Captive Retention – A look beyond the losses

Greg Lang (pictured), founder of the Reinsurance and Insurance Network (RAIN), explains why retention selection is so important in the current market.

The Federal Deposit Insurance Corporation (FDIC) standard insurance limit has been $250,000 since July 2010. A dollar in 2010 buys about $0.67 cents of the same goods and services today.  In commercial insurance, a $250,000 retention is an institutional number selected for many captives before reinsurance kicks in. This figure is chosen for convenience.  It is one of the standard intervals ($250,000, $500,000, $750,000 etc.) offered by the commercial market. I think it’s time to reexamine your father’s retention structure.

Workers' compensation severity claims have increased 100% since 1990. Today’s dollars buy about 40% of what they did then. The severity claims leaders are medical inflation and medical utilisation. This trend is not changing.  Nuclear verdicts impact retentions too.    Captives operate best when retaining working layer losses. Commercial insurers are moving up attachment points to reflect the new normal. One million dollars is now considered working layer for commercial auto.  Does your reinsurance cost go up every year regardless of loss history? Confusing?   That $250,000 retention might not make sense either.

Retention selection is a dynamic process, not a check once and forget exercise. Loss history is one factor.  Captive financials, program structure, and your insurers or reinsurers risk appetite are important too.  

Loss History

Loss history is the starting point of any retention analysis.  Captives function best when insuring or reinsuring frequency losses.  The frequency layer is a dollar range of annually expected losses.  Most insureds, unless they are large, don’t have enough loss data to credibly determine an annual average.  This is why actuaries add industry data to your losses to better estimate loss picks and help you select a retention.  Better data, not more data improves forecasting.   

What data does your actuary use?  Have you ever asked?  I do a lot of workers compensation and auto liability business. For workers’ compensation, state specific data is important.  Loss development in California has a longer tail and greater severity than say Florida.  This is due to a frequency of cumulative trauma claims.  Florida has had nine straight years of rate decreases.  The Florida market is soft compared to California.  Florida also provides faster claims resolution. Florida’s downside is insureds now receive increased underwriting scrutiny due to lower rates. The tradeoff is worth it

Auto liability has similar state specific issues. States with tort reform often provide caps on non-economic damage.  This reduces litigation costs.  These states include Texas, Florida, Indiana and Ohio.  States with the worst tort environments “judicial hell holes” include Pennsylvania, New York, Georgia and California.  

An Insured’s loss information is not always credible. Some have something to hide. Removing historical losses from discontinued operations is ok.  Removing a workers compensation loss because a claimant is no longer employed is not.  Some insureds don’t report small claims for fear that frequency will impact reinsurance costs.  It does. So does late claim reporting.  All impact credibility.  Yours and your losses

Credibility issues can also stem from the third-party administrator (TPA) handling your claims.   A fatality claim still open on a loss run after 10 years is an example of a red flag.  Patterns of under reserving or over reserving are red flags too. 

Repricing medical bills is an area where overcharging and inflated claims reporting occurs.  Most TPA contracts allow the administrator to keep a portion of the medical savings.  Savings range from 20 to 30% for in-network claims and up to 50% for out-of-network.  Average medical bill repricing results in 60% savings off the original billing.  That’s a big number. Some TPA’s are willing to cap their fee.  You need to ask though.

TPA’s should be rewarded for negotiating lower payments. The problem is these billing amounts are often inflated beyond what realistically would be reimbursed.  Hospitals might bill $60,000 for shoulder surgery when they routinely accept $10,000. The savings are manufactured, not negotiated. This is not just a TPA issue.  The same problems occur when your insurance company is handling claims.   When you understand your losses, you are in a better position to choose a retention.

I often help create unique coverage where industry data is not always available. I talk with a lot of prospective captive owners who want to look at risk differently.   Be sure to ask your actuary where they get their “industry” data from.  It might be for a specific state or industry, just not yours.

