When the insurance marketplace begins to change, alternative risk management comes to the forefront. While this type of approach has been around for several decades, it is not for everyone and requires not only a high-risk tolerance, but also solid financial wherewithal.
Nathan Brainard
Roughly two years ago we began telling readers and insurance buyers to prepare for a change in the insurance marketplace. Because of incidents taking place from earthquakes in Japan and Christchurch in New Zealand, and most recently Super Storm Sandy, all indications were that the insurance carriers were going to begin pulling in the reins and increasing their rates to recoup the massive amounts of dollars paid in claims. Now, we have officially entered into the hard market insurance cycle.
A Hard Market
In general terms, a hard market is when insurance carriers increase their premiums, do a thorough review of their books of business and determine what classes/industries are not performing well (what the industry calls “loss leaders”) and begin to shed that business lessening the number of potential markets for the consumer. A prime example of this is the solid waste industry, which in 2012 was rated the fourth most dangerous job in America by the Bureau of Labor Statistics.
Facts like this do not generate eager Underwriters and Actuaries as the insurance carriers want to make a profit just like your company does. Because of this, we are seeing rather substantial increases for the waste and recycling sector. One other very important item to point out is the (fewer) number of carriers interested in this class of business.
We have clients who consistently tell us that they don’t understand how there can be more than 100 insurance carriers out there, but agents are only able to generate a handful of proposals. Not every insurance carrier is interested in all types of business. As stated above, they are in business to turn a profit and many classes of business are considered “high hazard” and are, therefore, not something they want to pursue. In some cases, the carriers are not able to purchase reinsurance for specific exposures. This is a concept insurance purchasers have a hard time grasping but one that is vital for them to understand. They often feel their agent isn’t working in their best interest by shopping the marketplace.
In some cases this could be true, however, if your company pays $50,000 for your auto and general liability coverage and your company is averaging $100,000 a year in losses, you are not considered to be good account. In this case, the carrier is paying out twice as much as they are taking in for you year over year. This will substantially limit the interested parties, and will certainly result in drastic increases in your premiums. Most insurance carriers feel that they “break even” with a loss ratio of approximately 65 percent.
Further to this point, if you had a number of bad years in a row and the most recent year or two have been claims-free, this does not cure all of your premium woes. Yes, your company has made improvements and appears to be heading in the right direction, but carriers want to see you can continue this trend moving forward. You could pay higher premiums for several years after you have taken corrective action until there are four or five consecutive years in a row showing the claims issues have been disposed of. Carriers anticipate a pop here or there, but they also operate under the concept that frequency breeds severity. If you have a large number of little accidents it is only a matter of time until you have a whopper.
Many consumers of insurance we speak with want to discuss ways to limit the increases in premiums they are seeing. Some of them have had little or no claim activity while others have had rather substantial losses. Unfortunately for both sides of the spectrum, and those in the middle, the current insurance marketplace is increasing for all regardless of past history. However, it is true that those companies who have had little to no claim activity will see smaller increases than those with average to high claim activity.
Alternative Risk Management
Generally, when the insurance marketplace begins to change, as it is now, the topic of alternative risk management comes to the forefront. While this type of approach has been around for several decades, it is not for everyone and requires not only a high-risk tolerance, but also solid financial wherewithal. There are several forms of alternative risk management. These range from various types of Captives (single-parent, association/group and rent-a-captive) to Large Deductible and a few other forms. We are going to discuss the various types of captives and large deductibles in this article as those are the most common requests.
It should be noted that each of the above options requires you, as the policyholder, to accept more financial risk in the event of a claim; however, they also provide for a greater reward when claims are prevented or kept at lower loss ratios. This reward can come via lower premiums, and in some cases the availability of cash dividends. These type of program designs typically require a fair amount of “startup” funding, including irrevocable letters of credit, collateral or other forms of financial guarantee which the carrier can rely upon should the insured fail to make a payment on losses, monthly installments, etc.
Captive Programs
We are going to discuss some of these available options from a cursory perspective. There are several types of captive options. They range from programs where you are the only member to sharing the program with other people you may or may not know. They can also vary by lines of coverage. Some are only for worker’s compensation while other can incorporate additional lines of coverage such as auto and general liability. There are three primary kinds of captives we are going to discuss:
- Single-Parent Captive—A captive with one shareholder also referred to as a “pure captive” or “single cell captive.” There are more of these than group-owned captives. This program design is based on the loss history and exposures strictly pertaining to your company.
- Association (Group) Captive—A captive insurer having two or more owners, typically members of an industry trade association. Sometimes the association itself is the owner of the captive. This is a generic term for all types of Group Captives.
