‘You bet your sweet bippy I did’: idioms of the captive life cycle
The expression “you bet your sweet bippy” was popularised in the late 1960s on the television show “Rowan & Martin’s Laugh-In”. The expression broadly means “you can be certain about that”.
In the insurance world, you bet your sweet bippy everyone wants a captive—right? Owners get free or discounted admittance to conferences. You can start hanging out with different insurance people—the cool kids. Seriously though, captives are not for everyone. I get three types of phone calls that bear this out.
The first type is absolutely certain (you bet your sweet…) that they want one and they just want to know how to go about it. Some, I think, are not quite sure what they will do once they have it. That’s ok, we can talk about that. I have been working in the captives space for a long time, and I still share their excitement about the advantages of taking risks, but very few of these calls result in new formations.
The second type is a little less excited, or maybe the excitement is wearing off. They have already paid someone to set up their captive and need me to find fronted paper and/or reinsurance to complete the process. I hate to be the bearer of bad news, but these folks are just getting started.
The front and reinsurance are central parts of the business plan and a captive’s success. Reinsurance impacts collateral and the actuarial report.
The last type is a bit of an emotional mixed bag. They have a captive but it’s not working out quite the way they thought, or were promised. Some want to novate or close. Others are looking for a fresh restart. Even if you’re happy with your captive, it makes sense to look at your current business plan and see what else your captive can be doing to better support the organisation’s enterprise risk.
As a result of these calls, I’m often asked to provide some training or education to the caller and their company, so here are some additional idioms to express some of my thoughts on Captives 101.
‘Crossing the Rubicon’
This famous saying dates back to Ancient Rome. Julius Caesar committed an act of war by crossing the Rubicon river, moving into Roman territory in 49 BC. According to Roman law, any governor—which Caesar was at the time—who entered Italy with his army forfeited his right to govern and command troops. The law was punishable by death to both the governor and any soldier who followed the governor’s order—truly a point of no return.
The crossing prompted a civil war, and Caesar gained power over the entire Roman Empire. Forming a captive is not quite like going to war or risking death, but owners need to be reminded of the commitment a captive requires.
Setting up a captive is forming a new company—you need a business plan and financial and human capital. Some financial capital can be purchased: renting a captive is one way, and purchasing reinsurance is another. Human capital can also be outsourced: actuarial, legal, claims, and accounting/captive management can be purchased separately or bundled.
Captive setup costs vary from a low of $25,000 to $250,000 and more depending on the type of captive and what is included in the cost calculation. Internal resource time and opportunity cost of capital/collateral are often overlooked. A bundled approach to captives can also mask some costs—I’ll talk more about this in a bit.
One of the biggest complaints I hear from captive owners is when an “expert” didn’t explain to them that year one cost is just that, the cost of the first year. No-one starts a business with the intention of closing it down in 12 months. The cost of operating a captive, particularly for long tail lines of insurance, workers’ compensation or third party liability is substantial. It’s like getting a puppy—you know what I’m talking about: it’s a point of no return.
‘A rule of thumb’
“Rule of thumb” refers to an approximate method of doing something based on practical experience. It has no established origin. Historically, the length of the first joint of a thumb was used as an equivalent for measuring an inch of cloth. The thumb was also used in brewing beer to gauge the heat of a brewing vat. I’m going with that one.
Two of the biggest captive insurance questions I hear are “how much premium do I need?” and “how much capital is required?”. Let’s start with the capital. Capital is a function of premium. But how much and what type? A $5 million premium will typically require more capital than a $1 million premium. When I say type of premium, I mean type of risk—short or long tail business.
The Kenney Rule or Kenney Ratio is a rule of thumb developed by Roger Kenney that sets a target of unearned premium to the insurer’s policyholders’ surplus of a ratio of 2:1. The Kenney Rule states that the ratio of surplus to unearned premium reserves indicates the strength of one insurance company to another. This same general ratio can be applied to captives as annual premium can equal 2x captive collateral.
Admittedly, this is conservative. My rule of thumb is 3:1 for single parents and 5:1 for groups, but your captive domicile may say something different.
Regulators have an important say in how much capital you need, but often not the final say. Domiciles typically set a minimum collateral amount which can vary by domicile. When a captive writes only direct first party policies, the captive regulator will have the final say. If your captive is the more typical reinsurance type, the fronting carrier and the captive reinsurer also have a vote.
