Still No Relief

Greg Lang (pictured), founder of the Reinsurance and Insurance Network (RAIN), casts an eye over the latest developments in property insurance captives.

Over the past few years, the commercial property market has sent millions of dollars in new premiums rushing to captives in search of price relief. Unfortunately, not much has been found. Most new premiums have gone to funding increased deductibles.

Raising deductibles has provided modest relief for some. It makes no sense for most. It can also bring new headaches. Lenders who hold mortgages on these properties are requiring front paper to mitigate the credit exposure these deductibles have created. Finding cash to fund deductibles is another challenge. 

Why don’t property captives offer the same savings as casualty captives? Property insurance has some unique issues. Before examining the property question, it’s important to see if a captive makes sense, period.    

Captives making sense.

There is a captive rule of thumb I’ve never agreed with. If you spend a million dollars a year on insurance, you’re a good candidate for a captive. This is where many of my property captive conversations start. I disagree with the rule. Some of my reasons are more obvious than others. 

Licensed captives have a 50% closure rate. For every active licensed captive, another one has closed. How do I know? Most domiciles don’t publish numbers. Fortunately, Vermont, one of the largest and best-run domiciles, does. Vermont has issued 1,362 captive licences as of December 24, 2024. 654 active and 679 closed. The difference? 29 are dormant. If one of the largest and best-run domiciles has these kinds of numbers, I’m going to assume the industry does. Captives are not for everyone. 

The number of policies making up the million in premium matters, too. Ten policies will have more frictional cost than three. Underwriting, actuarial and reinsurance all get more complicated with each additional policy. Frictional costs such as fronting paper and captive management can be substantial. Collateral requirements in year two and beyond are often overlooked in many of the captive proposals I review. Frictional expenses and the cost of collateral often eliminate any opportunity for savings. 

Some less obvious captive deal breakers include probable maximum loss (PML) and the payback period. This is especially true for property. A $10 million premium is still not a good captive candidate if you are trying to insure billions of dollars of total insured value (TIV). 

If the expected loss limit retained in your captive exceeds the captive premium, the numbers usually don’t work. It’s why there are so few property captives. If you are new to property, terms like PML, TIV and loss limit may be unfamiliar to you. Let’s cover them. We can then look at some property captive examples 

Loss Limits

A loss limit in property insurance is a limit that is less than the total property value at risk but in theory high enough to cover the value exposed to damage for a single loss event. Calculating a loss limit is both an art and a science. Insurers and reinsurers use different approaches for calculating them. A policy loss limit refers to the maximum amount an insurance policy will pay for a single claim. The policy caps coverage at a specific value. Without reinsurance, captives have little ability to cap losses.

Factors that determine loss limits

• Location: Considerations such as exposure to natural hazards, proximity to emergency response (distance from a fire hose or hydrant) as well as local building codes all require consideration when calculating a loss limit. The expense of bringing properties up to code following a loss can be significant.  These factors are further complicated when a property portfolio is in multiple locations. 

• Construction: Materials used to construct properties include both fire-resistive and wind-resistant materials. Most replacement roofs in Florida, for example, have minimum wind speed requirements. Reimbursements after loss also consider depreciation. Insurers no longer provide full replacement costs on 20-year-old roofs. Replacement estimates also need to account for inflation. A commercial building constructed five years ago will cost on average 50% more to build today. 

• Loss history: Historical loss data is always important. Losses from similar properties in your area are now being factored in too. This has become critical for both wildfire and wind-driven events. 

• Other: A list of a property's contents, and/or inventory, is needed if providing these coverages. Business interruption exposures (BI) need to consider both direct and indirect damage. Chubb recently paid a $200 million BI claim for a hospital due to an electrical fire. That size of claim can certainly change future underwriting and loss limit calculations.

A power outage caused by damage away from your property is an example of an indirect loss. The loss of a bridge or even a highway as occurred in the floods last year in Tennessee impacted many businesses. Not many insureds forecasted an interstate highway (Interstate 40) being unavailable for months. 

Given these factors you can see why loss limits need to be updated frequently. The quality of data, or lack thereof, is one of the biggest complainants’ insurers and reinsurers have when trying to cover property exposures. You can also understand why the property market likes insureds who are risk takers. Everyone is vested in getting the data right.

PML vs TIV 

Probable Maximum Loss (PML) represents the highest realistic loss an insurer might face from a single loss event. PML considers the likelihood of a catastrophic scenario such as fire, earthquake or wind event. PML is an estimate of the worst-case scenario for a single loss event. Your captive actuary would say reserving to the 99% confidence level is the PML. A loss limit would be more likely 70-75% confidence level. 