- Rent-A-Captive—An insurer or reinsurer that rents its capital, surplus and legal capacity to client users. The sponsor, not the policyholder, controls the rent-a-captive and usually provides administrative services, reinsurance and/or an admitted fronting insurer. The insured’s underwriting account is typically segregated from other insureds of this entity. This segregation can be achieved by words, through accounting procedures or statutorily. This could also be known as a Protected Cell Company (PCC). A PCC is a single legal entity that operates segregated accounts or cells each of which is legally protected from other liabilities of the company’s other accounts. An individual client’s account is insulated from the gains and losses of other accounts, such that the PCC sponsor and each client are protected against liquidation activities by creditors in the event of insolvency by another client. Many domiciles have enacted legislation enabling the formation of PCCs or other similar structures (e.g., segregated account companies in Bermuda and segregated portfolio companies in the Cayman Islands).
Many captives are based in international locations such as Bermuda or the Cayman Islands; however, in recent years we have seen growth in Vermont and Delaware based captives. Where the captive is based will dictate the compliance laws you, as the captive owner/participant, must meet. Technically, a captive is an investment vehicle; in this case, you are investing in your company by starting your own insurance carrier. Because of this you will be held to the same type of financial conditions as other insurance companies.
Underwriting Process
The underwriting process of captives is a bit different from that of the traditional marketplace. When moving into a captive format, your losses are reviewed and a loss pick is generated. The loss pick is the estimated amount of losses you will incur over the course of the year. The underwriters and actuaries then take this number and use it as the base premium or “ceded funds”. This is typically due in a lump sum or in quarterly payments. Further, there is an extensive amount of work done on reviewing the applicant’s financial records.
The carrier needs to know you have the financial means to pay claims while at the same time have funds to run the company in a safe and profitable manner. Once the above items have taken place and terms are offered, the owner of the captive will generally secure an irrevocable letter of credit to meet the collateral requirements above and beyond the ceded funds; however, in some instances companies will secure this using cash. At the inception of the program, this isknown as the “Gap” Collateral.
The ceding of the captive is really the base premium. As losses transpire and the captive pays out, invoices are generated and become payable to the captive entity. Should the captive have a good year with little to no loss activity, these funds can roll over so the pay in for the following year is not as substantial. Over time these funds will begin to grow and generate underwriting profit. As this happens it is possible, if the captive owner/participant perform extremely well, that the captive premiums can be paid in full strictly by the underwriting profit being generated. Further, should the captive perform extremely well it is possible that the captive will generate dividends available for distribution to the owner/participant.
Oftentimes, it is this potential profit that gets interested parties into trouble. They only want to look at the upside, but the downside is very real. If you have a 50,000 GVW truck blow through a stoplight and collide with a school bus filled with children and deaths occur, you, via your captive, are now on the hook for those claims. A situation like this is awful, however, it can, and does, happen. If one does, the outlay of capital by the owner/participant can be massive and all earned underwriting profit can disappear in an instant, or before they ever truly get the ability to begin growing in the first place.
Large Deductible Plans
Large deductible plans are more like traditional insurance. In fact, they are traditional insurance programs with a slight change. Instead of a policyholder having a $1,000 or $2,500 deductible per claim, the policyholder has a deductible in the $100,000 range plus. Deductibles of $25,000 or $50,000 are available, but when speaking of large deductibles, that typically begins at the $100,000 level. Essentially your company is putting $100,000 (or whatever number amount you select) on the line for every claim that comes in and the insurance carrier is there to provide funds for amounts above and beyond the elected retention. The benefit of this approach is that the carrier can now separate themselves from the first $100,000 of every claim. Because of this, you, as the policyholder, are rewarded with lower premiums based on anticipated loss picks. However, here again, you and your company are putting skin in the game. Four large accidents could equate to an additional $400,000 in premium. This could be more than you would have paid total for a policy with a lesser deductible.
Stop Loss Aggregate
One way to hedge your bet so to speak is to include a Stop Loss Aggregate in the policy. This is a number established prior to binding the policy to which you and the insurance carrier agree upon. For example, you could purchase a large deductible policy at $100,000 per claim, but once your company paid out $400,000 (or whatever the predetermined number is), you no longer are on the hook for deductibles on accidents moving forward. Here again, you are putting skin in the game, but you know what your threshold is. You will still get the benefit of a large deductible plan, but the reduction in policy premium might not be quite as large.
Do Your Research
There are a number of ways to tackle the alternative risk management approach, and depending on your risk tolerance and financial position there could be some options not covered in this article. If you do elect to pursue one of the above options we advise you to meet with an organization with extensive experience in this type of plan placement. Many agents will tell you they have experience with this kind of program. We suggest you ask them for references and call them for verification. While purchasing a poor, traditional insurance policy can hurt your company, getting into one of these programs without fully understanding both the up and down sides could potentially put your company out of business.
Nathan Brainard, AAI, is Vice President of the Environmental Division at Insurance Office of America (IOA) (Longwood, FL) and a member of the NSWMA Safety Committee. Nathan has been with IOA for seven years and specializes in Environmental Insurance with an emphasis on insurance for the Waste, Recycling, Remediation and Demolition industries. He can be reached at (407) 998-5287 or via e-mail at [email protected].