Navigating the hard market for SMEs

For many years, carriers were focused on generating premium volume. They enjoyed an extended period without significant catastrophe events, allowing insurers to offset underwriting losses with additional capacity. The result was more than a decade of relatively flat rate change.

But all good things must come to an end—for the insurance buyer at least. A string of significant global catastrophic losses impacted the insurance market, resulting in decreased capital and market capacity. The decrease in capacity then necessitated an overdue correction in underwriting methodology, from a volume-based business model towards one of examination of underwriting profitability of individual risks.

The new focus on underwriting performance, attributed to relatively recent directives at Lloyd’s that reduced syndicate capacity, created an environment where rates soared, and are expected to continue to do so. Meanwhile, the advancement of data and actuarial sciences allowed carriers to more effectively project the future performance of specific trades and classes. This allows them to pivot strategy faster than ever before—particularly in the US market, where it is now commonplace for insurers to leave a market entirely the moment they see a growth of losses in a particular class, trade, or location.

This new rate environment is felt clearly in the small and mid-sized enterprise (SME) market. Although quite often the most profitable segment of an insurer’s book, best-in-class SME entities are also often victims of circumstance. Unable to access the same capital and talent resources, SME insureds have watched their larger enterprise brethren exit the guaranteed cost market and formally participate in their risk and premium via captive insurance ownership.

Casualties of adverse selection, well-managed SMEs have been left holding the bag for the traditional insurance market, subsiding the losses of poor performers with their good premium dollars.

Unfortunately, the solution to mitigating rate increases is not going to be renewal marketing. The days of brokers being able to submit a risk to a dozen carriers and drive a competitive price are long gone, thanks to market consolidation. However, owners of successful SMEs and their broker advisors need not roll over and accept their fate on the rollercoaster ride that is the guaranteed cost market.

As has been the case with past rate increases, insureds and their brokers are again turning to captives for control and cost reduction. Unlike in previous hard markets, brokers and their SME clients are now presented with potential captive insurance options that were previously available only to Fortune 500/Global 1000 companies.

With the near-infinite permutations of captive insurance structures, the foray into the captives space can be misunderstood, overwhelming, and even frustrating if expectations aren’t set appropriately. With these thoughts in mind, what should brokers and insureds take into account as they start their journey?

Self examination

Entering into a captive insurance arrangement is a long-term risk management strategy and not an annual marketing tool to chase lower premiums. As such, one of the most important foundational questions in the determination of captive viability is often overlooked: is the insured ready to take on risk formally?

This question should dive deeper than just the maths behind the captive insurance equation. Does the insured have a history of proactive risk management? Is management actively engaged in driving the success of their risk management strategies and vested in the creation of a zero-loss culture? Is the insured comfortable with additional complexity and responsibilities (provider interaction, board meetings, etc)?

Do they truly understand the potential for loss? Are they aware of the additional expense for capitalisation, potentially stacking collateral, and ownership of a regulated entity? It’s vitally important for the long-term success of a programme to have a sometimes hard and honest conversation about the cultural aspects that make up a best-in-class risk management programme.

It’s perfectly acceptable practice (and quite a good one) to use captive ownership as a goal for an insured, but it would be poor advice to attempt to determine captive structure and risk transfer strategy before the risk management house is in proper order. Don’t let the potential for equity and underwriting profit blind you to the essential foundational details.

Group captives

As the name would suggest, group captives are structured in such a fashion that allows for unrelated insureds to purchase a minority share of stock of, and post collateral to, an existing captive insurance company. Classes underwritten through group captives are typically limited to worker’s compensation, primary commercial general liability, and primary commercial auto liability, and physical damage.

Minimum premium eligibility starts anywhere from $150,000 to $500,000, depending on the appetite and size of the group. That encompasses a significant portion of the SME market. Due to significant marketing efforts by some group captive aggregators, such as Captive Resources, Kensington and Artex, brokers are often familiar with the concept and it is not uncommon for them to have at least proposed the concept to their quality SME clients. As such, a group captive strategy often becomes the lead offering by a broker. However, it is not necessarily the correct fit.

Premium dollars paid to the group captive by member companies are pooled and used to pay for fronting, reinsurance, management and other administrative fees, allowing members to benefit from the combined buying power of the group. Premiums in excess of the expenses listed previously are deposited into a loss fund where the insureds pay for their claim expenses (typical group captives members retain about 60 to 65 percent of their premium in their loss funds).