Total insured value (TIV) refers to the total estimated value of all of properties an owner wants to insure. It’s the maximum payout an insurance company could provide if an entire property or property portfolio were destroyed. A loss limit and PML are based on a single loss event. TIV covers multiple events. Hence, a loss limit policy is typically cheaper. There is also greater risk to the property owner. Which you choose to purchase is a classic risk-vs-reward situation.

Catastrophe Modeling 

Catastrophe (CAT) modeling helps insurers, reinsurers, lenders, public and private agencies predict and manage natural and man-made catastrophe risk. The rating agency Moody’s estimates there are more than 400 models currently in use in over 100 countries. Users often run more than one model to better estimate the likelihood and severity of future disasters. The two most popular models in the US are Moody’s RMS model and Verisk’s AIR model. RMS is used for core perils, AIR is used exclusively for US hurricane risk.

I’m often asked how accurate I think these models are? Given there are 400 choices, I would say opinions vary. Moody’s latest RMS catastrophe model is on version 23. That means it has been updated 22 times.  

In 2005, Hurricane Katrina hit Louisiana. Most of the damage and deaths were caused by storm surge.  CAT models were updated for storm surge in 2006. The US terrorist attacks in September of 2001 forced insurers to begin tracking concentration risk for workers compensation. I’m sure the severity of both the 2024 wildfires in California and the flooding in North Carolina and Tennessee will result in model changes, too.

Repayment Expectations

Insurers and reinsurers recognise and accept risk. Their contracts forecast a repayment or payback period after a loss. The payback period is the number of years it takes to be repaid through collected premium after the loss. It’s also called an amortisation period. The amortisation period for a property mortgage is the length of time it takes a borrower to pay back the full amount of a loan’s principal plus interest. Risk takers use a similar calculation. Instead of interest, a risk taker includes a profit margin. Captive risk takers need to do the same. The payback period is an inverse of the rate online.

Rate online (ROL) is derived by dividing the premium paid by the policy or covered limit; A $10 million limit with a $2 million premium would have an ROL of 20% and a payback period of five years. Some property captives have lost sight of this. A $10 million premium on the $1 billion property portfolio bears this out. The payback on a $1 billion loss would be 100 years. That doesn’t include profit. This is why underwriters only offer a small premium adjustment of say 10 to 12% to an insured who takes a $1 million retention on a billion-dollar exposure. 

Underwriters are more concerned about catastrophic risks than frequency risks. Frequency of loss is typically not a property concern. It is more common for casualty; workers’ compensation for example. With 1,000 employees, a company can expect several workers compensation claims each year. A property owner can go for years or even a lifetime without a significant property loss. Funding for claim frequency is typically the reason captives for casualty insurance often make more sense than property insurance captives. 

Captive examples

Example One: A prospect called saying they were excited about saving 12% on renewal by raising their property deductible to $250,000 per occurrence. They asked me if they would be a good candidate for a captive. Premium savings over expiring were $18,000. If this insured has a single $250,000 claim, it will take almost 14 years for that premium saving to pay back one limit loss. There is no ROL. The $250,000 dollar limit is per loss. There was no aggregate. How often do you have two catastrophe events in the same year? Ask the poor people in Florida. I don’t care how good your loss experience has been; I’m not taking this bet. No commercial reinsurer is, either.  

Example Two: Class A multifamily property. Premium was $1.1 million. TIV was a little over $1billion. ROL worked out to @$900 per million. Raising the property deductible to $1 million was going to save 15%. $165,000. 

Example two is worse for two reasons. The payback appears better at around six years.  The problem is the insured has losses every year in this layer. The other issue was the frictional cost we talked about earlier.  A “$165,000 savings” even with no losses is not all savings if 50% or more goes to captive expenses.

Where do property captives make sense? When you have a large portfolio of properties and a good spread of risk. Insuring to a well thought-out loss limit rather than TIV can result in a significant saving. It takes a big balance sheet to assume such a risk. 

You also need an understanding lender or lenders. I am aware of one large property portfolio that saw significant savings going to the loss limit approach. They took this additional risk several years ago. So far it has worked out. The good news is that the premium savings are building in their captive. They will be better prepared, at least financially, if an unforeseen loss or multiple losses occur. How big is their portfolio you might ask? It’s several portfolios, actually. The cost of front paper just for their large deductibles exceeds $10 million annually. It’s big.  

Conclusion

Captives are not for everyone. For property owners, you need to be even more selective. A well thought-out loss limit supported by good data, and one or more models can make good sense. Be mindful of the captive’s return period and frictional costs including collateral. Captive owners need to consider all these factors when evaluating proposals and potential saving. 

Greg Lang can be contacted at: glang@rainllc.com  

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