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Captive insurance becoming attractive to more midsize companies

Range of structures offer more options to cover exposures


Growing sophistication among mid-market executives who want to find a better way to finance the risks their companies face is driving many midsize businesses to turn to captives as an alternative to traditional insurance, experts say.

While group captives often are the entry point to alternative risk transfer for many middle-market organizations because they require less capitalization than single-parent captives, many mid-market executives also are showing interest in what are known as segregated or protected cell captives as well as micro captives, the experts note.

While most mid-market captives are being used to insure or reinsure workers compensation, general liability and auto liability exposures (see "Private company takes alternative route"), some recently formed captives finance medical stop-loss insurance for self-funded health benefits programs at mid-market companies (see "Group captives help firms tackle health benefits funding issues").

Group captives can be effective for industries that have predictable losses, such as manufacturing, service, wholesale and retail, said Steve Bankes, managing director of group captive solutions at Aon Insurance Managers Ltd. in Chicago. “Their risk profiles and commitment to loss control are very similar. They are committed to keeping their employees safe, protecting the public from harm and don't want to spend too much on insurance.”

Such group captive members generally have about $10 million in payroll and about $100 million in annual revenues, but are paying perhaps as much as $500,000 for insurance when they may have only $100,000 to $200,000 in claims in any given year, Mr. Bankes said.

“You will always find companies with good loss experience that want to profit-share with other companies,” said Lisa Wall, senior vp of captive consulting at Lockton Cos. L.L.C.

Although group captives require lower startup costs because each member contributes, Ms. Wall and other captive consultants say they also are seeing interest among mid-market executives in single-parent captives and protected cell captives, which basically are a collection of single-parent captives within a captive.

Single-parent and protected cell captives generally require between $250,000 and $1 million in initial capitalization to open, depending on the type of risks financed and the requirements of the selected domicile, captive experts say. However, the captive owner doesn't necessarily have to put all that up in cash. The funds can be borrowed from banks that issue letters of credit to the captive to satisfy capitalization requirements.

Although they require the same capitalization as a single-parent captive, protected cell captives have lower administrative costs, which can be attractive to cost-conscious mid-market executives, said Donna Weber, senior vp at Marsh Inc.'s captive solutions group in Melville, N.Y.

“The dividing line is whether you want to share risks with others or whether you want your risks exclusive to your business in a cell or a single-parent captive,” said David McManus, president of ARTEX Risk Solutions Inc., a division of Arthur J. Gallagher & Co. in Hamilton, Bermuda.

“Typically, when you're putting a group captive together, you want to make sure everyone has similar loss control measures in place,” said Greg Petrowski, secretary/treasurer at GPW & Associates L.L.C. in Phoenix.

In most cases, mid-market group captives include an assortment of somewhat related businesses, perhaps geographically dispersed, that reinsure insurance policies issued by admitted insurers, referred to as “fronting” insurers. Because these fronting insurers assume credit risk, they usually require collateral from the captive, which often is provided in the form of a letter of credit issued by a financial institution. They also charge fronting fees.

Despite the fees and costs associated with letters of credit, which have become a more expensive option in recent years, such arrangements typically are cheaper than traditional insurance and reinsurance.

In addition to serving as reinsurers, most mid-market captives purchase reinsurance as a backstop, either on a per-claim or aggregate basis. But even though the same reinsurers that serve large captives cater to the mid-market, some are hesitant to provide coverage at the often low attachment points required by smaller captives, which is why some mid-market companies may combine their risks with other similarly situated mid-market companies, either in a group captive or as part of a pool, captive experts said.

For example, in ARTEX's pooling arrangement, mid-market captive owners pay premiums to their captive based on their own experience for the first layer of coverage, also known as the frequency layer because that is usually where the most claims are filed, Mr. McManus said. Then the captive pays premiums into a pool for a second layer of coverage, which pays the less frequent but more severe claims.

“We have very few middle-market companies that...throw their hat in the ring openly with other entities without there being some sort of separate frequency and severity fund,” Mr. McManus said.

As reserves grow in their captives, many mid-market executives are eyeing 831(b) captives as a way to preserve those assets for other uses, such as insuring risks for which traditional coverage may not be available, experts said.

“It's a merger of entrepreneurial thinking with risk management,” said Rick Stasi, chief operating officer of the alternative risk division at Avizent in Dublin, Ohio. “They come up with things no one in the insurance world would ever think of.”

For example, a group captive formed in 2004 to provide auto liability, general liability and workers compensation coverage to a group of about a dozen owners of various national fast-food franchises decided to form a micro captive with the dividends they had received.

“Because they were getting such great dividends, averaging 30% to 40% of premiums, after three or four years they decided to set up an 831(b) behind the group captive to provide reinsurance,” Mr. Stasi said.

Because many middle-market companies are privately held, some owners are using 831(b) captives for “wealth transfer” and estate planning, said Doug O'Brien, managing director and national casualty and alternative risk practice leader at Wells Fargo Insurance Services USA Inc. in New York.

“The surplus builds up on a tax-beneficial perspective over the years. Then the dividends or capital gains are given to an heir at a more favorable tax rate,” he said. “I probably get five calls a week regarding interest in these types of captives.”

In the wake of this year's earthquake and tsunami in Japan, Les Boughner, executive vp and managing director of Willis Global Captive Practice in Burlington, Vt., says he is seeing interest among mid-market companies to use captives for supply chain management.

“A captive is nothing more than a financial tool,” he said. “I don't know how any company of substance—and that would include most midsize companies—can say they have a full array of financial tools if they don't have a captive.”