Taking a Closer Look at Captive Costs
October 2004
Previous articles in this captive column have
examined the role of fronting, and the costs associated with fronting, from
a big picture perspective, using general numbers for things like taxes, boards,
bureaus, profit, and other items. It behooves the cost-conscious captive owner/operator
to drill down further into these costs. While improvement may only come in single
percentage points, accumulated from several line entries over time, these can
be material. As it is your money, it should be looked at more closely.
by Michael
R. Mead
M.R. Mead &
Company, LLC
The location, identification, and successful execution of fronting, or risk
sharing, for captives continues to be problematic, but some progress is being
made. Many captive owner/operators have successfully negotiated the acceptance
of certificates from their captives, with no rating or admission by a state
other than their domicile. Some carriers remain solidly in the marketplace,
and offer terms to all comers.
For those captives that must use the services of a risk sharing partner for
certification of credit and regulatory risk, there are several factors which
deserve a closer look. A tip of the hat goes to my friend Andy Barile for recently
reminding me of some of these aspects of fronting costs.
The typical breakdown of costs for a captive program will show line items
such as:
| Taxes, boards, and bureaus |
2%-4% |
| Fronting fee |
5%-15% |
| Claims administration |
2% |
| Loss control |
2% |
These may appear to be small, even benign in the overall scheme of things.
Often, it is heard from the underwriter, "Well, they are what they are." Well,
usually they are not.
Taxes, Boards, and Bureaus
The logic in lumping taxes, boards, and bureaus together is that they are
assessed by states on the insurers overall book of business as state income
tax, support of guarantee funds, fire marshal taxes, second injury funds, and
the like. I agree that these are nettlesome, small matters when you are putting
together a large program to save your business. The temptation to let them pass
without further examination is the norm.
But the facts are that these numbers are known. If you are dealing with a
publicly held, admitted, rated carrier, which is usually the case, then the
exact numbers are in their public financial filings for all to see. Further,
the states clearly reveal such charges, usually on their websites.
So, if your underwriter says that the state charges are 4 percent, and you
research or ask your consultant/broker to research (which a good one would have
done already) and learn that they are actually 2.8 percent, and that captives
are exempt from state taxes and that risk retention groups are excepted from
guarantee funds, either you or your underwriter have picked up $12,000 on a
$1 million premium. Whose money is it? Who will get to keep it?
Some may wonder if an underwriter or insurance company representative would
purposely misstate the numbers to improve his/her own position. I think not,
but if, in the interests of their shareholders, they can successfully negotiate
a higher return through dealings with an uninformed party across the table,
why would they not do so?
Fronting Fees
Costs may also include an item known as residual market loadings. These are
basically legacy charges for the carrier having been successfully in business
in a particular state for some time, and accumulated charges to reimburse claims
for insurers who were not so successful. Your risk sharing partner may well
attempt to include some of these charges in your fronting charges. There is
some logic to this, particularly in programs that are essentially large deductible
programs disguised as captives.
I would assert that if a carrier is fronting for a captive—which captive
is taking licensed, actuarially sound, adequately financed risk—then there should
be no reason to include charges for risks to which the captive will never be
asked to contribute by regulators. But should a good negotiator for the fronter
be able to lay off costs? As a shareholder, I would applaud the effort.
Claims Administration
Charges for claims administration should likewise be subject to scrutiny.
The risk sharing partner may take the position that only its in-house claims
staff is qualified to represent them, which is a reasonable position to defend.
Adjusting claims is a difficult endeavor, usually handled by trained, skilled
individuals, and the stakes in event of an error are huge.
If, however, the captive determines that it is best able to handle the claims
that it will be financing, then, after it has proven that to the satisfaction
of all parties, it should not be charged by others merely to oversee. Certainly
not at rates that are charged to those who are merely accepting risk as a part
of an overall risk strategy in which they are not licensed, and not securing
IBNR to actuarial levels.
These are complex issues to confront, but, again, it is your money if you
are the captive owner. So, it is worth it in the end.
Loss Control
Similar issues arise with charges for risk control. No party has more at
interest in controlling risk than the owner/operator of a captive. Measuring
and evaluating that risk, and managing it, requires skill and knowledge, not
just the desire to spend less on insurance.
The risk sharing partner, fronter, is also invested in the successful execution
of informed risk management. If the captive is not able to demonstrate the clear
ability to do what is necessary to manage risk, few observers would criticize
the risk sharing partner for protecting not only its position, but that of its
less capable partner. Ultimately, the paper put forth is that of the fronter,
and the consequences for mistakes are huge.
Therefore, a charge for risk control must be analyzed to determine who is
doing what, and what chance of success exists, and who will secure the risk.
A standard charge of 2 to 4 percent, with no discussion of details, costs, and
measures of success requires a closer look. I would argue that if all losses
are already secured, then why add a charge for risk control? But insurers must
answer to shareholders, regulators, and reinsurers, in addition to policyholders.
Captive owners must answer to themselves. It all makes for great conversation—with
your money.
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