Captives outperform the market
We at AM Best have for a long while found it interesting that the captive industry outperforms the commercial insurance market year after year. This article will describe how the captive industry, using a proxy of rated captives, substantially outperformed the commercial insurance industry in 2010 and over the last five years taken as a whole. Through the discussion, some of the reasons for the outperformance will be isolated. It will also provide captive owners and managers with the ability to benchmark their captive/s against a rated captive benchmark.
AM Best has compiled statistics from 194 captives which they formed into a captive composite that can be used as a proxy for the captive industry. The major line of business weightings of this composite are: 48 percent medical malpractice, 22 percent liability, 7 percent auto warranty, 6 percent workers’ compensation, and 17 percent other (mostly composed of short-tail property coverages).
This weighting compares reasonably well with the Cayman Islands Monetary Authority (CIMA) Captive Insurance Company Statistics (excluding life) which contemplate premium weighted statistics of approximately 40 percent medical malpractice, 26 percent workers’ compensation, 11 percent liability and 23 percent other. Admittedly there is some juxtaposition of liability and workers’ compensation between AM Best’s composite and CIMA’s statistics, but for our benchmarking purposes this should still lead to meaningful comparisons.
From a pure underwriting performance perspective it is interesting to note the five-year average pure loss ratios of the captive composite by major line of business as: medical malpractice 36.2 percent, liability 55.9 percent, auto warranty 59.6 percent, workers’ compensation 62.1 percent, and other 55.8 percent. It is clear that while these pure loss ratios compare favourably with those in the commercial property/casualty industry, they resonate with the value of the customised policy coverages, lasered loss control, and specific claim mitigation qualities found as a matter of course in the alternative risk industry.
It is also interesting to note the declining pure loss ratios of the captive composite over the last five years: 2006 recording 51.2 percent, 2007 47.8 percent, 2008 49.9 percent, 2009 48.1 percent and 2010 44.6 percent. That these declining pure loss ratios were accomplished during the trough of a soft commercial insurance market is remarkable.
When AM Best analysts speak with captive owners and managers during the ongoing rating process it is apparent that captives have the ability and willingness to let underpriced business go. As an example, a few rated group captives serving the residentialhomebuilders market have seen premiums shrink by 50 percent or more without issue. There is little incentive for a group captive to chase underpriced business in the marketplace since market share tends to be a minor objective of a group captive. The incentives of the management teams differ. A captive officer is incentivised to maximise policyholder owner benefit generally by reducing the cost of insurance to policyholder owners. On the other hand, publicly traded or privately held commercial insurance companies’ officers are incentivised to maximise shareholder returns, which adds to the cost of insurance for policyholders.
"On a combined ratio before policyholder dividends are factored in, captives significantly outperform the commercial insurance market."
The five-year average pure loss ratio of the captive composite was 48.5 percent as of 2010, which compares favourably to the commercial casualty composite of 55.0 percent for the same period. However, the loss adjustment expense (LAE) component of underwriting performance was skewed in favour of the commercial composite whose five-year average was 13.7 percent as of 2010, compared to 18.9 percent for the captive composite. As a result, the five-year average captive composite loss and LAE ratio was 67.4 percent as of 2010, which still compares favourably with the commercial composite of 68.7 percent. The difference, following discussions with several captive and commercial management teams, appears to show that there is an overriding factor at work.
The captive industry tends to pay liability claims only where there is reasonable assessment of liability, and they will fight the claims where they believe no liability is present. This has a bilateral effect on increasing LAE. These costs increase because a thorough assessment of liability is somewhat more costly than doing a more in-depth cost:benefit liability assessment. In addition, fighting claims is much more expensive than settling them from an expense perspective.
The difference in approach is that the captive industry seems to invest in LAE to avoid unnecessary claims payments, while the commercial insurance industry appears to take a cost:benefit approach to spending LAE, which is their right when they are writing a guaranteed cost insurance policy. Thinking about this another way, the captive industry spends 5.2 percent more LAE to save 6.5 percent in loss dollars. If the qualitative impact of this dynamic is considered, the captive industry, driven by its owner service focus, seems to demonstrate a willingness more often to pay legitimate demonstrable liability claims without regard to spending reasonable investigation and defence costs. This can have positive reputational consequences for the policyholder owner(s) of a captive.
Another significant difference in operating performance between the captive industry and the commercial insurance industry is the expense ratio. The five-year average expense ratio for the captive proxy as of 2010 was 21.6 percent, versus 29.4 percent for the commercial insurance industry. This is a significant difference that needs some analysis to understand. If we consider bifurcating expenses between commission expense and other operational expenses, then we can see where the divergence manifests itself. The five-year other operational expense ratio for the captive composite as of 2010 was 17.1 percent, versus 18.2 percent for the commercial industry. It appears that captives are somewhat more efficient than the commercial market. The larger driver, however, was evidenced in commissions as the five-year average commission ratio for the captive composite as of 2010 was 4.5 percent, versus 11.2 percent for the commercial industry. Because captives generally either don’t pay commission at all, or pay a ‘skinny’ commission because the agent or broker has a limited role due to the captive manager’s involvement, there are substantial savings that can be passed on to policyholders.
On a combined ratio before policyholder dividends are factored in, captives significantly outperform the commercial insurance market. The captive proxy five-year combined ratio before policyholder dividends as of 2010 was 89 percent, versus 98 percent for the commercial insurance industry. That’s a huge difference in terms of real dollars since, depending on how it is measured, somewhere between a quarter and a third of the commercial premium is now in the alternative risk marketplace. Similarly, the captive proxy five-year operating ratio as of 2010 was 75.3 percent, versus 83.1 percent for the commercial insurance industry.
Where the commercial insurance industry shines compared with the captive industry is on investment portfolio returns. Commercial insurance companies tend to have more sophisticated investment policies that take more risk and generate more return than captive companies. Captives, by and large, invest relatively conservatively with an eye toward principal preservation, while commercial companies need to get yield since they make far less profit from underwriting.
Another interesting financial measure to note as a difference between the captive proxy and the commercial composite is the policyholder dividend. The captive proxy five-year policyholder dividend ratio as of 2010 was 4.5 percent, versus 0.3 percent for the commercial insurance industry. To be fair to the commercial side, the five-year policyholder dividends for mutual commercial insurers as of 2010 was 1.3 percent, and most captives have a similar alignment of interest from policyholder owners as mutual insurers experience. Still, 4.5 percent for the captive composite versus 1.3 percent, a difference of 3.2 points of premium, is quite significant. If you add the 3.2 percent extra savings that captive policyholder owners experience from additional policyholder dividends, to the 9.0 percent savings from the captive combined ratio before policyholder dividends, we get 12.2 percent savings from the captive composite compared to the commercial composite.
Based on these data the captive industry clearly outperforms the commercial insurance industry on all measures except investment income. What is not so apparent, perhaps, is the fact that from a policyholder owner perspective, a captive insurance solution saves a significant and substantial amount of insurance cost.
Steven Chirico is assistant vice president at AM Best. He can be contacted at: email@example.com