Captive Flexibility Proves Ideal for Growing Array of Risks

This article originally was published in Captive Review and is reprinted here with permission.

Not all that long ago, captive insurance was often viewed as something of a novelty. The few risk managers who explored the concept were usually seeking ways to find more affordable strategies for common coverages such as employee benefits, workers' compensation, and property. The approach became more familiar as those pioneers proved the many advantages of establishing a captive.

Today, the use of captives has expanded to address a growing list of risks. Managers who employ a captive to handle one area increasingly ask “what if” questions about other risks in their organizations. The approach's inherent flexibility, combined with creative thinking on the part of managers and their captive consultants, is extending captive-centered risk management programs to a long list of coverages.

While many of those new uses for captives come from companies new to the concept, we’re seeing the majority of the new ideas appear from those who have long used the strategy. Cost savings are central to most considerations, but existing owners frequently seek ways to make their captives work even harder for the company and fill gaps in their risk management efforts. If commercial coverage is cost-prohibitive or impossible to find, adding the specific risk to an existing captive allows them to capitalize upon its performance and create diversification within the captive.

We’ll examine several of the most common examples of these creative uses.

Creative Uses of Captives Insurance

Umbrella. As jury verdicts increase, coverage beyond the limits of primary policies becomes more important. Umbrella liability policies have long been ideal for that role, but today’s awards can exceed even a large policy’s limits. If adequate coverage is available, premiums have also seen steep increases. That incentivizes companies to consider better ways to manage those big-dollar exposures. Using a captive to provide an excess layer of coverage can trim costs.

Executive risk. Discussions about using captives for executive risk coverage such as directors’ and officers’ liability frequently stem from a common frustration. Given the potential for massive verdicts, risk managers recognize the need to implement higher limits but discover purchasing that coverage through traditional sources is cost-prohibitive.

Creating a captive insurer for executive risk policies allows the company to gain access to the reinsurance market and price coverage based on its unique historical exposure. Captives also allow coverages that traditional insurers may exclude. In addition, because the likelihood of claims is slim, a well-structured and prudently managed captive should quickly generate a healthy surplus that can fund other loss control efforts.

Benefits. Employee benefits programs are more than just a way to help workers through life’s challenges. In this stubbornly tight labor market, attracting and retaining talent is especially critical to a company’s strategic initiatives. The captive might also support those efforts by being used to finance recruiting costs. A captive is particularly well-suited for use with voluntary benefits from prepaid legal services, to pet insurance, to identity theft and more. A company could develop a lengthy menu of choices and fund all the claims through a single captive.

Medical stop-loss. Captives have been used for decades to help companies structure protection from high-dollar health claims for innovative therapies ranging from gene therapy to new medications. Companies that are financially able to retain significant portions of risk simultaneously reduce their insurance costs while taking greater control of their benefits program. They develop deeper insight into the nature of their claims, so they can determine the optimal balance of risk retention and risk transfer. They can use a variety of strategies such as case management to mitigate risks and select the coverage options their employees need most.

Captives also give companies incentives to control costs through wellness programs and other initiatives that will improve their employees’ quality of life and lead to long-term reductions in claims. We’ve seen many companies add medical stop-loss coverage to existing captives.

Property. No matter what you may believe about its cause, there’s no disputing the fact that the planet’s changing climate presents costly challenges to companies. Historic flooding and treacherous storms have devastated large areas, while wildfires are becoming common in new places, like the Carolinas. The coverage cost (when available) reflects the record claims.

One key advantage of using a captive to cover part or all of the property risk is that it can be tailored to an organization’s specific conditions. A company in a state with high wildfire rates may have been able to significantly reduce through material choices and the like, yet commercial underwriters may lump them in with riskier properties and price coverage accordingly.

We are also seeing greater use of parametric coverages for specific weather risks such as flooding. For example, we’ve worked with companies to install sensors to monitor rainfall and potential floodwaters. Their policies are designed to make automatic payouts anytime more than a specific amount of rainfall occurs over a three-day period. That eliminates the need for a formal claims process and incentivizes the insured to install effective flood defenses and steps to limit damage.

Product liability. Although product liability coverage is not difficult to find in the current market, many companies find standard policies costly and inefficient for their needs. That’s particularly true for manufacturers whose quality standards allow them to confidently offer lifetime warranties. The risk of a large liability claim from their product may be microscopic, but all it takes is one big loss to put the company’s financial health at risk. Once again, a well-structured captive offers a practical solution based specifically on an individual company’s situation.

Risk retention. Activity in the risk retention group space has increased and become more interesting as sectors with difficult insurance markets seek practical solutions. Long-haul trucking associations that have struggled to find affordable coverage for their members are an excellent example. They’re using risk retention group strategies to fill gaps in traditional coverage or make the cost more reasonable.

Franchises. The franchise market is another interesting vertical for which captive insurers have proven to be a problem-solver. Franchisor profitability depends largely upon how well individual franchisees perform, so management closely monitors the pulse of every location. As franchisees struggle with common issues, the franchisor is incentivized to help them find solutions. For many, captive vehicles have been developed that provide key coverages and implement loss reduction strategies such as employee safety programs. It’s a concept that’s similar to the group purchasing programs many franchisors offer.

Instead of having to buy liability and similar coverages from a national insurance market in which they’re likely to be rated alongside competitors with strikingly different risks, the captive structure allows the franchisor to create coverage that’s as unique as their business concept. By sharing common risks, the franchisees are able to enhance profitability – and may have incentives (and even funding) to reduce their risks even further.

Cyber. Commercial coverage has matured as it has adapted to the constantly changing mix of threats. Just as risk managers became conversant in the many ways cyber criminals could endanger their companies, something called artificial intelligence (AI) arrived. Companies marvel at AI’s capacity to transform business processes, but what new types of cyber risks will those managers need to prepare for? What kinds of controls will insurance carriers demand? We may not be able to provide a key forecast for what’s ahead, but we’re quite confident captives will play a big role in whatever needs arise.

Environmental, Social, and Governance (ESG). It may be a contentious issue in the U.S., but organizations that do business globally are well aware that other nations aren’t using American dissatisfaction to walk back their own environmental and social policies. A captive insurer can serve as a practical tool for handling ESG-related initiatives and diversifying the company’s associated risks.

Larger customers are pressuring middle-market companies to prove they’re meeting standards, which can create a significant risk of losing business. Companies may even be expected to document compliance throughout their own supply chains, so third- and fourth-tier suppliers’ business practices could be affected by the top company’s ESG expectations.

Political. The turmoil affecting many of the world’s democracies over mutual defense issues and trade-related matters such as tariffs is likely to create risks that have yet to be noticed. As longtime trade alliances and security agreements crumble, the likelihood of conflict and outright war increases. Some companies are already feeling the effects of today’s political climate. As they become better able to quantify the potential risks in all the places their companies do business, captives may provide a vehicle for mitigation.

One more. There’s another emerging risk the captive community needs to remain mindful of: the imminent retirement of many of the experts who built today’s industry. A significant amount of knowledge will depart with them, so today’s risk managers would be wise to invest in finding ways to transfer what they’ve learned to the field’s new minds. That will ensure that companies interested in exploring the nearly limitless potential of the captive approach won’t struggle to find the expertise they need to succeed.

The above information does not constitute advice. Always contact your insurance broker or trusted advisor for insurance-related questions.