Alternative markets and risk financing

The income potential in an agency captive can be as much as 10 times greater than that available through insurance company profit-sharing schemes.

You cannot open an insurance trade magazine these days without seeing at least one article devoted to what is commonly called the "alternative market" or "alternative risk financing." Most of the current literature on the subject is general in nature, designed to provide basic information to a diverse readership.

If you're a middle market insurance agent, you sell a variety of insurance products and services. Your commercial clients include law firms, physicians, manufacturers, transportation risks and contractors. If you're an independent agent, you represent an average of eight-to-ten commercial lines insurers. Eighty percent of your business is concentrated within your top five companies. Historically, your competition has been comprised of agents your size; but many of these agents have been purchased, either by a bank or by one of the growing number of regional and national brokerages.

You're finding that most-if not all-of your companies are raising premiums with or without a valid reason to do so. While you're renewing most of your best accounts, selling significant premium increases is extremely difficult, especially when they're not warranted. Let's say one of your physician clients has recently been approached by a competitor with the prospect of joining a group captive designed specifically for doctors. Since you have no experience with or knowledge of group captives, you cannot advise your client whether or not this opportunity has merit. More important, you have no idea how to access the alternative market and initiate the formation of a group captive yourself

This article will suggest ways that you can add specific alternative risk transfer/financing strategies to your arsenal of products and services.

What exactly is the alternative market? The alternative market is not really a market, per se. The expression is used as shorthand to describe a variety of risk transfer/financing options that, by definition, are not available from the standard multiline insurance companies. Insurance plays an important role in most alternative market programs, but usually in a reinsurance context, i.e., excess of a self-insured retention. The alternative market is comprised of captives, renta-captives and risk retention groups.

Captives represent the dominant alternative market structure. Captives are insurance companies owned by their policyholders. Their primary benefits are the recapture of investment income on loss reserves, and the return of underwriting income. While captives owned by one large corporation (the single-parent variety) remain popular risk management tools for firms with premiums that exceed $3 million annually, group captives have captured the imagination of middle market firms (and their agents and brokers).

The concept is straightforward. A captive usually insures only the primary layer of risk, sometimes known as the burning layer. Except in extraordinary circumstances, the primary layer is funded to contain the majority of claims. Captives are able to fund this layer only if the insured(s) have enough historical claims activity to produce a credible actuarial projection of future claims within the funded layer-losses that exceed the funded layer are covered by reinsurance.

For example, ABC Manufacturing, Inc., forms Widget Insurance Company (WIC), a Bermuda captive designed to cover ABC's products liability exposures. WIC is fronted by a U.S.-licensed multiline insurer and insures the first $250,000 of each products liability claim. The fronting company covers losses that exceed the captive's funding, up to its $1 million policy limits. ABC's premium must be sufficient to cover expected losses within the captive's funded layer (the first $250,000).

In the above example, WIC is owned by one company; therefore, it is a single-parent captive. Group captives are identical in structure, except for the fact that the $3 million premium is derived from a group of insured owners rather than just one. Single-parent captives require at least $3 million in annual premiums; group captives satisfy this requirement collectively. Group captives can be either homogeneous, i.e., all members are in the same business, or heterogeneous, meaning that many different types of businesses are represented.

Rent-a-captive

Rent-a-captives, as the name suggests, are single-parent or group captives owned by unrelated third parties. Rent-a-captive owners literally "rent" their capital to clients for a fee. Rent-a-captives resemble conventional insurance plans, as they are "one-stop-shops"-all services, e.g., claims handling, loss control, policy issuance, etc., are included in the deal. They resemble captives in that they also return a portion of the investment income and underwriting profit.

Risk retention groups (RRGs) are similar to captives with one important difference-a risk retention group can insure only liability lines. Workers compensation, a mainstay for captives, is not permitted in risk retention groups. As the name implies, RRGs are a form of group self-insurance. They are formed under the auspices of the Risk Retention Act of 1986, which allows a group to form under the laws of one state, regardless of where the group members are domiciled.

All alternative market options have two major things in common: (1) the insured is expected to assume a significant amount of its own risk, and (2) in exchange for assuming risk and controlling losses, the insured receives commensurate benefits. One important difference between insurance company cash flow programs (such as large deductibles) and alternative market programs involves the disposition of investment income on loss reserves and underwriting income. While the insured technically earns investment income on loss reserves held under a large deductible plan, insurers usually make a charge for loss of investment income. Underwriting income, i.e., loss reserves not used to pay losses, reverts back to the insured in virtually all alternative market programs.

How can a captive earn an underwriting profit when the insurance industry's combined loss and expense ratio rarely drops below 1.00? The answer lies in the fact that captives are created for specific purposes. Successful captives maintain stringent underwriting guidelines and provide high-quality loss control and claims management. Multiline insurers rely on the "law of large numbers"-i.e., the premiums of the many pay the losses of the few. When markets are soft, competition drives premiums below breakeven, and combined ratios rise above 1.00. Captives, on the other hand, cannot afford to engage in cutthroat pricing competition because of their small size relative to multiline insurers. In successful group captives, each member is acutely aware of how losses and inadequate premiums adversely affect profitability and survival. In fact, if a captive doesn't earn an underwriting profit, it will probably fail.

