As counterintuitive as it sounds, captives are no longer considered "alternative" risk financing tools. Many captive-eligible organizations eschew captives for a variety of reasons, but in the main, they are no longer the exotic proposition they once were. I hesitate to declare the captives market mature (like the entire conventional insurance business), but their utilization mostly is composed of the usual suspects—deductibles and self-insured retentions of workers compensation and various forms of public liability insurance policies.
Before we delve into a way in which a captive, in this case a single-parent captive, might become a profit center, we must define "profit." Many captive promoters claim that, along with investment income earned on a captive's loss reserves, a captive earns underwriting profit.
Commercial insurers earn underwriting profit when losses and expenses do not meet or exceed premiums. This is a simplistic definition, but it's true. It's true because commercial insurers sell insurance to large numbers of unrelated policyholders. The operative word here is "sell"; they sell insurance. Many single-parent captives also create underwriting profit assuming losses and expenses do not meet or exceed premiums, but this so-called profit is an illusion. Why?
If viewed in isolation from the parent company, it is indeed profit. However, because the captive's sole shareholder is also its policyholder, what looks like underwriting profit is usually just premium overpayment. As the captive's only client is its parent, profits do not naturally result. However, there is a situation where a single-parent captive may earn profits without selling anything to anybody.
A captive's purpose is to hold funds (reserves) for the sole purpose of financing insured losses that fall beneath a maximum per-occurrence and (maybe) an annual aggregate threshold. This threshold is known as the attachment point, above which commercial insurance or reinsurance begins paying for losses. At this point, a basic discussion of the relationship between risk and premium is in order.
Regardless of the insurance vehicle (commercial insurer or a captive), premiums are based, in large part, on the probability of the occurrence of the loss. Given enough historical loss and exposure data, actuaries establish "expected losses" that occur beneath a predetermined threshold (as discussed above). Actuaries forecast future losses using a range of confidence levels. The term "confidence" roughly means probability. For example, losses forecast at the 55 percent confidence means that the actuary thinks that the forecast has a 55 percent chance of coming true.
This 55 percent confidence is very commonly used in loss-sensitive risk financing schemes. Although we don't see them very often these days, retrospective rating plans usually have maximum and minimum premiums, regardless of the amount of the losses. A very common maximum premium fact is 150 percent of standard premium. This helps to protect the insurer against losses that exceed the standard premium, which is calculated using loss funding at the 55 percent confidence level.
Do you see what's going on here? The insurer is willing to let the client fund the premium knowing that the probability that the losses will be contained within the premium is only 55 percent. If we stopped there, the insurer would be on the hook for losses exceeding the original premium funding, which, for insurers (an additional 45 percent), is a bridge too far.
This untenable situation is greatly reduced if not eliminated altogether by the insurer imposing a penalty maximum premium on the client. Coincidentally, the amount of that maximum premium is usually 50 percent greater than the original premium. Now, the insurer is statistically removed from paying any losses. When we add the 55 percent loss confidence funding to the 50 percent maximum penalty, the insurer is theoretically protected at 105 percent.
However, regardless of the result of the arithmetic, loss confidence cannot exceed 99.99 percent, because no one (including the very best actuaries) can guarantee that any risk financing will produce a given result, regardless of how much money is thrown at it. If you're wondering how insurers cover themselves in large deductibles ($100,000 and up), they require that the clients provide letters of credit commensurate with the insurer's liability.
Now, let's get back to captive profits. I find that an example almost always brings clarity to a concept. Assume that you have a captive in which you insure the first $250,000 of each loss. Expected losses in this primary layer are $1 million, which is funded in the captive. The premium was calculated at the 75 percent confidence level. As expected, annual losses came in just under $1 million for the year—$950,000. For the year, there were 5 claims that breeched the $250,000 captive retention. All of these claims were settled for amounts between $250,000 and $500,000, and totaled $200,000, which the excess insurer paid.
The insurer charged the client $400,000 for the layer $250,000 to $1 million. All told, the client's cost was $1,350,000 plus expenses for the year. The client's risk manager then asked the excess insurer to quote her a premium for the layer $500,000 to $1 million (raising the captive's retention to $500,000).
The excess insurer returned to the risk manager with a premium of $100,000 for the $500,000 excess $500,000 layer.
Now, let's back up and reconfigure the arrangements assuming a $500,000 captive retention instead of a $250,000 captive retention. Let's assume that expected losses under $500,000 are $1,300,000. As for losses, they total $1,150,000 ($950,000 plus $200,000) at the $500,000 retention level. Add the excess insurer's premium of $100,000, and we get at total of $1,250,000. The difference between the retention levels is a reduction of $100,000. (This does not include the $150,000 remaining in the captive; this is premium overpayment, but it facilitated the real $100,000 cost reduction.)
Is This Really Profit?
Does a cost savings of $100,000 constitute a captive profit? I believe it does if we consider that, if we left the retention at $250,000, the excess insurer surely would have counted that $100,000 as profit. But you may not be convinced that the $100,000 is profit because your Risk Management department is a cost center. Your mindset is focused on reducing costs. This is how you create value for your company.
The captive is assuming additional risk, which has been calculated actuarially, thus saving enough excess insurance premiums to make the change appear to be worthwhile. A skeptic might point out that all it would take would be one $500,000 loss at the new retention level to wipe out the profits.
This is certainly true, but this statement ignores an important component of the decision to increase the retention: the probability of loss excess of the $250,000 retention. When the company was evaluating the potential financial ramifications of increasing the retention, it recognized that it must assume additional risk—but only a small probability of additional risk. Based on all of the factors, they decided to assume a little more risk in exchange for lower overall costs.
The net effect for the company was that it realized a profit of $100,000 by doubling its captive retention. This was only possible because its loss characteristics set up probabilities favorable enough to create value by increasing the retention by an additional $250,000. Other companies have different sets of probabilities to consider based on their loss profiles, but if the tradeoff is reasonably favorable, the captives should assume additional risk.
If this were a simple large deductible plan instead of a captive, the final loss costs would include the $100,000 savings, but it wouldn't be formally recognized as value accruing to the company; it would be just another cost reduction, for which the risk manager would receive an "attaboy" from senior management and perhaps a few more shekels in the pay envelope. Viewing value creation as nothing more than cost reduction just confirms that the Risk Management department is nothing but a cost center. And, like the old Soviet collective farm system, you'll be expected to at least match those cost savings year after year. As I'm sure you know, the cost center mentality leads to nothing good. "No, we weren't able to cut costs this year." The cost center conundrum makes life very difficult at times.
Captives are insurance companies, regardless of how many or how few policyholders they insure. Insurance companies make or lose money based on a raft of management decisions, not the least of which is how much risk to retain. Consider the above cost center black hole recast in a captive. Instead of the dreaded question, "How much did we save this year?" if you had a captive, the question becomes, "How much did the captive earn this year?"
Aside from the obvious, note the subtle difference between these questions. The cost center "What have you done for me lately?" question is replaced by a question informed by the knowledge that the company has a valuable, long-term asset, creating returns on invested capital. It's all in there.
The method described here to produce a captive profit is only the tip of the captive-benefit iceberg. Savvy captive owners know how to turn the "necessary evil" cost center into a valuable company asset.
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