Financials

Risk retention is as much a function of losses as an insured’s ability to assume risk. I recently wrote a three-part series on captive collateral. A captive’s retention is as much about losses as how much money you are willing to post to achieve an anticipated cost savings for the risk assumed.    Unfortunately, you are not the only person who determines how much collateral you need.  Your actuary, the fronting carrier’s actuary, your reinsurer and your domicile’s regulator all have a say.   They may want more collateral than you think is reasonable.

Established captives are normally better capitalised and better positioned to assume higher retentions, so why don’t they.  Most new captive owners are just so happy to find a fronting carrier and/or reinsurance; they never bother to explore other options as their captive matures.  If it isn’t broke… it doesn’t mean it can’t be improved or maximised.  Most captive owners are also not in the insurance business.  Outside of for-profit captives, most owners spend 11 months of the year running a business that has nothing to do with insurance.  It is only a priority at renewal time.   Your broker or captive advisor should shoulder this responsibility.  Hopefully they offer options before it’s too late in the renewal cycle to implement them

Captive Structure

Group captives often use a layered retention approach.  This is commonly referred to as the A fund/ B fund approach to retention management. Group captives typically allow for more retention of risk before outside reinsurance is considered.

The A Fund or frequency layer handles smaller, more frequent claims.  The range is from $0 to $100,000 or $250,000 per occurrence. Losses in this layer are usually paid for separately by each individual insured.

The B Fund or severity layer addresses larger, less frequent claims, typically handling losses from the A Fund threshold up to a total captive retention of around $500,000 to $750,000. The losses in this layer are typically shared by all the members of the group.  Funding and repayment of the B fund varies. 

Direct writing captives can often assume more risk with less collateral since the risks they are trying to protect are their own.  Betting on yourself makes sense.  Who knows better than a business owner how much risk they are willing to take.  It’s also the reason why regulators mandate that coverage like workers compensation and auto liability can’t be written directly as those losses impact the lives of more than just business owners.  Fronted paper provides additional financial security, as the balance sheet of the insurer is available to make sure employee claims are paid and third parties injured by your commercial vehicles also receive fair compensation. 

Don’t confuse a loss limit or retention with a premium limit.  Micro-captives or 831(b)s have annual premium limits.  In 2026, the IRS increased the annual premium limit by 831(b)s to $2.9 million.  This allows these entities to retain more risk and profit internally

Reinsurers appetite 

I am often asked to provide quotes for lower retentions.  These requests are driven more by a need for capital than a desire to reduce risk.  Most captive owners are risk takers.  Reinsurance is a form of collateral that pays when adverse losses occur. It doesn’t mean reinsurance is your only option though.   

It’s important to “occasionally” test the market to see what alternatives are available. I put occasionally in quotes as some insureds and their brokers want to go out to market every year.   Speaking as a former reinsurer, they don’t need the exercise.  It’s important to test the market to understand the cost/value trade-offs of purchasing reinsurance.  This exercise often results in retaining more risk.  How often you should test the market is specific to your circumstances.  If your “expert” can’t speak to this, they are not experts.  If you are constantly testing the market, it’s like the little boy who cried wolf.  When you really need help, you won’t be taken seriously.

One reinsurer wanted to charge my client $400,000 to lower their retention $250,000.  This client never had a loss which pierced this lower retention.  The high premium was a good indicator this reinsurer preferred to keep the retention where it was. They considered the lower retention to be in the working layer.  They offered coverage, but for a price. Here is my number.  It’s not competitive but I’m offering it because you are a good customer and you asked.  That’s fair. This reinsurers pricing at the current retention is competitive.   My recommendation was to keep the current retention.  The $400K savings can contribute to future capital growth or be used to pay future losses.  Reducing expenses and holding your money is often a good strategy.

What if you need reinsurance (collateral) but the cost is too high or is simply unavailable. The market is getting more creative.  Blue Owl is one example.  You may have heard their name in the news recently.  They provide private capital solutions.  The opportunity mentioned in the news included a captive.  There are several private capital reinsurers out there.  Some take risk offshore in Bermuda and Cayman or in the UK through specialty captives or Lloyd’s market entities.

