When the state steps up
The crumbling concrete foundations crisis affecting Connecticut homeowners is in the process of being resolved with the help of a captive set up by the state. US Captive explores the viability of states forming captives to help respond to crises.
When more than 35,000 homes in Connecticut were discovered to be facing a potentially devastating problem that was causing the foundations of their home to crumble, the state government realised it needed to act.
The problem was caused by pyrrhotite, a naturally-occurring iron sulfide originating from a quarry in Willington, CT, being exposed to oxygen and water. The reaction was causing swelling and cracking, leading to irreversible deterioration.
The problem was not covered by the commercial insurance policies held by the owners of the affected homes. In 2017 the Connecticut General Assembly took a bold step, setting up the Connecticut Foundation Solutions Indemnity Company (CFSIC) to deal with the problem of crumbling basements.
CFSIC was launched in January 2019 with no liabilities and no applications. Within five months it had accumulated almost $90 million in incurred liabilities, of which almost $30 million are active foundation replacement projects.
“It would be difficult to imagine faster or more effective progress,” says Michael Maglaras, superintendent of CFSIC.
Connecticut is no stranger to innovating with captives. In May 2018 the state passed a bill that would allow licensed insurance agents to establish an agency captive insurance company to insure against risks covered by the policies they sell. CFSIC is therefore the latest in a line of innovations in this area.
The experiment has so far been a success. Kevin and Aisling McCloskey became the first homeowners to receive a grant from CFSIC, worth $175,000, to repair their crumbling basement, but many more homes are expected to have their foundations replaced with funds from CFSIC. The cost to replace a home’s foundations in Connecticut ranges from $150,000 to $250,000 per home.
The problem has also spread to Massachusetts, and the CFSIC has been in dialogue with representatives of that state for its mandate to be extended to cover that state as well.
Why a captive?
Just as captives were born out of the need to fill gaps in the provision of insurance in the commercial market, CFSIC emerged as a result of the abandonment of claimants by commercial insurance providers.
“This is, in one way or another, the reason all captives are formed,” says Maglaras.
Captives have always been used to rapidly deploy underwriting capacity for specific needs, frequently as a result of capital inadequacy in the commercial market, he adds, for example when they were used in the medical malpractice crisis in 2002.
According to a 2003 American Medical Association survey of the 50 US states, some 18 states had serious medical malpractice liability insurance problems. The response was a wave of captive formations, particularly from physician groups and nursing homes and assisted living facilities.
“Captives in their maturity have evolved into problem-solving mechanisms. It’s a natural evolution,” Maglaras says.
“Captives have proved themselves to be disciplined and efficient claims-paying mechanisms. Whether it is improvements in obstetric care or the replacement of concrete foundations, captives have been used to manage claims while reducing the profile of risk.
“The historic record of the success of captives and the fulfilment of their purpose is beyond dispute, abundantly clear, and filled with continuing promise for the future.”
Very few government entities use captives, however. Matthew Queen, general counsel at Venture Captive Management, says: “The reality is that governments can allocate funds for emergencies and deploy them at their leisure. Theoretically, there is no need for a captive as long as a government provides adequate funding for the covered exposures.”
A number of municipals have captives to handle their workers’ compensation schemes, which are state-funded, but where captives have been harnessed as problem-solving mechanisms, they have tended to be privately funded.
The experience of the CFSIC proves state-funded captives are a viable option for dealing with large-scale, regional crises affecting large numbers of people who are without the right coverage.
Maglaras does not know of another state-funded captive doing anything comparable to what his own is doing, but he predicts more are coming.
“I see a very interesting future in captives owned, or certainly sponsored, by governmental entities,” says Maglaras. “It will become a more viable and meaningful option in the future. CFSIC will serve as the leading example of how you take a problem that no-one else will address, and fix it.”
Others play down the significance of the role of captives. “There are lots of comparable arrangements,” says David Provost, deputy commissioner of the captive insurance division in the State of Vermont Department of Financial Regulation.
“Calling it a captive makes it sound sexy, and helps promote a captive domicile as innovative, even though the idea predates captive insurance.”
Trust in a trust?
Queen suggests the trust structure as a viable alternative. “The state of Pennsylvania has a number of municipal trusts that are customised via the trust agreement to operate in a similar manner to any other insurance company,” he says. “The trust’s corpus is the reserves for the insurance company, and premiums are paid via taxpayer dollars.”
Municipal trusts are an underutilised municipal solution, says Queen, offering the same benefits as a captive, while making sure the assets cannot be raised and used for purposes for which they were not intended.
Provost agrees a state fund would achieve much the same thing as a captive. The principal differences between the two relate to technical issues such as how they are taxed and the legal processes around setting them up and managing them on an ongoing basis, the details of which will vary between jurisdictions, Provost cites the Florida Hurricane Catastrophe Fund, a tax-exempt state trust fund, as an example that achieves a very similar result as a captive might.
Similar structures could be set up to insure against other natural disasters, such as floods.
However, there is also a downside to the trust structure. Governments are notorious for raiding trust funds to make room for the latest great idea, notes Queen, creating a heightened risk that the assets will not be available when they are needed.
A key advantage of creating a captive is therefore instilling discipline to ensure that does not happen. Queen says: “Captives require audits, actuarial studies, underwriting, insurance policies, and all the normal trappings of an insurance company. This is lacking when the government simply hopes that there will be enough funds in the general fund to fund the liability.”
Jeffrey Kenneson, senior vice president of business development at R&Q Captive Management, has argued for captives to be used to fund repair work for damage caused by hurricanes. This would typically mean setting up a captive before the crisis had hit, and funding it on a commercial basis, via premiums from those that would enjoy the coverage it offered.
The prospect of states setting up captives as part of their strategy for dealing with crises that have already occurred is a step further from this. It is not clear that many states are considering such a course of action for now, but the CFSIC’s experience may give them something to think about, especially if they encounter a similar situation to that Connecticut faced with its pyrrhotite problem.
Much will depend on how scaleable CFSIC’s solution proves. Maglaras believes CFSIC needs between $500 million and $750 million of additional funding to eradicate the pyrrhotite problem in Connecticut alone. This does not factor in what will be needed in Massachusetts, Canada, Ireland and other locations of pyrrhotite-infected foundations.
That remains a significant challenge. Connecticut is in the midst of a budget crisis and pyrrhotite is not the only thing making financial demands on the state, although the governor has assured CFSIC of his continued support.
“When the history of CFSIC is written, it will be a story about how a state government used the captive concept to jump-start a massive programme of controlled and disciplined relief to restore people’s lives, improve the tax base, revitalise the economy and serve as an example of equitable and compassionate claim adjustment,” says Maglaras.
“Every day in this publication and throughout the captive industry we read stories highlighting the usefulness and effectiveness of captives. How often do we read a story about how a captive has been employed to return a home to its family?” he concludes.
