The possibility of a costly insurance claim as a result of contract or technical errors, communication breakdowns, or haste is one of the worries that keeps firm leaders up at night. Professional liability insurance (PLI) is necessary for most firms to provide some peace of mind in the event a firm’s best efforts to manage risks falter. Additionally, firms typically carry general liability, workers compensation, property insurance, and in some cases, project excess endorsements to round out their risk management. All of this protection adds up to a significant line item on businesses’ budgets.
Yet, as important and costly as it is, many firms don’t reevaluate their coverage as often as they probably should. Experts recommend such an assessment be performed annually to ensure that — in addition to fair premium pricing — insurance coverage is adequate, is in line with the firm’s current business mix, and that the carrier’s service offerings are top notch. Simply checking your new premium price for the upcoming year with the same agent and carrier isn’t enough.
What’s more, most firms have yet to explore the growing market for captive insurance as a solution now available to smaller firms. If they had, more firms would understand that a captive solution could help their firm lower premium costs and yield profits while maintaining the backing and services offered by a commercial insurance carrier, as well as increase the flexibility of their coverage.
What is captive insurance?
Captive insurance is a risk transfer alternative to purchasing insurance in the commercial market. It is also an enhancement to being self-insured. A commercial insurance company is still involved in backing the risk of the company (or companies) insured by the captive.
In the article, “Recent Developments in the Captive Insurance Industry” by Shanique Hall, CIPR senior research analyst, published in The Center for Insurance Policy and Research Newsletter in January 2012, the author said, “In its simplest form, a captive is a wholly owned subsidiary created to provide insurance to its non-insurance parent company (or companies). Captives are established to meet the risk-management needs of the owners or members. They are essentially a form of self-insurance whereby the insurer is owned wholly by the insured. Once established, the captive operates like any commercial insurer — i.e., it issues policies, collects premiums, and pays claims, but it does not offer insurance to the public — and it is regulated as a captive, rather than as a traditional insurer.”
Because captives weren’t an option for smaller firms until recently, the engineering industry has not been exposed to this solution like Fortune 500 companies, which almost all hold a captive insurance company. A.M. Best Company, Inc., which provides news, credit ratings, and financial data products and services for the insurance industry, estimates that there are more than 5,000 captives worldwide.
Captives are extremely versatile and flexible. An engineering firm could insure through a captive all or some of the following risk types: professional liability, general liability, workers compensation, automobile liability, property insurance, and financial insurance.
Here’s how it works: A firm sets up a captive program with the help of an experienced captive advisor. The monies the firm has been using to pay insurance premiums would now be paid to its own captive. These funds would accumulate over time and could be invested for the firm’s own profit. The premium pool is essentially divided into two parts — expenses and loss fund. The expenses portion is used to pay a fronting company, a reinsurer, the risk advisor, claims manager, actuary, and other third-party administrative service providers. The loss fund is used to pay claims. If claims are less than estimated, the captive retains these funds for the future. (This is important because if your claims are less than estimated with a commercial provider, they keep it, you don’t get it back!). Additionally, a well-designed captive program will be more cost-effective than the open market, further enhancing your bottom line.
To the outside world, a firm insured by a captive looks just the same as other firms. The captive will arrange for a fronting company to provide proof of insurance, strong financial backing in the form of A.M. Best A rating, and policy administration.
To set up a captive, a firm would have to allocate capital (typically using a letter of credit supported by balance sheet assets) to help back the layer of risk assumed by the captive. In the event claims exceed the loss fund and safety margin, this collateral is used to meet loss expenses. In the case of a catastrophic loss, a reinsurer is contracted to cover significant losses that exceed the collateral fund.
While the idea of placing assets at risk to help cover the event of an unlikely spike in losses can initially sound unsettling to a business owner, it is important to remember that such a spike in losses would typically result in an equally painful premium increase in the open market. In other words, a captive is not a way to avoid paying losses but rather a way to enhance and profit from prudent insurance risk management.
Even in an adverse loss scenario, there are two distinct advantages of captives. First, your insurance costs revert back to the true loss experience following the bad year (the open market tends to be less forgiving). Second, you have more control over your risk program, allowing such a situation to be averted or more effectively mitigated in the first place.
A captive advisor can help firms walk through these steps and considerations, and guide them on the best structure to maximize the dollars put toward risk management. They would help determine the best types of coverage to insure through the captive, and would help arrange a fronting company and a reinsurer, as well as the other necessary third-party administrative service providers, including a claims manager, actuary, and accountant.
Avatek Risk Management (acaptive.com), headquartered in Charleston, S.C., is an independent captive advisor that offers a turnkey approach to captive formation and ongoing management services for engineering, architecture, and construction firms, among other markets. Scott Gorman, executive vice president of business development for Avatek, said, “Our programs simplify the entire captive process for smaller businesses. We make the transition from commercial insurance to a captive solution seamless so our clients can stay focused on their businesses.”
Benefits of a captive
According to Gorman, there is a suite of benefits captives may provide. The following are some of the most impressive financial advantages:
- retain or effectively “take back” the profits from insurance policies that were going to an open market, commercial insurer;
- earn investment income from the premium fees paid into the captive annually;
- realize reduced premiums; and
- benefit from potential tax advantages (note that this is specific to each company).