Not ready to get that creative.  Sometimes your bank can help.  That is if they understand statutory accounting and captives.  Unfortunately, most don’t.  I work with a few that can help maximise the value of the cash you have on deposit and convert that value into a letter of credit you can post as a statutory asset in your captive.  How that works is above my pay grade.  I don’t provide tax and legal advice.  Fortunately, readers of this publication do.     

Other Considerations

Opportunity and frictional costs are often overlooked when calculating the total cost of an insurance program.  Costs that can be mitigated or magnified by retention selection, program structure and how claims are handled.  The two frictional costs I want to discuss are premium taxes and collateral.  

So far, we have talked about captive retentions. Captives are legal entities used to formalise risk funding, gain tax efficiency, and access reinsurance.  A Self-Insured Retention (SIR) is a "pay-as-you-go" approach where an insured covers specific losses directly, retaining both the risk and the cash to pay claims within the SIR.

An SIR is a pre-determined dollar amount an insured pays for defence and indemnity costs before commercial cover applies. Unlike a deductible, insureds handle claims and payments directly until the SIR limit is reached. This form of risk retention lowers premiums.

The choice between a deductible and an SIR depends on the financial position and risk tolerance of the risk taker. Businesses with strong financials and a willingness to manage claims use high SIRs to reduce premiums and exert more control over how claims are handled. Those prioritising predictable payouts and insurer's claims handling may find deductibles a better fit. 

Deductibles and SIR’s reduce loss picks, hence premiums and premium taxes. They can also reduce collateral.  Collateral is a function of your loss pick.  A typical collateral formula is to collateralise to 120% of expected loss. This means adding a 20% collateral cushion to your funded loss pick.   If a deductible or retention reduces your loss pick/premium by 25% that’s 25% less premium tax and collateral that needs to be posted.    Not all insurers offer collateral credit for deductibles.  Most deductible policies require the insurance company to pay the deductible if the insured can’t or refuses to.  Insurers typically want collateral to mitigate credit risk.  

SIRs create a gap in coverage.  The insurance policy does not provide protection until the retention is satisfied. Insurers generally do not require collateral for SIRs since the insured is directly funding the initial claims costs.  SIRs are typically outside the policy limits, meaning the full policy remains available after the retention is satisfied.  A $10 million dollar policy with a $1 million SIR provides $10 million of protection after the insured pays the first $1 million.  Insureds need to check with their creditors and vendors who require proof of insurance to confirm if a large, self-insured retention is acceptable. 

Deductibles and SIRs also reduce the acceleration of tax deductibility. Losses are only deductible as business expenses when they are paid.  Captive retentions accelerate tax deductibility through a prefunding of losses and create opportunities for underwriting profit.

Stacking collateral is an ever-growing request for funding by the insured as new policy years add to the existing obligations even as claims are paid. It's a significant financial consideration.  New collateral stacks on top of existing collateral posted in prior years.  Collateral obligations impact on an insured's cash flow until all claims are paid. Some refer to this as collateral jail.  Having all your collateral tied up with one insurer makes it difficult to change insurers if you need or want to.

When an insurer first offers coverage, they require collateral to cover the gap between the premium paid, and their worst-case scenario. This is the 20% cushion.  When a new policy year begins, new collateral is requested on top of the collateral already held for older policy years.  This creates the stack. The total collateral held grows as each new policy is written.  Collateral in older years can also increase if prior year loss develop worsens.  Collateral only shrinks as claims are paid and closed.  Closing claims quickly and not allowing them to reopen is the best collateral management strategy

Stacking collateral increases costs. This is part of my frustration with feasibility studies and the parties that push them.  They often don’t explain this. I saw a recent estimate of $300 billion dollars trapped in pledged collateral.  I think the number is higher.  

Conclusion

Retention selection is a dynamic process that should be revisited often. Personal claims history is important but program design, TPA selection and finding reinsurers and fronting carriers that share your thinking on what “working layers” are all important when considering your overall cost of risk.  Alternative collateral and program design can save money and reduce opportunity costs. Don’t be helpless.  Be educated.

Greg Lang can be contacted at: glang@rainllc.com

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