higher levels than they could as individual entities. The employers reinsure the added retention exposure through the captive. Silvia says that several such captives are active and a number of employers are exploring the feasibility of a similar approach.

Summing up

The past 30 years have seen a lot of changes in the captive movement. It has grown and matured in ways that could never have been envisioned just a few years ago, and it continues to do so. As Crouse correctly points out, "It's not as simple as it was." Initially, he says, "A corporation would start a captive to assume part of its major risks—workers compensation, general liability or auto liability risks—and that was it." Today, he says, it's much more complex, with "lots of twists and turns." Overall, he observes, corporations are making better use of their captives and finding more ways to build value into them.

The rise of the mid-sized corporation in the captive movement provides a corresponding opportunity for mid-sized agents and brokers, Silvia points out. They can now compete effectively with the big brokers for captive business. This trend, he adds, has been aided significantly by the growth of independent captive management firms. As the risk management needs of corporate insurance buyers have increased, mid-sized agencies are finding opportunities to become involved in the captive movement, and Silvia says these agencies are well advised to prepare to capitalize on these emerging opportunities.