Why You Should Start a Captive in a Soft Market
August 2006
Many recent articles in the trade press have
cited surveys talking about the softening insurance market. Liability rates
have declined, property coverage is available, and underwriters are looking
for business.
by Michael
R. Mead
M.R. Mead &
Company, LLC
Profits are up, and the future looks rosy for traditional insurers. Even
some medical malpractice rates have declined noticeably. So, why would a business
consider financing its own risk when so much risk transfer is available? This
is a question frequently addressed by the captive community. It is a good question
that goes to the heart of the captive philosophy and thus deserves a bit of
attention.
Certainly thoughtful analysis must be given to the cost of transferring risk.
When rates are low, perhaps a buyer should take advantage of the situation and
purchase traditional risk transfer products. Establishing and running a captive
involves heavy up-front costs and is dependent on some factors that may be difficult
to influence let alone control. It is often a good choice to transfer the risk
of loss to a larger firm with professional resources and capital.
However, if you believe that the industry remains subject to pricing cycles,
then perhaps the best time to look into a change is when the market pricing
is soft, and underwriters are accommodating and responsive.
Reasons To Move Now
There are several good reasons to consider launching your captive when the
traditional market rate structure is on the down side. The first reason is that
most of us believe that what goes down goes up. For risk and financial officers
who are frustrated with an inability to forecast accurate risk costs into the
future, a slowing insurance market is not always a good thing. Predictability
is often valued more highly than soft rates followed by hard rates.
In my experience, insurance rates are frequently responsive to the overall
economy. We know that there have been and believe that there will be again changes
in the overall economy. Thus, I believe it is safe to assume that there will
continue to be changes in insurance pricing. The pricing approach may not look
like approaches in the past, but change they will.
If you have designed a business model with set costs and profits, and sold
this model to investors/employees/the board/regulators, it is particularly frustrating
to see costs fluctuate unpredictably. You likely want to take control of these
costs. Captives are all about control. If you are able to accurately forecast
costs into the future, your business will likely gain acceptance and profitability.
If you can control the costs of operating your business, you can improve its
overall results.
Another good reason to consider a captive in a soft market is to expand coverage
lines for risks that are not covered in the traditional market. While the rates
may have softened for basic insurance, there are still many exposures to loss
which are not addressed completely. Terrorism remains an exposure which is not
well addressed in the traditional market place, even as premiums have softened.
Employment liability and directors and officers coverage may not be affordable
in a hard market, but perhaps the small, private company which has declined
such coverage in the past can now write it in their own captive and obtain reasonable
excess risk transfer. Construction industry risks, particularly in residential
building, continue to face a lack of availability and a plethora of exclusions
and restrictions. These exclusions and restrictions can render the coverage
useless for lenders and other interested parties.
How To Move Forward
To take full advantage of the situation, I would suggest that a captive owner,
or potential captive owner, analyze the cost of traditional products with a
view to incorporating some of them into a captive program in which costs can
be controlled and moved about depending on the then current state of the traditional
market. Buy traditional risk transfer when it is cheap; move the coverage to
your captive when it is dear. But the captive should be in existence and ready
to perform when needed.
It is certainly easier to set up a captive and begin learning how to use
it profitably when there is less pressure for it to address pressing needs.
Get it up and running, learn about corporate governance, get to know your regulators
and managers, and watch the performance of your risk sharing partners in a less
demanding situation.
If excess costs have come down, consider a lower attachment point for that
coverage. Lock-in the rate for an extended period. Underwriters are usually
interested in adding new accounts and new lines of coverage when their pricing
has reduced premium inflow.
Conclusion
All in all, one should consider the wisdom of being prepared, and making
hay while the sun shines. When the market turns, and time is short to solve
challenges, it won’t be as pleasant an experience to form a captive than when
the pressure is nonexistent or lessened by the soft premiums.
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