Aon’s Professional Services Practice share insights to help firms navigate a hardening insurance market in the sixth article in a series exploring risk retention.

Successful captives have tended to evolve over time, adapting their operations to market conditions and the needs of individual firms and the risk climate. The best results have tended to occur where there is a clear purpose and strategy that will stand the test of time. Captives formed purely as a reaction to short term market conditions have tended to provide lower value.

This article will discuss past experiences and examine strategic approaches, providing some design principles that consider captive desirability, feasibility and long-term viability.

Past Practice

Captive insurance companies have been utilized by professional service firms for several reasons. The most common application has been to insure the primary commercial insurance layer retention, often done in conjunction with an increase in the size of the retention. More strategic and imaginative approaches have also been taken.

The motivation for the insurance of the retention has been tactical or to achieve a longer-term objective:

• To act as a buffer against actual or potential hard professional indemnity insurance market conditions.
• To smooth recurring but annually volatile costs between generations of partners: in this scenario, the attachment of commercial insurance has been adjusted to remove “frequency” claims. This should have the beneficial effect of reducing commercial premiums.
• Match risk premium with current generation rather than leave to a future generation.

The most common objective historically for captive formation has probably been to reduce commercial insurance premium costs by:

• Limiting premium increases that might result from insurers paying losses at low levels and to self-insure a level of losses that is reasonably predictable
• Hedging against an actual or predicted deterioration in market conditions

There have been more imaginative and strategic applications. These tend to deliver longer term viability and satisfaction and include:

• Perceived opportunity to reduce costs in the long term: captive funding of risk is seen as a potentially lower cost option where there is confidence in a continuing favorable loss record.
• Coverage improvements: larger entities have retained a substantial retention before purchasing commercial insurance and received wider coverage within the captive layer.
• Assuming coinsurance on commercially led layers: historically this approach could fill program gaps caused by the unavailability of commercial insurance.
• To coordinate international insurance program purchase to achieve consistency of cover and facilitate issues such as central control of claims.

The captive can create the coherence and agility to cope with future changes in the shape and scale of the organization, for example, the integration of new lines of business. Even more ambitiously, to cover risks that are difficult to insure or for which there is no insurance market.

What has the experience been?

Approaches have varied by firm geography, sector and size. Here are some general observations.

• Many captives were formed to assume risk on an incremental basis to reduce dependency on the commercial market. The long cycle of benign insurance market conditions reduced the attraction of this reasoning.
• Some entities regard their captive as a risk pool to share or spread retention costs without any ambition to further expand its use.
• Some firms have used captives to insure their own risk and in these instances it is difficult to significantly expand their scope without the spread created through a larger risk pool.
• Some entities have explored so called protected cell captives, which represent a capital efficient way of using a captive but where premium pools are discreet to the entity (the cell). Utilization of a ‘protected cell captive’ may incur lower frictional costs than an owned captive. A protected cell uses third party capital and avoids a capital contribution from the firm but involves having less control over the captive and its funds.
• Entities in the same network have pooled risk. This approach can be used as a vehicle to access commercial insurance. We discuss this below under “More ambitious approaches”.

The experience of global law firms represents a good case study. This sector tends to buy global insurance programs. Their ownership and management structures determine variations in practice and approach, but their programs tend to be centrally purchased and coordinated.

In the US, group approaches that include risk retention and a collective approach to the insurance market have a long and successful tradition. Elsewhere, individual firm approaches have tended to insure retention costs and to create common levels of commercial layer attachment with desired retention structures. In the latter situation:

• The retention may be insured for smoothing or “tactical” reasons to increase retention levels and introduce more program flexibility (coverage and claims handling). This also addresses the generational equity concerns.
• Soft market conditions have restrained further expansion due to the plentiful supply of affordable insurance, but of course a hard market driven by claims may not be the best time to retain more risk.

More ambitious approaches

Captives constitute the major risk transfer vehicle for some large professional service firms, supported by commercial reinsurance that attaches at high per loss points or provides aggregate excess of loss protection.

The journey to that level of maturity has been one of evolution: risk profiles and risk transfer availability have fluctuated. In the initial stage the captives were modest in operation, insuring retentions but they managed the pricing and availability environment in the insurance market by gradually assuming more risk.

A long-term strategy has thus enabled flexibility in program structure and the ability to bear increasing amounts of risk.

In a mature captive the balance can shift to using commercial insurance to reduce capital need or insure aggregate risk accumulations, or only very large individual losses. This approach may also allow the captive to offer cover that is difficult to obtain or unavailable in the commercial market. It enables innovative approaches to issues such as regulatory and reputation risks.

The Strategic Perspective

In summary, the advantages that have materialized are:

• Consistency, breadth and flexibility of global cover, and rational purchasing of limits and retentions outside of commercial requirements and market trends. Local compliance can be achieved by using fronting arrangements.
• Control over operations: in addition to design issues, operational advantages can be explored, such as central claims management with the close cooperation of the commercial market lead insurers.
• Commercial market purchase can be moved to more remote levels thereby reducing the cost and potentially capturing the results of good loss experience.
• In time, with favorable loss experience, a buffer of capital can be accumulated that permits the long-term consistency of the supply of insurance at a stable cost independent of the commercial market cycles.
• Extensions of cover can be written in areas that are not traditionally within the scope of professional indemnity insurance, although arise from professional practice.

It is worth emphasizing that successful ventures tend to evolve and mature over time and capturing some of these benefits is a long-term project.

Design Principles

In considering whether to form a captive it is worthwhile therefore to start with the big issues of purpose and strategy. The scope of underwriting is a primary planning issue. Building out from that here is a fuller list of considerations:

• What is the business case to form a captive? Objectives and benefit sought?
• What is the organization’s tolerance to pool and assume risk in such a vehicle?
• What is the current cost of risk (claims assumptions are important) and can this be reduced using the captive?
• What would the captive program look like?
  • Policy cover, participants, limits and retentions
  • How much capital is needed?
  • How to set and allocate premiums
  • Reinsurance availability to efficiently utilize the commercial market.
  • Claims management responsibility and process
  • Domicile choice and tax issues
  • Governance, management and ongoing costs

Assessing these issues permits a strategic evaluation of the desirability of a captive. The next step would be a full feasibility study looking at the economics and expected costs, and the ability to fund through premiums, capital or other support.

Conclusion

Successful captives evolve over time, adapting to market conditions and more importantly to changing risks and risk profiles.

Without developing a planned approach, a captive may not be the panacea that some would have us believe. Desirability, feasibility and viability are sound design principles. This approach is more likely to yield a successful long-term venture than merely a tactical approach aimed at fixing an immediate problem that might disappear in the medium term.

By addressing the key issues initially, and by taking a strategic perspective, a plan can be created to navigate through the decisions required to ensure a successful outcome.

Contact

Aon’s Professional Services Practice values your feedback. To discuss any of the topics raised in this article, please contact Keith Tracey.

Keith Tracey
Managing Director
London