Since a front assumes the captive credit risk, it is ultimately responsible for paying claims. Therefore, the front cares the most about the quality of the reinsurance, which in this case means the financial strength of the captive. That usually means the front has the final say on collateral. However, some fronts don’t want to assume a captive’s credit risk, so they contractually pass this risk to the other reinsurers on the programme. In these instances, the reinsurer will ultimately determine what collateral is required.
So how much premium do you need to set up a captive? The answer depends on your appetite for risk and the cost of operating this new company. Risk appetite is a function of capital. Given a frictional cost ($25K to $250K or more), you can do your own math on what amount of premium makes sense for you.
Remember, most of these costs are recurring. Even if your premium spend is $1 million, that might be spread over four or five different policies. How large a retention can you assume per line? What is the premium savings for assuming that risk in a captive?
The captive insurance question is really one of capital management. Does it make economic sense to keep a large portion of your insurance risk on the balance sheet? Do I allocate capital or purchase insurance? It always makes sense to set aside formally or informally funding for any risk not covered by insurance, including deductibles and retentions.
Captives formalise (meaning fund) retained exposures—both known and unknown. Once you have answered this question, you can proceed to the next logical step.
‘A white elephant’
The term “white elephant” is believed to have originated from a king in Thailand who used these rare animals as a form of punishment. According to legend, the king would present a white elephant to a rival as a gift. White elephants were notoriously difficult to care for and would often leave their owners in financial straits. They were also difficult to sell. Today, it means a burdensome or unwanted possession.
Unfortunately, there are as many captives in run-off as there are active ones. How do I know this? I don’t—no-one knows how many captives there are. Estimates vary—and that I do know. The State of Vermont’s captives website is one of the best for sharing information. As of March 2023, Vermont had licensed 1,295 captives. I also know that the number of active Vermont captives is 50 percent of that number. If the “gold standard” and largest US domicile has 50 percent attrition, I feel fairly confident that 50 percent is a good number.
There are many reasons why businesses close, and the same goes for captives. Some are acquired. Business plans change. Some just don’t have the appetite to take risks. The ones I hate to see are when the captive owner was not given the complete story or true picture of what it is getting into until after it is too late.
I saw one of these proposals a few weeks ago. Fortunately, working with the owner’s broker, we were able to prevent this captive insurance mistake happening.
“Something must be wrong, very wrong. Switching to a captive does not automatically make 50 percent of your cost go away.” Greg Lang, RAIN
The programme was a new bundled captive. It included everything one might need to get into a rent-a-captive cell: the front, reinsurance, claims, actuarial, captive management, etc. It was cheap, too. The total cost was almost 50 percent lower than the client had paid for guaranteed cost the prior year. A no-brainer, right?
Something must be wrong, very wrong. Switching to a captive does not automatically make 50 percent of your cost go away. Why would anyone try and sell that?
The programme was for contractors’ general liability. I’ve written about this before. It’s a tough class—tougher still depending on the state. It’s also a long tail line of business. Construction defect claims can take seven years or more to manifest themselves. The captive loss pick was 50 percent of the insured’s average incurred losses for the past five years.
The way the programme was structured meant the majority of claims would fall into the retention of $500,000. The 50 percent savings was a savings only in year one. Eventually, the insured would pay for all the losses. An honest proposal would have explained this.
I would not recommend it, but some insureds might choose this approach to take advantage of the cash flow in the early years. A fair point, but the insured needs all this information to make an informed decision.
This proposal didn’t include premium tax. For an admitted programme, the carrier would ultimately need to collect this. There was also a loss fund charge billed outside the premium. The taxes and the loss found were both conveniently omitted from the total cost estimate, which would make it very difficult to do a side-by-side cost comparison.
I’m not knocking bundled programmes, but I am critical of this one. There are some great bundled providers providing a good service to their insureds. In this case however, the bundled approach masked a major concern that one or more independent servicers would probably have caught and pointed out. Fortunately, we did.
These historic idioms have stood the test of time. Captives have been around for 70+ years; risk retention groups for 37. I’ve been around captives for a long time too. None of us is going anywhere—we have all stood the test of time but some are ageing better than others.
Greg Lang is the founder of the Reinsurance and Insurance Network (RAIN). He can be contacted at: firstname.lastname@example.org