14 November 2023ArticleAnalysis

Bad deal insurance company warning: this captive could be hazardous to your business

Not all rent captive proposals are created equally. I recently reviewed three, each from a different sponsor. All should have come with a warning: “This captive could be hazardous to your business”.

Each was problematic in its own right, but all shared a common theme—programme savings were overstated, and programme expenses were understated. No wonder I get so many calls from frustrated insureds and brokers. It’s also no surprise that captive default rates sit at 50 percent.

Let’s start with a definition of “rent-a-captive”. As the name implies, if you don’t want to go through the trouble and expense of setting up a captive, you can rent someone else’s. The owner of a rent-a-captive is called the sponsor, and typical sponsors include brokers, captive managers, and insurance companies. By renting a captive, you can save time getting started and avoid some of the cost of forming your own captive. Of the proposals I’ve reviewed, two were broker-sponsored and one was carrier-sponsored.

Rent-a-captives are special purpose insurers or reinsurers. Sponsors establish separate segregated cells or underwriting accounts for each risk. Renting a captive is like renting a hotel room. You may have access to the whole hotel but you get the keys to only one room (a cell). The assets and liabilities of that cell are typically kept separate from the other cells. Sponsors typically assume no risk.

Historically, the term “rent a captive” implied you were renting the sponsor’s formation capital. I’m seeing more and more proposals that have capital contributions included. For one of the proposals, the capitalisation was not included in the cost projections. It was $25,000, and the small print added that a capital contribution was required for the first three years.

I think $75,000 is meaningful to any business and needs to be reflected in the overall cost. Even if the insured gets this money back at some point, it’s definitely an opportunity cost. That capital is at risk—it may never come back.

Three proposals

The first proposal I reviewed was for a property captive. The insured’s current per-occurrence retention was $250,000 and it was self-funded. The proposal was to raise the insured retention to $1million and prefund the new larger retention in the captive.

Raising property retentions and prefunding is a common and often smart hard market strategy. The problem with this proposal was it forecasts a 25 percent premium savings for the increased retention—a nice number but there was no justification for it. It was an estimate. The property markets I spoke to were willing to offer 5 to 7 percent savings.

For most property risk, the reinsurers’ concern is not frequency of loss but severity. They want the majority of premium to fund a catastrophic event. Increasing your retention by $750,000 dollars for a 5 percent premium savings is rarely a good idea.

The second proposal was for a construction company’s general liability insurance. The first red flag was the new premium was 50 percent of expiring. Captive insurance magic? I don’t think so, so what? There were no material changes in exposure and no new risk mitigation plan, yet the loss pick was 50 percent of expiring.

One hundred percent of the savings was the arbitrary reduction in loss pick. Some insureds might appreciate the cash flow of an upfront premium savings. They will, however, pay all of their losses over the next five to seven years. The proposal might have wanted to mention this.

The third proposal was for a multi-line captive: workers’ compensation and general liability for a franchise restaurant. The first problem was a templated proposal with a bad cut and paste job. The heading for general liability said auto liability. It made me wonder what else I might find. It didn’t take long.

There was a separate page at the back of the proposal with some not-so-small print that was conveniently missing from the front end of the proposal: a claims escrow outside the premium and a one-time captive formation fee. The proposal was also missing premium taxes and fees. For workers’ compensation, fees alone can be as much as 20 percent of the workers compensation premium.

I’ll grant you that a claims escrow is just a deposit on future paid claims and captive formation cost is also once only. These two items, however, required an additional cash outlay of $90,000. Not good.

It’s hard to compare a rent-a-captive proposal to an expiring programme when pertinent facts and expenses are missing. It’s also difficult when savings are estimates versus reality and the true cost is buried in the back pages or in small print. It’s important to consider all the facts, such as collateral and one-time fees before making a captive decision.

These are three specific examples I have encountered. It’s important to look these proposals at a macro level too.

Understand the motivation

Does the sponsor have your or your client’s best interest in mind? The potential for conflict exists when a broker places your business and also owns the rent-a-captive. Is their proposal competitive with other rent-a-captive options or just a good deal for them?

They have an opportunity for two bites at the revenue apple and the potential lock in the insured long-term. The same question applies to a carrier that offers both underwriting and a rent-a-captive option. Sometimes “one-stop shopping” is a good thing, but other times, not so much. A captive manager who gets nothing if they don’t sell you a captive is not necessarily the most objective party either.

Understand what you’re looking at

The bottom line of every captive proposal is a projection of savings for switching from your current plan. Make sure the savings are real. Premium savings due to increased deductibles are not savings if there is no corresponding projection for the increased exposure. And even if the new projected losses show savings, what happens in a bad loss year? Yes, they do happen, so they need to be taken into account.

We all understand that TBD stands for “to be determined”. TBD expenses in a captive proposal is not very satisfying when you’re trying to compare cost. If the sponsor can’t tell you what their product costs, how are you supposed to know?

Understand the commitment

Captive owners need a long-term view. Renting a captive doesn’t change that. Captives are a commitment—most programmes require three to five years of seasoning to show their true cost and therefore their true benefit. That’s three to five years of collateral stacking and three to five years of captive operating expenses.

Chickens and pigs both contribute to the breakfast table. The pig, however, is committed. Captive and rent-a-captive owners need to be too. So, as you look at these proposals, you need to ask yourselves, are you the ham or the eggs?

Greg Lang is the founder of the Reinsurance and Insurance Network (RAIN). He can be contacted at: glang@rainllc.com