Microcaptives help facilitate ERM programmes for SMEs

It is a well published opinion that in a free market, a better-managed risk is a competitive advantage.

The world’s largest companies embrace this and employ a team of risk management professionals, support personnel, and at least one company of insurance brokers, to manage their risk better.

This highly skilled task force is purposed with identifying, quantifying, and helping to manage the company’s risk exposures. They review company operations, logistics, suppliers, clients, markets, financials, compliance issues, and environmental exposures—all aspects of the enterprise. This team works to quantify risk in terms of frequency (how often it could go wrong) and severity (how bad could it get) to better target impact events.

The output is often a register of risks prioritised by what could hurt the company the most, typically represented by financial measures such as: lost profits; liability payout; property damage; costs to repair a brand reputation; etc.

The register is reviewed with senior management and an enterprise risk management (ERM) strategy is drafted which identifies risks in four buckets: worth taking, sharing, transferring, or avoiding. These risk professionals work with the business leaders to ensure the owner’s appetite for risk is managed through various loss control programmes and custom-designed insurance programmes, consisting of a combination of commercial and self-insurance.

A vital role

A captive (the company’s privately-owned insurance company) is often used to fund the enterprise risks which are too costly to transfer contractually or through commercial insurance. The captive plays a vital role by insuring these risks, reducing commercial premium expenses, and providing a dashboard to monitor the insurable risks of the enterprise.

The company benefits by having full insurance coverage and a good measure for the effectiveness of their risk management approach.

Here is the problem—and the opportunity. Most business owners who could benefit from this level of risk management thinking, planning, and funding, are not sitting atop supersized multinational conglomerates. They are leaders of growing small to midsize companies.

According to the Statistics of US Businesses (SUSB), US Census Bureau, small businesses (those defined as having fewer than 500 employees) employed nearly half (47.5 percent) of the private workforce in 2015. This sector has continued to grow as represented by the 1.8 percent increase during the 12-month period ending February 2018.

From 2000 to 2017, small businesses created 8.4 million net new jobs, contributing nearly two-thirds (65.9 percent) of net new jobs, and that is just in the US.

In 2018 the world came together through the United Nations to declare a “Micro-, Small and Middle-Sized Enterprise (MSME) Day”. One of the outputs of this gathering reported that the primary needs of MSMEs is for “education and simplification” of the business ecosystem, tax burden, financing costs, and managerial training. Risks management services fit well within this description.

What one observes in this growing MSME market are very smart, very busy, and often rather young company owners and leaders. They don’t have a team of risk professionals, so by default they are the risk management team. Risk management is done by walking around, being involved in major decisions, talking to the staff directly about important decisions and the importance of safety, and buying insurance—lots of it.

A captive solution

Many MSME businesses still have the same insurance coverage and deductibles as when they started out. Why? Most of these leaders are vibrant individuals and avoid catatonic insurance presentations.

Many owners are simply unaware of, or have not been introduced to, risk management tools such as captives. Insurance is often seen as a non-critical business necessity until you need it, or until it has grown to an attention-grabbing expense item.

Micro-captives can help facilitate an ERM solution for the small to medium-sized business by relying on an outside ERM consultant and, in many cases, a captive manager. Micro-captives are generally viewed as those with premiums of less than $2 million.

While involving a multi-step process, it will take a fraction of the time and resources of the business owner. Done for the right reasons, this approach may lead to the formation of a captive insurance programme which funds self-insured exposures and tracks risk performance. An ERM micro-captive version may not be as robust as a mega-company’s ERM programme, but many of the same benefits may be achieved.

Four steps

One ERM micro-captive approach is a four-step process which leads to a better-managed risk, as follows:

1. Identify: the first step is to identify insurable risk. A trained consultant experienced in ERM interviews the leaders to identify significant risks exposures to the company. A review of the company’s activities, financials, losses, payments made to fix problems, current commercial insurance policies, and their industry, aids in targeting uninsured exposures. The captive manager or consultant, with the help of outside finance and legal counsel, identifies the insurable risk exposures and helps structure insurance policies to appropriately transfer these risks.
2. Measure: risk events are measured by looking at historic losses, potential exposures, and through the eyes of an experienced actuarial professional. Potential impacts to the company are evaluated individually as well as in groups of events likely to occur together, or sequentially.

For example, fire damage to a production facility may cause employee injury, property loss, liability for damage to neighbouring property, loss of profits, expediting expenses to get back up and running, and potential damage to the company’s brand reputation. The uninsured exposure to the company is calculated by subtracting what could be covered by any commercial insurance. The results are factored to a realistic funding number to cover a high confidence level of these potential events occurring over time. An independent, qualified actuary performs the analysis. This will be the basis for the premium to transfer these risks to the captive. After these risks are funded into the captive, the financial health of the captive becomes a critical ERM measurement tool for owners to evaluate their own risk management performance.

1. Manage: prior to insuring any ERM risks into a captive, the risks identified and measured are shared back with company owners. At this point, loss control plans are enhanced to strengthen the avoidance of risk events (eg, contractual risk transfer; building protection; safety processes and equipment; cybersecurity; etc), and loss control plans bolstered to mitigate the severity as the result of a risk event taking place (eg, back-up suppliers for critical parts; work hardening for new employees; disaster recovery plans; etc).

Managing risk also involves looking at the company’s commercial insurance and adjusting coverage to fit the growing needs of the owners. Many MSMEs have changed significantly since startup and subsequently, so has the owner’s appetite for risk. Companies may be quite profitable yet continue to pay top dollar premiums for small deductible policies with many restrictions of coverage. Their existing insurance broker may be hesitant to review captive insurance alternatives, as lower commercial premium means lower broker fees. For the owners, lower premiums can be used to fund higher limits of commercial coverage or to fund deductible exposures into a captive.

Managing the risks in the captive may also involve the long-standing practice of most all insurers seeking to lessen their own risk: purchasing reinsurance. This is similar to the owner purchasing standalone commercial insurance on each line of insurance, except that the captive can aggregate its coverages and often buy more cost-effective aggregate or quota-share coverage from the reinsurance market. Captives purchase reinsurance to help manage the maximum dollars at risk and often will reinsurer part of their exposures to other like-minded companies through insurance pools, which helps diversify their risk portfolio and gain premium income. This step can be more involved, requiring a certain level of consulting expertise, yet many MSME owners welcome the management and sharing of risk.

1. Fund: at this point, the captive can be set up and appropriately funded with regulatory capital and annual premiums. These funds become the company’s war chest to help protect the company in the event of an insured loss. When good risk management helps minimise losses, profits in the captive are still the property of the owners and not lost to the commercial insurance market.

The result of this approach can be extremely beneficial to MSME owners. For a fraction of the cost, their risks can be identified, managed, and properly funded. When the captive is profitable, it is a good sign the ERM process is working. To enhance the benefit, some owners align the incentive for safety and good risk management with staff by giving them a share of the captive profits through various structures.

Some captive owners extend insurance to their customers through extended warranties or other customer-focused programmes. Others may help manage supplier risk by offering custom insurance programmes. There are many creative uses of insurance and captive programmes, and these should be structured only as legitimate insurance transactions by professional advisors.

If you are an owner of a growing, profitable, middle-market company and desire lower exposure to risk and better-designed insurance, the benefits of a properly designed ERM micro-captive may be worth considering. It often pays off at least to invest in a proper feasibility study that will reflect gaps and omissions in commercial coverage. This is often a better use of hard-earned cash than over-buying primitive commercial insurance.

If it is true in your market that a better-managed risk is a competitive advantage, then consider a micro-captive strategy as an alternative to simply buying commercial insurance.