Captive Underwriting Profits—without Third-Party Business
February 2010
Several quarters ago in this space I wrote
an article, Do Captives
Earn Profits? My conclusion was that profits were in the eye of the beholder.
From the parent's perspective, a pure captive doesn't earn profits, but from
the captive's standpoint, it does if losses do not exceed premiums. This time,
I want to address the profits issue from another perspective.
by Donald
J. Riggin
Spring Consulting
Group, LLC
But first, a quick definition of the term "profit" as we use it in the insurance
business. Profits are earned when the owner of capital, the insurance company
in this case, sells insurance to unrelated third parties at a rate that exceeds
its loss and expense costs. I don't think that anyone would take issue with
this simple definition. Now let's have a look at your garden-variety single
parent or group equity captive.
The first thing we notice is that neither have any unrelated business (remember,
these are garden variety). Without unrelated business it is, using the above
definition, impossible to generate a profit from the parent(s) perspective.
Why? Owned captives (as opposed to rental captives) are flexible when it comes
to funding for losses. Actuaries will usually provide a range of potential funding
options, known as confidence levels. Expected losses are normally equal to the
50 or 55 percentile (confidence level), so sometimes there's a penalty provision
that triggers additional premium once a certain loss threshold is breached.
(I usually recommend that my clients fund to the 70 percent confidence level
in the absence of such a penalty provision.)
So, let's say that you decide to fund your captive at the 70 percent confidence
level, but losses ultimately settle at about the 55 percent level. Is the difference
between the two figures underwriting profit? From the captive's perspective
it is, but from the parent(s) perspective, (which is the only one that really
counts), it certainly is not underwriting profit; it's just overfunding.
But, dear reader, do not fret! There is indeed a way for a captive with no
unrelated business to earn underwriting profits. It all depends on how much
risk you're willing to assume and the economic tradeoffs. In this case, however,
we have to rethink our definition of the term "profit." Instead of the traditional
definition—margin of net revenue over expenses—our definition involves a more
aggressive risk/reward approach. As usual, an example will illustrate.
An Illustration
XYZ Company is considering forming a single-parent captive in which it will
insure its products liability exposures. Currently, XYZ's products liability
is insured in the commercial insurance markets subject to a $250,000 per occurrence
self-insured retention (SIR).
XYZ's actuary has determined that roughly 90 percent of XYZ's historical
losses (over a 5-year period) have fallen at or below $250,000 per occurrence.
The remaining 10 percent have been contained in the $250,000 excess of $250,000
layer, i.e., all historical losses fall under $500,000 per occurrence. Moreover,
there have only been 2 losses in the $250,000 excess of $250,000 layer over
the 5 years. These losses average out to about $300,000 each, for a total of
$100,000 of losses excess of the $250,000 retention ($50,000 x 2 = $100,000).
As for the captive's retention, XYZ's consultant recommends $250,000 per
occurrence, as 90 percent of losses over the last 5 years have fallen under
this figure. This certainly makes sense, but aside from the other captive-benefit
arguments, what has changed? Nothing. XYZ will continue to assume losses beneath
$250,000 per occurrence and purchase excess insurance for everything above this
retention. Moreover, XYZ's excess insurer will continue to provide $25 million
of excess limits for the same premium, $150,000.
What can we do to increase the value of this captive? The answer has much
to do with XYZ's risk appetite; XYZ's new consultant (the old one had no imagination)
has recommended that the captive assume risk up to $500,000 per occurrence.
So now the captive will assume the $250,000 excess of $250,000 layer, and purchase
excess insurance attaching at $500,000 per occurrence.
You might be saying, wait a minute, captives are supposed to restrict their
loss funding to actuarially predictable levels. The loss experience excess of
$250,000 is not predictable enough to be included in the captive. Yes, you are
correct. However, let's complete the example and if you still maintain this
position, we can talk about it offline.
Remember, we're working with a 5-year loss horizon. Over the previous 5 years,
XYZ's loss experience excess of $250,000 hasn't been particularly severe or
frequent. But, as we all know, the past 5 years, at this level of loss, isn't
a very good indicator of what might happen over the next 5 years, but it's all
we have. So because the losses are woefully inadequate to have any predictive
value, let's double that loss experience for our captive's purposes. So instead
of $100,000 in excess losses, we're going to assume that the captive will pay
$200,000 in losses excess of $250,000 per occurrence over the next 5-year period
($100,000 x 2 = $200,000).
Now let's talk about the excess insurance premium. Remember, the excess insurer
agreed to maintain the $150,000 premium (at least for this year). But we've
now increased the retention from $250,000 per occurrence to $500,000 per occurrence,
so the excess premium should reflect the increased retention. So we return to
the excess insurer to obtain a revised premium quote. Of course, the excess
insurer underwriter is not happy about this, because the richest part of her
rate was for the $250,000 excess of $250,000 layer. Now she's being asked to
provide pure catastrophic risk coverage, which costs considerably less than
does the layer immediately following the original $250,000 retention.
She starts the negotiation with a $125,000 quote for $25 million excess of
the captive's new $500,000 retention. XYZ's broker is, however, smart enough
to know that this is excessive given XYZ's loss history. The only reason why
the excess insurer could charge $150,000 in the first place was because of the
occasional excess limits loss. They finally settle on an excess premium of $75,000.
We now have to increase the captive's premium to reflect the fact that it's
assuming additional risk, and we're going to use our loss fund of $200,000 divided
by 5 to get the annual premium of $40,000. ($200,000 / 5 = $40,000)
Now let's see what happens with the captive. First, we decided that based
on the thinness of the loss experience excess of $250,000, we would double it
to $200,000 as our loss assumption for the layer $250,000 excess of $250,000,
over 5 years. We also decided that the captive should charge $40,000 annually
for the next 5 years for the $250,000 excess of $250,000 layer, producing total
premiums of $200,000.
Next, we negotiated the excess insurance premium down to $75,000 annually,
and for our purposes, we're assuming that this premium will hold, more or less,
over the next 5 years. 5 years' worth of excess insurance premiums equals $375,000
($75,000 x 5 = $375,000). Click here for
Figure 1, which depicts the results at the end
of 5 years for the $250,000 excess of $250,000 layer.
This result assumes, of course, that the loss assumption for the 5-year period—double
that of the last 5 years' experience—will come to pass. Of course, it could
exceed this figure, but if history may be considered to be an anecdotal guide,
there is perhaps a greater likelihood that the loss experience excess of $250,000
per occurrence will be closer to $100,000 than to $200,000.
Conclusion
Please remember that while this is a highly simplified example, e.g., none
of the figures are discounted to net present value, it illustrates the potential
for a single-parent captive to reduce expenses and convert some of it into underwriting
income. You may argue that the underwriting profit is due to overfunding. This
would be true if the additional funding (the $200,000), did not replace the
excess insurer's premium, which was on a guaranteed cost basis. But because
a loss-sensitive captive premium replaced a fixed commercial market premium,
and the captive premium was justifiably lower than the commercial premium, underwriting
profits may result. In this example, XYZ has assumed a reasonable amount of
additional risk in exchange for a material amount of potential savings.
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