The increase in captives is not a fluke

Captive formation is on the rise. It nearly doubled in 2020, according to the “2021 Captive Landscape Report,” compiled by consulting firm Marsh. Across industries, captives have exploded in popularity, accounting for $60 billion in gross premiums, an increase of more than $6 billion.

This explosion isn’t happening by accident—it’s part of a seismic shift in the industry brought on by a customer base looking to take greater control of their own destinies. Making their insurance more affordable and more flexible is certainly something companies and individuals want. For many larger companies and certain individuals, captives provide both affordability and flexibility, giving them the control they seek.

Pre-COVID-19, captives were becoming increasingly popular among businesses and the very wealthy, looking to mitigate risk more effectively and maintain more control over their policies. Hard markets led to unstable premiums and decreasing coverages. Businesses who wanted to know that they could count on the liability protection their policies afforded them, and that their premiums wouldn’t hamper the bottom line, began looking for risk mitigation alternatives, and many chose captives. Soon more states were adopting captive insurance laws, and it looked as though they were becoming more than just a trend for those who could to put down a lot of capital up front.

However, the pandemic turned the insurance landscape into the Wild West, with countless new claims flying in, and carriers struggling to keep up with them all, deciding which to deny and which to cover. COVID-19-related exclusions and even more premium instability created unprecedented chaos across the industry and pushed customers to the brink.

The pandemic has caused business disruptions just about everywhere, as companies scrambled to get by and find new ways to operate amid a global panic. In the insurance industry, attempts to cash in policies for COVID-related delays, loss of business, liabilities, and other concerns forced insurance companies to deny claims wholesale, to create exclusions, or to jack up premiums so that their companies could stay profitable.

Better options

Captives can give businesses additional options and help stabilise the industry for those who have the resources to capitalise on them. Captives are virtually customisable policies that give the entities creating them a great deal of flexibility and thus limit risk exposure. The coverage structure can be adjusted to cover essentially anything they want.

If you use a captive, it’s essentially your money to cover as you like, within the constraints of the law. When the insured is its own insurance provider, policies can be created to cover a variety of risks, mitigating the chance of a pricey denial.

Captives represent a significant financial burden up front, but low claims directly impact the quality of the captive. Fewer claims mean more money in the bank, so to speak, because all the capital isn’t dropped into premiums. In a captive, at the end of the term unused funds return to the customer to either roll back into another captive, or cash out if the risk is gone.

When companies have low claims, alternative risk can be a sound investment if the claims are likely to continue to be very low. A claims history under 30 percent is considered good. For example, a company has premiums of $50,000 a year, and the claims are $10,000. In the traditional insurance model, the customer is losing money that it chalks up to the price of business. Instead of that money simply being gone, why not take that $50,000 and put it in a captive, keeping the money, and rolling over the unused $40,000 each year? After a few years, it’s as though the insurance is paying for itself.

That is an attractive prospect indeed, creating a calculated risk that not only saves, but makes money. The insured owns the insurance company it’s using to protect its interests, and lower claims in a year means money not spent, which can then be rolled over, invested, or otherwise used as the insured sees fit.

In view of the way premiums rose to the tune of 15 percent in the third quarter of 2021 alone, captives are going to continue to be needed. No-one wants to feel they’re being gouged, and while it would be easy to tell people these higher premiums are an aberration that will go away, price stabilisation can be a slow and expensive process. Also, even if prices do stabilise, will they drop back to pre-COVID levels? It seems unlikely.

Flexibility is another factor. Captives give their owners a variety of benefits that make them very attractive when used properly. These benefits include:

The different ways captives can be constructed allows captive customers to vary their buying behaviours widely. Depending on their preferences and tolerances, they can create wildly different captive structures, even within the same line of business. In a hardened market, the same coverage a captive provides would potentially require multiple policies and be many times more expensive in monthly premiums.

In other words, when you have heavier claims, you can customise your risk profile. By contrast, the customer has no control over market conditions changing, which can cause changes that extend to premiums. Even when they haven’t had a significant number of claims, the customer is on the hook for larger premiums. That leaves them up a creek without a paddle in the traditional model.

Captive owners, on the other hand, can adjust their exposure based on their own needs, creating the policy they want, that is most attractive to them based on their needs. By customising their own policies, they can provide the protection needed.

No miracle cure

The potential for increased profits is also driving the rise in captives. Marsh’s report noted that captives are writing third-party business in increasing numbers, which is legal since captive owners form an insurance company that is all their own. If they have the resources, they can cover customers of their parent company, suppliers, pooling facilities, and employees, which allows the captive to bring in even more money.

Captives aren’t a miracle cure for what’s ailing the insurance industry. Certainly, most small businesses wouldn’t be able to meet the front-end demands of setting up a captive, and for those with more traditional needs a captive wouldn’t be the best move, or even a feasible one.

However, for companies with the capital, it remains a viable option. Carriers and customers alike quickly recognised the need for a solution, and in many instances, captives fill that need. What it ultimately comes down to is value, and in the right situations captives demonstrate their value beyond a temporary solution to a volatile commercial market. By looking long term, the overall value of captives can shine through, and the potential not only to mitigate risk using a non-traditional method, but to make money, makes captives quite a tantalising idea.

The fallout has been real, and while the market chaos seems to be slowing, it seems unlikely that rates will return to their pre-pandemic levels. New risks will continue to emerge, and more companies will see the benefit in captives. Looking at the long-term implications of the pandemic, and its lasting impact on the economy, captives remain a viable alternative to traditional insurance.

The increase in captives is no fluke. It’s been years in the making, and the ability for companies to reduce total cost of risk and manage their own risk exposure makes captives a no-brainer given the right situation.

Jeremy Colombik is a managing partner of MSI. He can be contacted at: jeremy.colombik@themsicorp.com