Captive owners should think like manufacturers when considering whether to add new lines of business to their captive, according to T. J. Strickland, partner of the insurance services group at Rives and Associates.
Much like manufactures, managers and owners must evaluate profitability and growth potential by identifying a broad range of factors, noted Strickland. While it can be tempting to focus on premiums and loss ratios, these factors alone do not tell the whole story. Factors such as the cost of labour, materials, and overhead expenses are also crucial in determining profitability.
“Just like a manufacturing company, captives have variable and fixed costs (premium taxes and administrative), cost of goods sold (reinsurance), and a profit margin (underwriting gain),” explained Strickland.
Cost accountants for manufacturers determine the actual cost of producing goods by assessing their fixed and variable cost, he continued. “Often, marginal costing is used which allows them to understand the impact on cost by adding one additional unit into production. If our variable costs or potential additional fixed cost exceeds the sales price, we are not making good financial decisions,” Strickland added.
It means that, since many insurance company’s expenses are directly driven by premium volume, it is possible for them to lose money by writing additional premiums.
“One of our clients decided they would add workers compensation to their captive as they believed that its low loss ratio would be profitable if that risk could be retained,” Strickland said. “A year passed and they were right. Comparing premiums and losses alone proved to be very profitable.”
Unfortunately, the client had not taken other factors into account. “The company had to hire a TPA to handle claims, the actuaries upped their bill due to the additional line of business, the auditors charged more due to the additional time, premium taxes were higher,” said Strickland. “Before things were over, the profit margin became very slim.”
He concluded: “In no way am I saying that you shouldn’t add a line of business, but be sure to take your insurance hat off every now and then and think like a manufacturer.”
Rives and Associates, T. J. Strickland