The member company is then issued a distribution for the amount remaining in the underwriting year loss fund (plus any investment earnings), typically three to four years after the end of a policy period. That is a good thing for the group members.

Due to their popularity, and general structure, group captive arrangements have become quite commoditised. Although there are varying ways in which a group may share risk among members, most groups underwrite minimal classes, which they do quite well. These classes are typically limited to frequency-based risks (worker’s compensation, primary commercial general liability and primary commercial auto liability, and physical damage) with the aggregate exposures of the member-insureds providing solid predictability and smoothing of losses.

Although groups provide the ability for a dividend, sharing of best practices, and other meaningful benefits, they can be inflexible. Although new group captives are formed each year, participation eligibility is still limited (often by trade/location), and member control is nominal, typically via committee participation or member vote. Delays in distributions also can complicate matters if an insured grows beyond the needs to participate in a group or wishes to exit the arrangement.

Traditional fronted captives

SME insureds that have larger premiums (single line premiums north of $1.5 million) and desire more control could be best suited to financing their risk in a more traditional captive insurance arrangement. In this structure the captive would typically engage with a fronting carrier to issue policies and satisfy the insured’s statutory and contractual insurance requirements (minimum rating, financial strength, admitted paper, etc).

In exchange for a fee and/or a share of the risk, these fronting carriers then reinsure risk and premium to the client’s captive insurance company. The captive is then able to engage directly with the reinsurance market to efficiently transfer undesired risk to reinsurance carriers.

These captive insurance structures typically provide the insured/captive owners with significant control over their programmes. They can often determine domicile, manager, carrier/underwriting partners, investment managers, third party administration, etc. If an insured decides it no longer likes its manager, it can change them. If a different domicile recently implemented a more attractive captive insurance statute, the captive can move.

If it is offered a sweetheart deal from a guaranteed cost carrier, it can be made dormant, and coverage bought from the commercial market, before being turned back on again when the deal expires. If it would like to issue a dividend or change investment allocations, it can do it—with regulatory approval, of course.

This control brings additional costs and complexities. These engagements are not common and represent new territory not only to the insured, but also to the broker. Carrier and provider negotiations also take time, often up to six months, requiring the broker and insured to be proactive instead of reactive to renewal quotes.

In addition to individual appetite for risk, fronting and reinsurance carriers often have minimum revenue or premium thresholds that they require of a transaction. Unlike in a group arrangement, these costs are borne 100 percent by the insured’s premiums. Likewise, collateral and capital are often significantly higher, creating a potential significant barrier for entry and eliminating many SMEs from participation.

The good news for insureds and brokers is that carriers such as Accident Fund, Transverse and ProSight are actively expanding into the captives space, increasing competition and available appetite for risks. Although the larger blue-chip carriers are slow ships to turn, the opportunity to front in the captives space has resulted in the creation of new programmes and carriers with business models specifically designed around fronting.

Although innovation in the carrier space is slow (as in the traditional insurance market in general), carriers that are willing to formally share risk reinsurance premiums with an unrated captive are in prime position to capture potentially significant, and quite profitable, premiums.

Small captives

Commonly associated with enterprise risks, smaller captives are primarily used by SMEs to fund for risks that were previously informally self-insured. This captive insurance structure allows for more unique classes; often these are severity-based business interruption coverages that would be cost-prohibitive or not commonly available in the commercial market.

Due to the commonality of ownership between the captive and the insured, this structure is ideal for the development of manuscript policy forms designed to mirror the unique exposures and operations of the insured.

Small captives can also be excellent vehicles for formally insuring deductible exposures of an insured. Raising the attachment point of the primary guaranteed cost policy should correlate to a rate decrease and lower the cost of associated premium. In exchange for premiums paid into the small captive, the SME can obtain deductible reimbursement policies for the applicable coverages. Depending on the deductible credit received, this strategy can be a very effective way to mitigate rate increases while efficiently funding for future deductible losses.

Cassie Bachman, managing director of compliance at Elevate Risk Solutions, says: “The industry is seeing more small companies using their captive for employee health benefits, such as medical stop loss reimbursement. With this control they are responsible for paying losses and they keep or reinvest any profits.

“When owners learn there’s a way to keep the insurance premium they didn’t spend, and how much of their commercial premium goes to administrative and marketing costs, the appeal of owning a small insurance company with low administrative costs is high.”