Client-owned captives

One way that middle-market agents can take advantage of the alternative market is by forming a client-owned group captive. To illustrate, let's refer back to the physician example at the beginning of the article. In today's hard market, doctor-owned captives can be viable alternatives to the standard marketplace, especially in light of the contraction of medical malpractice insurers. The reality is that any agent who insures a handful of physicians is in a position to potentially create a group captive, especially in today's market environment. The only real caveat to this would be geographic considerations. In certain highly litigious parts of the country, the potential for loss may be so volatile that the risks associated with captive ownership are too great. Otherwise, that handful of doctor clients can represent a group of founding members. Each founding member is then motivated to attract enough members to start the program.

For example, let's assume that you currently insure five physician groups, with a total of 30 doctors. All are interested in starting a captive. Each doctor currently pays, on average, $25,000 premium for medical malpractice insurance. If we assume that $3 million is the minimum required first-year premium, your current clients represent $750,000 towards that goal. So, assuming that $25,000 is the average premium paid by other physicians in your area, you'll need an additional 90 physicians-or a total of 120 physicians-to make the program work.

Rounding up 120 interested physicians may seem like a daunting task, but your best "salespeople" are already in place-your 30 clients. These doctors will be motivated to entice their colleagues into joining because they can't do it without them.

The benefits to the doctors were discussed above. However, there are also significant benefits for you, the agent. Aside from earning commission income, agents who sponsor group captives can take advantage of two additional potential sources of income. One, captives pay fees for essential services. If your agency can satisfy one or more of these requirements, e.g., loss control or claims management, additional agency income is available. Second, if your agency qualifies as an "accredited investor," it can purchase stock and join the physicians as one of the captive's owners. This strategy can be useful in demonstrating to the group that you're committed to the program and have a financial stake in its success. Ultimately, however, regardless of whether or not you have a financial stake, a captive can be a highly effective marketing tool in a hard insurance market. Also, successful captives rarely lose members for competitive reasons, so client retention remains high.

Forming an agency captive

Agency captives, also known as PORCs (producer-owned reinsurance captives), are growing in popularity and utility. An agency captive is simply a way for an agent to participate in the underwriting risk that is usually borne entirely by an insurer. Agency captives can be initiated by one agency, or a group of agencies. These programs offer agencies an opportunity to earn investment income and underwriting profit on a limited book of business. In fact, the income potential in an agency captive can be as much as 10 times greater than that available through insurance company profit-sharing schemes. An example will illustrate the concept.

L&M Insurance Agency, Inc., has $50 million in total premium volume, distributed among 10 insurers. L&M has no intentions of "raiding" any of its companies in order to start an agency captive. However, it recognizes that its total profit-sharing income will be significantly lower than it has been in recent years. L&M decides to create an agency captive initially with business from each of its 10 companies, thus not decimating any one insurer. The business should be considered the "cream of the crop," subject to strict underwriting guidelines. The first-year goal is to place at least $3 million in premium volume into the captive. Similar to any other captive arrangement, the agency takes a relatively small portion of the risk, usually the primary layer, either in an excess-of-loss or quota share layering structure. The remainder of the risk is borne by the fronting company, which also usually provides the essential services.

Ideally, business placed into an agency captive should currently be insured by your agency. This gives you an opportunity to see how the account performs before you begin to take risk. It also gives you time to get to know the owners or managers and judge their attitude toward loss control and claims management. The last thing you want in your captive is a client who does not believe in the importance of loss control.

You are not legally required to disclose to the client that you have placed its business into your agency captive since the agency (not the client) is assuming the risk. However, in the interest of full disclosure relative to the income you earn on clients' business, you may decide to inform your clients.

Summary

As a middle-market insurance agent, you have a significant advantage in terms of leveraging the alternative market: your client base. When you mine your current book for group captive opportunities, you're creating uniquely marketable programs unavailable to your competitors. When you form an agency captive, you're creating an additional source of income independent of commissions and the vagaries of insurance company profitsharing formulas. Neither approach can be accomplished without an up-front investment of time and money; but in today's unpredictable insurance market, the alternative market can represent a profitable long-term investment.

An overview for middle-market agents

The author

Donald J. Riggin, CPCU, ARM, is a risk management and insurance consultant with Schiff, Kreidler-Shell, Inc., in Cincinnati, Ohio. He also created, edits and writes the monthly journal, Financing Risk & Reinsurance, published by International Risk Management Institute, Inc. (IRMI). Don can be reached at (513) 977-3153. His e-mail address is driggin@sksins.com.

Copyright Rough Notes Co., Inc. Sep 2002
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