An affordable alternative
While captives are mostly used to cover the same kinds of risk that insureds buy in the traditional market, their potential to address newer, evolving or expensive risks should not be underestimated.
This is particularly true in the healthcare sector, in areas such as health benefit coverage.
“Skyrocketing cost increases in the traditional health benefit market are making self-insurance for larger employers a way to maintain benefits at current levels and still hold the line on costs both for the employee and employer,” says Dennis Silvia, president of independent captive consulting firm Cedar Consulting.
“In recent years much more health benefit coverage is being placed in captives. Driven partly by the Affordable Care Act, employers are retaining higher limits of stop-loss coverage over their approved self-funded programmes in order to capture the value of meaningful loss reduction programmes such as smoking cessation, physical fitness and weight loss initiatives.”
Using a captive structure has the benefit of lowering insurance costs, while also retaining the backing of the traditional market to absorb the more severe losses that captives cope with less effectively.
For example, captives are commonly used to retain lower limits of risk in lines such as auto liability, general liability and workers’ compensation, while severity risk is transferred to the traditional market.
“Frequency layer losses are often a premium for loss ‘dollar swap’ that is much more efficiently self-funded than passing to the traditional market with its profit and overhead mark-ups,” says Silvia.
“WHAT GETS CREATED IS A BESPOKE INSURANCE MECHANISM THAT CAN COMPETE WITH TRADITIONAL INSURERS ON AN ECONOMIC AND SERVICE BASIS.” DENNIS SILVIA, CEDAR CONSULTING
Supply and demand
The narrower the pool of traditional insurers willing to cover a specific risk, the more attractive a captive solution can become. Silvia illustrates this with the example of a group of social services organisations that offer drug counselling and rehabilitation services, and are having a difficult time in securing professional liability coverage in the traditional market.
“It isn’t that no-one will offer the insurance coverage, but only a few companies are actively involved in that market,” he says. “Supply and demand dictates that the price will be high because the supply of companies willing to offer the coverage is low.”
Using a captive to provide the professional liability coverage brings additional capacity to the market and begins to drive the price back to a reasonable level.
“The captive retains frequency layer losses because they are predictable and easily funded, and then it reinsures the more catastrophic loss away.
“They have created a homogeneous group of risks that have very similar characteristics so that the reinsurance costs are focused on their risk, hopefully making it very efficient, and they are able to customise loss control and risk management programmes that are laser-focused on what they do to mitigate loss exposure. What gets created is a bespoke insurance mechanism that can compete with traditional insurers on an economic and service basis.”
Another area successfully addressed by captive solutions is the cyber risk faced by healthcare providers—an issue that has come to the fore in recent years as a result of the Health Insurance Portability and Accountability Act (HIPAA) in the US.
“HIPAA has caused quote a lot of interest in cyber,” says Peter Willitts, vice president at Liberty Mutual Management and vice president of the Bermuda Captive Owners Association (BCOA).
“All big companies are facing cyber risk but HIPAA has shone a spotlight on cyber in healthcare.”
The application process to purchase cyber risk outside of a captive has tended to be very lengthy and complicated, says Robert Vermes, president of the BCOA and CEO of The Captive Advantage, a group captive within the human and social service industry.
“It’s a risk that was hard to procure—the application process was very tedious. Over the years, as the industry has become more familiar with this risk and how to underwrite it, the application process has become a little bit easier, but trying to quantify the risk is the challenge.
“Early on it was not in the traditional market because of the issue of trying to quantify the risk itself. Cyber risk has evolved but so has our understanding of that type of risk.”
Captive programmes have taken the lead in terms of understanding that risk in order to quantify and properly underwrite it, and as a result cyber risk is starting to become a little more affordable.
As with Silvia’s example, the decision of whether to proceed with a cyber risk captive solution comes down to the pricing and the availability of cover in the traditional market, and whether the risk is best addressed by a captive.
“Early on, the coverage itself was pretty hard to procure, and it’s still not cheap to place that type of coverage. Just like with any type of insurance, you need to understand the risk and whether it is feasible for the captive industry,” says Vermes.
“When you are asking that question there are several mechanisms you would look at to see if that is a possibility. Placing the coverage in traditional markets versus into a captive is one thing, the pricing is another, then there is the issue of understanding the liability.”
As cyber liability is becoming much more of an issue and a little more developed within the traditional insurance industry, the ability of captives to understand and address it is has also developed, he adds.
“The plaintiffs’ bar is always looking for that next big liability that may come up. Cyber is prevalent because of the portability of data today.
How to quantify that risk is the challenge because it’s not been around for a long time.”
A major cyber-related issue has been calculating the cost of breach notification.
“The liability to the actual individuals is a little more difficult to quantify for the litigation side of it—there are a lot of moving parts in that,” says Vermes.
“The legal costs of telling people their personal information has been compromised is only part of the transaction,” adds Willitts.
“There’s also some reputation risk involved that is difficult to evaluate, and then there’s any consequential risk of credit card information that is accidentally lost or made public. Indeed, for people involved in some entertainment industries, that has proved to be pretty catastrophic to the whole business model.”
A safe bet?
The danger from a captive point of view is that such aspects of cyber coverage could fall into the category of what Willitts calls a ‘roulette-type’ risk.
“Captives respond well to predictability. What I would call roulette-type insurance relates to risks that are either going to hit you full bore or are not going to hit you at all. That really is an inefficient use of capital, unless you have a lot of things going into the captive and you are using the capital many times over.”
The advantage of a captive solution is flexibility of form, and the potential to decide exactly what is covered and what is placed into the traditional market.
“Organisations should be commissioning experienced practitioners to conduct feasibility studies and to present the options and pros and cons of a captive programme,” says Silvia.
“This is often a bigger decision than just the economics of a captive versus traditional insurance. Captives can bring flexibility in claims handling schemes, access to reinsurance markets for excess layers of coverage, and manuscript policy wordings that may greatly benefit the parent organisation when they face a claims fact set that is excluded in the traditional coverage.”