BENEFITS OF CAPTIVES HARDER TO SEE IN SOFT MARKET

SOUTHAMPTON, Bermuda-Captives continue to have their uses in a time of soft insurance pricing, but companies may find it more difficult to justify launching a captive for the first time in today's market, risk managers say.

While there may be less expensive risk financing options available, the captives also can deliver a means for a company to provide protection or added value to customers and other third parties, they say.

It also can be valuable as a financial incentive for operating units to improve their loss control.

In addition, a captive eventually may be a viable means to underwrite employee benefits for companies.

But that doesn't mean risk managers would do it all over again today.

"For the captive we have, I'm not sure we would start it again in today's market," said David Burr, assistant vp-risk management for Burlington Northern Santa Fe Corp. of Schaumburg, Ill. "We use it now primarily to enhance value for third parties, and there are probably other ways we can do that. The reason we choose to use the captive at this point in time is that we have an established base of capital built in to the company and ongoing relationships," he said.

William Drum, vp and director of risk management for Ralston Purina Co. in St. Louis, said his company still would consider launching a captive today. "This has nothing to do with the market situation, or whether captives are good or bad, friction costs, etc.," he said. Rather, he noted that Ralston Purina is moving to a more global, centralized structure, in which there is less impetus to have costly multiple risk financing arrangements for local operations.

The two risk managers were part of a panel on using a captive in a soft market held during the Bermuda Insurance Symposium III, in Southampton, Bermuda, Feb. 18-21.

Not all captives survive the soft market. At least one large industry mutual insurer-Railroad Insurance Assn. Ltd.-has been disbanded because of changing needs and priorities of its original members (BI, Sept. 16, 1996). RAIL's shares were sold to X.L. Insurance Co. Ltd., which will seek to continue coverage for members that want it.

Paraphrasing Charles Dickens' "A Tale of Two Cities," Mr. Burr noted that "RAIL began in the worst of times and ended in the best of times."

In 1985, when a dozen passenger and freight railways formed RAIL, there was about $50 million of liability capacity available in the market, rates were 40% higher than 1984, and the attitude of underwriters was "take it or leave it."

By 1996, capacity of at least $500 million was available at rates 60% lower than 1985 and 30% lower than 1984, he said.

The primary reason for the sale was a "lack of a common purpose," Mr. Burr said. Available capacity was more than adequate, rates were low, so there was no "common enemy," he said.

Other reasons, he said, included: an inability to alter the rating method to reflect individual companies' loss potential; disagreement on the adequacy of its capital and surplus, which had grown significantly over the years; and disputes over whether new members would dilute the capital of original policyholder owners.

"However, I don't believe we would have reached that conclusion if market conditions were the same as they were in 1985," Mr. Burr said of the decision to sell RAIL.

BNSF also has a Vermont captive insurer, Sante Fe Pacific Insurance Co., which was set up in 1990 to provide it with an efficient risk financing cost allocation system for its various operations.

Since that time, the company has spun off all but its core railroad operation, yet has expanded use of the captive, Mr. Burr said. BNSF now uses its captive to: gain more direct access to reinsurance markets; reduce federal excise tax on premiums paid to foreign companies, as the tax rate is lower for reinsurance than direct coverage; replace inefficient self-insurance programs; and recover frictional costs, such as placing coverage through the captive for certain contractors that do business with the railroad.

In the future, BNSF will explore writing employee benefits through the captive, though "I don't think it's likely we'll do much on this very soon. We were very interested in it before the CSX decision came down, but I think that's going to limit our use of the captive for benefits at this time," he said.

CSX Corp. last year dropped its longstanding effort to win federal approval to reinsure group term life insurance benefits through its Vermont captive (BI, March 18, 1996). The U.S. Labor Department in 1994 rejected CSX's application, contending too much CSX-related business would have been funded through the captive. The department requires that no more than 50% of the captive's gross premiums be generated by the parent. CSX would have generated about 90% of the captive's premiums.

"Some think the problem with CSX was the way it submitted its application. There's a thought that if it was submitted substantially differently, then you might get that through the Department of Labor," Mr. Burr said.

Ralston Purina's Bermuda captive has evolved over the years to serve a variety of purposes and is "more than a market reaction tool," Mr. Drum said.

"Most of what we do is not driven by what is state of the art in risk management, but predominantly driven by the strategies of our operating units and what they need," he said.

Checkerboard Insurance Co. was set up in 1975 "to control non-U.S. property programs, recapture excess tariff rates, permit a reasonable retention on the corporate level, and broaden restrictive local coverage," Mr. Drum explained.

Currently, Checkerboard is used to underwrite global property reinsurance and global marine cargo coverage, he said. Past uses for the captive have included: directors and officers liability reinsurance; underwriting various coverage certificates; and to pay "unusual" claims not covered by other coverage, he said.

In the future, the captive may take on more third-party coverage, including for a former subsidiary that was spun-off from Ralston Purina, he said.

Ralcorp, a former unit that encompasses ski areas, cereals and crackers, contracts with Mr. Drum to provide risk management services and also may purchase coverage through the Checkerboard captive.

Another unit, RPI, which includes worldwide animal feed operations, also has been targeted for spinoff and may contract with Mr. Drum and the captive, he said.

The key attraction of using the captive to write coverage for the former units is that while the risks may be very familiar, the coverage would qualify as third-party business, Mr. Drum said.

Writing business for Ralcorp and RPI would put the volume of unrelated business written by Checkerboard at more than 50%, a threshold President Clinton proposed for captive tax deductions (BI, Feb. 10).

The Ralston Purina captive also has been useful to help standardize coverage among operations worldwide and centralize programs.

"I've exercised control, within parameters, of local premium charges and used the power of allocation as an incentive to local management to perform certain loss prevention measures," he said.

Ultimately, Mr. Drum recommended that risk managers constantly evaluate their use of the captive.

"If you have a captive, my advice is review its use constantly. If you are considering one, do it very cautiously. Always consider the captive as one of the key tools in your box to look at risk management issues," he said.

Kathryn J. McIntyre, publisher and editorial director of Business Insurance, moderated the discussion.