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.
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). In the following example, the results at the end of 5 years for the $250,000 excess of $250,000 layer is depicted.
Single-Parent Captive Example
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.