Additionally, there are significant benefits to captives that, while not financial, are equally compelling. Some firms have risks that are too costly to insure or could never be insured through a typical insurance policy. Captives solve this problem because you can customize your risk coverage. By establishing your own captive, you open the door to flexibility in your risk management program.
Other benefits are direct access to reinsurance markets and pricing stability. Further, the team of third-party administrators that support a captive (such as claims specialists, accountants, and attorneys that your captive advisor will organize) can be customized for your industry specialty and hand picked based on their services and strengths. They are working for you, not a huge insurance company, so you can expect better, timelier service.
According to Dennis Bissett, director of professional liability claims for Sedgwick Claims Management Services, Inc., (www.sedgwick.com) a technology-enabled claims and productivity management solutions company headquartered in Memphis, Tenn., you can also expect more personal service from third-party administrators. He said the main advantage for a firm working with his company as opposed to a commercial insurer is “the specialized and tailored services our clients receive. We stress that we want to know [our clients’] businesses and be a partner.” Bissett also mentioned that his captive clients have said that programs in the standard insurance market can sometimes be cost-prohibitive for them.
Is my firm a good fit for a captive?
For engineering firms, amassing the collateral fund may be the most difficult part of setting up a captive since many firms are used to “stripping” their firm each year and don’t save profits. But with some planning, the benefits of establishing a captive might make a change in corporate financial practices extremely appealing.
If a captive is intriguing to you, be sure that your firm meets the following basic requirements:
- your firm’s total annual property and casualty and PLI premiums paid are more than $100,000;
- your business exhibits solid financial performance; and
- your firm has below average loss ratios.
As with any business scenario, there are unsuccessful captives or ones that lose their relevance over time. Chuck Alpert, general counsel for Kleinfelder, an employee-owned architecture, engineering, and science consulting firm headquartered in San Diego, said that Kleinfelder had a Hawaii-based captive from 2003 to 2013. The beginning of their captive history was positive, but they ended the captive because “they did not see a financial benefit any longer,” Alpert said. He cited his firm’s administrative costs as a major factor.
What are the negative aspects of a captive? For some businesses, a captive could tie up too much corporate capital. Additionally, the culture of a firm may be out of line with operating a captive successfully. While captives offer potential for significant cost savings and risk management improvements, firm leaders need to be fully educated on the various requirements and structural options involved in developing a captive program.
“Captives are not for everyone,” Gorman said. “In determining whether a captive is a fit for your business, a good captive advisor should be willing to spend a significant amount of upfront time evaluating not only your insurance coverage and loss and premium history, but also your company culture and overall financial and risk management objectives.”
Common misperceptions about captives
There is some mystique to the captive industry, as well as some downright false information out there. Consider the following “myths,” or misperceptions, about captives and the corresponding truths.
MYTH #1: Captives domiciled internationally are not a viable or safe option. Such an endeavor would also be too complicated for my U.S.-based business.
TRUTH #1: You can create a captive in many U.S. states, however the United States’ options for captive formation are typically not as competitive as global offshore financial centers such as the Cayman Islands or Bermuda. Today, these offshore financial centers are considered essential to global trade and capital flow, and are home to captives for businesses of all sizes and types, even small, U.S. businesses like many engineering firms.
Because these countries are so specialized and experienced in captives (among other financial services), the supporting services, tax laws, regulations, and fees are typically more favorable for U.S. companies. Basically, offshore financial centers make it easier and less expensive to structure a captive. What’s more, the risk protection of an offshore captive is equivalent to one domiciled in the United States. The decision about where to domicile a captive is something you will review with your captive advisor.
MYTH #2: Engineering firms have to provide proof of insurance to their clients and cannot if they are insured through a captive.
TRUTH #2: Most captive advisors recommend that a captive employ a fronting company with an A.M. Best A rating. An engineering firm using a properly structured captive program has the same proof of insurance and financial backing as a firm purchasing insurance in the open market.
MYTH #3: If we have a captive and have a bad claims year, we are not going to recoup our unplanned expenses.
TRUTH #3: If you have many unexpected claims, your rates will most likely increase with a traditional insurer the next year. You have no role in the decision of how much more you will pay, even if you make significant internal investments to avoid future risks. If you have many unexpected claims with a captive, you may have to fund the captive to cover these expenses but the funds required would typically be the same or less than the premium increase you would face in the open market. However, the next year, you have more control over how to adjust your collateral and your loss fund. You can make your own, informed decisions about how to plan for the future. And remember, if the opposite scenario is the case and you have a better-than-expected claims history, your firm reaps the benefits of holding on to that profit.
Ray Messer, president and chairman of the board for Walter P Moore, headquartered in Houston, shared an important reminder: “Any article on the subject of risk must be underscored by the importance of plainly doing a good job to minimize risk.” As it turns out, many firms that have a captive do exactly that, as the motivation to manage risks and do great work go hand-in-hand with running a successful captive.
Shanon Fauerbach, P.E., was formerly the editorial director of CE News and Structural Engineer.