Crawl, Walk, Then Run: Adding Non-Traditional Captive Coverages

This article originally was published on Captive.com and is reprinted here with permission.

“Set it and forget it” may be smart advice for a kitchen appliance, but thinking about a captive insurance company that way limits your opportunities and potential benefits. All too often, we see organizations that have wisely chosen to establish and maintain a captive for a particular risk but have never given thought to how that captive can serve as a practical, cost-efficient way to protect additional risks.

Every organization’s risk profile changes over time, as does the insurance market. Additionally, well-structured and carefully managed captives have the ability to accumulate surpluses. Using the captive and those surpluses to address other risk management objectives may allow the organization to reduce its overall insurance spend, freeing up cash for other uses.

That’s why we believe it’s important for captive owners and board members to regularly examine their entire risk portfolio and consider opportunities to incorporate additional risks. We identify and address those opportunities by conducting a comprehensive strategic review to develop a framework we refer to as the “crawl, walk, run” method. Just as infants test their ability and build their confidence in getting around on their own, this strategy helps organizations take increasingly larger steps to broaden the benefits of their captives.

The review focuses on aligning the captive strategy to more precisely match that of the organization by:

• verifying that the structure and domicile remain optimal for the organization’s needs
• identifying changes that may impact the captive’s performance, such as regulatory changes and parent company changes
• considering retention levels and alternatives, additional lines of coverage, what-if scenarios, domicile issues, and market trends
• interpreting and analyzing actuarial, financial, and other data
• assessing vendors and assisting in RFP processes
• evaluating risk areas where a captive could enhance protection, reduce cost-of-risk, and improve profitability
• evaluating the efficacy of captives, along with surplus and utilization opportunities

Based upon the analysis, we break the opportunities for expanded captive utilization into three categories. What we call “crawl” opportunities are those we recommend for the short term, typically six to twelve months. “Walk” opportunities are those best suited for the next two to three years, while those in the “run” category focus on what can be accomplished in the long term.

To build out a data-driven, economically efficient five-year captive strategy using the crawl, walk, run methodology, we focus on three critical question areas:

• How much risk now placed in the insurance markets can the organization safely assume?
• Is the amount of total insurance limits optimal, and are the current retention levels adequate?
• Does it make economic sense to assume that additional risk, and which risk layers should be considered for captive placement?

Before we dive into exactly where the opportunity for greater utilization of the captive exists, we must first determine what we call the organization’s financial capacity to bear risk. Using the captive’s data and the organization’s financials, we can identify how much additional risk they may be able to assume without endangering the company’s financial security.

Once we have determined how much additional risk is safe to assume, we begin our analysis to determine which risks are most economically efficient to assume or move into the captive. First, we model an organization’s potential for losses and loss volatility for each line of coverage. To do this, we use historical claims, exposure information, and industry data to run thousands of simulations with varied frequency and severity to generate what losses could look like at different confidence levels. The confidence levels summarize the likelihood of different loss scenarios occurring in a given year. We generally assume that the mean equates to about a 55% confidence level—these are the losses an organization can reasonably expect. A confidence level of 99.9% represents a once-in-1000-years loss scenario. This information helps us understand whether an organization’s limits are sufficient or if they are over- or under-insured.

We use those same confidence levels to determine whether the organization’s retentions are appropriate or if it could explore alternative deductible options. Additional analyses using actuarial models allow us to simulate how the organization’s retained risk could change at different retention levels and calculate optimal pricing at each option. We can then determine which options offer the greatest economic opportunity based on changes to the total cost of risk.

To determine whether the program is appropriately priced, we analyze each layer individually. This helps us decide the most economical way to shift additional retention into the captive over the five-year period. Beyond the rate paid for premiums, this analysis also considers the organization’s return on premium investment.

Ultimately, this highly analytical process guides our recommendations to bring additional coverages and services into the captive in an economically efficient way that aligns with the organization’s overall business and growth strategies.

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