By Graden Marshall
In 1492, Christopher Columbus set sail from Spain to find an all-water route to Asia. To his surprise, 12 months into his voyage, he found America. Today, setting sail on the ocean of the captive insurance world may seem more treacherous than the perils faced by Columbus but the good news is that someone has already blazed the trail. While there may be much to learn for most business owners looking into a group captive alternative, the following may be helpful as you navigate the captive insurance world.
First, the definition of “group captive” insurance is an insurance company that is owned and operated by a another company (or multiple companies or group of companies) to insure itself. This article will specifically discuss how group captives have emerged as a mainstream alternative within the commercial insurance arena over the past 10-20 years. The concept of captive insurance structures is not new and captive insurance alternatives have been around for over 50 years.
Is captive insurance something you should consider? If so, how do you know which option is the best fit for you? Are all captives the same? If you’re already in a group captive, how do you know if you’re in the right group? When Columbus sailed across the ocean, not everyone could do what he did. Today, group captives are not for everyone and every business. There are certain risks involved and should always be properly and thoroughly reviewed before entering into any group.
What are some of those risks? With hundreds of groups captive options available and not knowing how to navigate that marketplace it can be a daunting task for any business owner.
The following are some key factors to consider when looking at the options:
Expenses. One easy way to measure one group versus another is the expense costs shared by the members. One of the easiest ways to compare which group is the right group for your company is found mainly in comparing the expense factor of the group you are considering. This is the part of the premium used to run the captive and is paid by every member on a pro-rata basis. It is usually expressed in a percentage. This is a sunk cost and won’t ever be returned to any member of the group. The key is to find the lowest percentage possible. A good percentage is under 33 percent.
Group size and composition. The size of the group can go from as few as 15 members to over 400. The smaller the group, the more control each member of the captive will have to run the captive. It is easier to choose who you’d like to do business with in a smaller group. The larger captives can feel more like being insured with a standard insurance company. They can and will add whomever they want. Also, what type of companies are you choosing to do business with? There can be advantages to working with other companies in the same industry. For example, contractors can work together with other contractors to share best practices. These are called homogenous groups. Heterogeneous groups will have a wide variety of industries included as members.
Risk sharing amount. Every group captive will have risk sharing to all the members. This can happen when one member has multiple claims that exhaust their funds set aside to pay claims. The IRS has determined that this is a key factor for any company that operates as an insurance company. (That’s why all groups have this element.) The key is to review the past history to see how much risk sharing happens annually. This amount should typically be less than 5 percent.
Tail fund. At some point, you may decide it’s time to move to a different insurance structure. In order to do that, you’ll need to have a “tail fund” set up. The tail fund uses the final residual amounts of each policy year and sets them aside for the possibility of paying claims that come in on a delayed basis. Every large insurance company today has a small amount of its active claims that arose from policies that are over 10 years old. These claims in the captive setting should be handled by the tail fund. By doing that, each owner can rest assured that they won’t have potential liability that goes on forever. The amounts set aside in the tail fund should be less than 1 percent of your actual premium. If there isn’t a tail fund set up, it’s either because the group is too new and the issue hasn’t been addressed or it’s because the group hasn’t been managed properly.
There are many benefits of group captives. One benefit is gaining control of the insurance marketplace that has historically brought uncertainty to their clients. It’s not unusual to see premium fluctuations flatten out for members of group captives. As the best and most profitable companies leave the standard insurance marketplace and go to the captive arena, standard insurers will be forced to raise prices on those companies that remain. This is the principle of “adverse selection.” If the best, most profitable companies leave, all that is left are those that aren’t profitable (in theory).
Christopher Columbus put it this way: “You can never cross the ocean unless you have the courage to lose sight of the shore.” Sailing across unknown waters is not for everyone, but for those who do, you just might find a place better than you had before. If you are willing to take a little risk, there can be big rewards. In the insurance world, a captive can be that world that can create a new profit center. This is how you can be rewarded for paying attention to safety and quality. Finding the right group can make all the difference.
Graden Marshall is vice president of Cobb, Strecker, Dunphy & Zimmermann Inc., a commercial and professional insurance agency in Salt Lake City