With relatively nominal operating expenses, small captives can be viable from premium levels starting at about $150,000, allowing the SME to efficiently fund for future losses while closing potential significant gaps in coverage. The combination of rate increases, lower operating expenses, and domicile-reported new formations (in North Carolina, for example, 61 new cells were formed in 2019) is clear evidence of her position.

It’s not all roses, however. Due to the relatively small premium size, this captive structure has some key limitations and unique complications, and can create potential ancillary risks.

Small captives are, by their nature, just that: small. As premium income is limited, these captives will likely never be able to qualify for, or obtain, even a minimal score from a rating agency such as AM Best or Fitch. As such, these captives will also likely never file for, or be approved on, an admitted basis.

These limitations stop small captives being able to fully replace almost all key lines of coverage that are currently being purchased in the traditional guaranteed cost market. Smaller captives also tend to write only first-party risks, requiring participation in reinsurance pools for risk distribution purposes. This is very important when considering transactions involving US tax-paying entities.

Due to the low-frequency and high-severity nature of the classes written through these arrangements, they also tend to accumulate underwriting profit extremely quickly. The potential for significant accumulation of underwriting profit also provides opportunities for abuse and additional scrutiny. Added to it is the complicated concept of risk distribution in general, so captive owners should complete thorough due diligence on the defensibility and legitimacy of their contemplated small captive arrangement.

Market innovation

If captives can be relied on for anything, it’s that they innovate. Classes that are now commonplace (cyber liability, reputational damages, legal/litigation defence) all got their start in captive insurance companies long before they were being offered by guaranteed cost carriers as part of a package or on a standalone policy form. This same innovation has continued to occur in captives, fuelling the engines of many insurtechs, rideshare services, and shared economy operations.

These organisations’ business models simply don’t match well with the methodology of the commercial market. They required a new way of thinking. Take a shared economy provider that leases a car on a short-term basis: the traditional rating methodology for commercial auto liability is ineffective because it doesn’t do a good job differentiating between the exposures of a driver who has a vehicle for six months and one who has the vehicle for six hours. These new and innovative businesses require an insurance solution that is equally innovative.

Eligibility gaps that exist in current captive structures are also being addressed with the emergence of new captive-backed programme business. These new programmes aim to combine the access to A+ rated fronting paper, claims authority, investment control and integrated reinsurance of larger traditional captives, with the minimum premium and collateral requirements of a group. They seek to do that while operating on the same nominal operating expenses of a small captive in a turnkey package.

Andy Jeckells, CEO and chief commercial officer of Intentional Re (I-RE), says his firm is seeing the hardening market stimulating demand for captives. “I–RE created RE–PAID, a unique, customer-focused insurance and reinsurance solution for high-performing mid-market business owners with captives,” he says.

“Large businesses have long-established commercial insurers for the captives they own, but high-performing mid-market businesses have so far been denied access to underwriting commercial P&C insurance.”

Jeckells says I–RE’s RE–PAID saves clients up to 50 percent of their total cost of risk, giving them control of their own claims. It means they can generate underwriting profit from their own commercial P&C insurance programme in their captives, he explains.

“As a result, we are experiencing significant demand for new captive formations from clients, through captive managers and brokers. Such demand can only increase as the commercial insurance market hardens and rates rise.”

This hard market is different from the last. Captives are much more prevalent and SME insureds are more educated, efficient and ready to take risk. Traditional captives are more accessible, as more fronting carriers enter the fray.

Group captives, although somewhat commoditised, are numerous and can be a great fit for the right insured—particularly for worker’s compensation and commercial auto liability classes. Small captives continue to drive coverage innovation and help control costs via deductible reimbursements.

Brokers and insureds alike should be extremely excited about the launch of new and innovative programmes allowing best-in-class SME insureds turnkey access to captive insurance solutions previously available only to their large enterprise brethren.

The current state of the insurance market is such that rates are expected to continue to rise for the foreseeable future. The continuation of current trends presents a real and present risk to the SME market. Owners face the difficult decision of whether to forgo adequate cover in lieu of obtaining new contracts, or maintaining existing revenues.

The combination of new and innovative programmes like RE-PAID, and competition among captive domiciles, is driving fundamental change in risk financing for SMEs, the like of which has not seen since the advent of group captives.

Well-managed SMEs and their brokers should look to leave the traditional guaranteed cost market as soon as they are culturally and financially able to do so, lest they find themselves priced out of their own market due to the rising costs of insurance.

Nate Reznicek is director of operations at CIC Services. He can be contacted at: nate@cicservicesllc.com