Blowing the Dust Off Your Captive’s Business Plan

In the new captive formation process the creation of the business plan uses the largest amount of time and intellectual resources.  That’s understandable because the document forms the foundation of the startup.  Front companies, reinsurance and claims administrators all use the statistical data and the narratives of the business plan to set their pricing and terms and conditions.  Domiciles use the information to judge the insurer’s acceptability and its potential to be successful within the location’s regulatory framework.   Once licensed, the business plan is used by auditors and regulators to make sure that the captive is operating according to its original approved plan.  Even years after a captive is licensed, regulatory bodies like the IRS take an interest in the business plan and how a captive is operating currently compared to its original business plan.

A business plan is required of virtually every captive.  The real question regarding a captive’s business plan is whether or not it is a static document or a dynamic document.  Once created and used as a part of the formation process can you just stuff it in a drawer and forget about? 

The simple answer is no!  The captive business plan should be a dynamic document that is reviewed regularly.  Let me give you a couple of reasons why…

Stakeholders like the domicile’s insurance department, your audit firm, claimants, reinsurers, the  Internal Revenue Service and the shareholders of the captive’s parent in a publicly traded environment all rely on the accuracy of the business plan to portray the business of the captive.  Unless this document is regularly reviewed and updated it is doomed to be inaccurate and will likely contribute to a problem for the captive and its ownership.  At a recent captive insurance conference session dealing with IRS regulation of captives, the two attorneys conducting the session both emphatically agreed that an updated and accurate business plan was a powerful deterrent to IRS “fishing expeditions” into the taxation status of a captive. 

Another reason for periodically dusting off the business plan is to make sure  that the captive is still supporting the parent’s strategic goals.  In my consulting practice I am regularly contacted by firms that own a captive and that have had personnel changes over the course of several years and they find themselves in the unusual position of not knowing why they even have a captive in the first place.  Either the new management is not schooled in the use of captive insurance as a part of a creative risk management regime or the company’s strategic goals have moved so far that the captive is no longer relevant.  A regular review of the captive’s business plan allows the captive to be re-aligned with the corporate goals and to make a powerful addition to accomplishing those goals.  Not only is this recalibration critical in keeping management informed of the captive’s capabilities, it can often contribute to new uses for the captive that keep it relevant and a contributor to overall success.

This review should be conducted every couple of years and should be the product of not only fact checking the captive’s operations against the existing business plan, but understanding the parent’s overall business goals and how  the captive might contribute to achieving them.  If you are interested in discussing how this process works send me an email at dennis.silvia@cedarconsulting.net and I would be happy to contact you to discuss it.

All Your Eggs in One Basket

Don’t Put All Your Eggs in One Basket

Its easy to see how it happens.  Your insurance broker comes to you with a great idea about how to more efficiently finance and manage your insurance risk.  They bring in the brokerage’s experts to conduct feasibility studies and work with you to license a captive insurance company.  The have their reinsurance brokers place the reinsurance and have their captive manager take care of the regulatory and management operations.   Because of their fully integrated capabilities your broker has delivered a captive insurance solution entirely from within the broker’s organization.  That’s good, right?

One of the biggest decisions that face the owners of captive insurance companies is whether or not to consolidate all the insurance and captive management services in one basket.  There are some obvious advantages to doing this.  It is simpler, and may be less expensive initially to let your broker put your entire program together.  They may even be willing to do the feasibility work within the existing fee structures, only charging for the ongoing management and collecting the commissions on the reinsurance placements.  But what are the disadvantages? 

• When a captive insurance program is created entirely from within a single organization with no outside input then you get that organization’s cookie-cutter program.  They only do things a certain way and that is what you will get, whether its the best structure for you or not.
• With no outside involvement there is no “gate keeper” making sure that the broker’s organization is doing everything it can to advantage the captive owner even if it means that it might disadvantage the broker’s organization. 
• Most broker organizations are limited in the number of domiciles that they can effectively do business in which means that they cannot be completely domicile neutral.  You may end up being steered to a domicile that suits their operational characteristics but may not be the best choice for your company.
• Even in the best of brokerage organizations things slip through the cracks.  The broker is less likely to spend the same amount of time reviewing work done by an internal department then they might work from outside.  The checks and balances of having a diverse makeup in the captive’s support mechanisms are eliminated.
• Pricing for captive services can often be overstated when billed all together as opposed to being presented on a line by line basis.
• Brokerage organizations are typically polarizing in the industry.  Some companies get along well with other companies and frankly some don’t get along at all.  An independent manager can often involve service partners that a brokerage could not because of conflicts in corporate cultures.

In my consulting practice I have reviewed programs that have had the captive services completely integrated within one brokerage organization.   My reviews always turn up issues.  In one case a mismatch between the terms and conditions of the policies being written by the captive and the reinsurance treaty could have caused an enormous financial problem for the captive.  In an another case the overall charges for the program were much higher than average because they were being billed in a lump rather than being detailed line by line.

If you are considering a new captive program be sure to weigh the advantages and disadvantages of an integrated approach.  Try to involve at least one outside advisory component to the program in order to mitigate the potential problems.  If you already have an integrated program, hire a consultant to do a review of your captive and make suggestions on structure and operations as well as benchmark your costs.  Its never a good idea to have all your eggs in one basket.

New Sheriff in Town

Depending on which side of the fence you live on you either see underwriters as the scourge of the industry because they get in the way of your producing business or they are the saviors of the industry because they are the gatekeepers protecting the company from risk.  This has been an age old battle and frankly I’ve always seen it as beneficial, helping to make sure that insurance companies write as much good business as they can get their hands on.  If producers want to write everything and underwriters don’t want to write anything then somewhere in between is a healthy balance that allows for something to be written profitably.

The compromise that a risk underwriter can strike with a producer when considering an application for insurance is predicated on the theory of large numbers and the recognition that over a large enough book of business and time that a measured approach to risk consideration will yield profit.  Sometimes they will get it right and sometimes they will get it completely wrong, but on average it will work out.  Risk underwriters are allowed to make a certain number of  mistakes and still be seen as successful.

There is a new underwriting Sheriff in town now and this one isn’t allowed to get it wrong, ever, and its causing a lot of consternation in the alternative risk and captive insurance arenas.  Credit underwriting has long been like a camel poking its nose under the traditional insurance tent.  Granted, there is a correlation between credit worthiness and risk quality and it should be considered as one of the underwriting criteria, but because of the current financial crisis it has taken on a life of its own particularly in risk sensitive programs.

In large deductible and captive insurance programs the insurance company providing coverages  must consider the credit worthiness of the risk taker as a part of the overall risk they are assuming.   These risk transfer programs have elements of both underwriting and credit risk.  Balancing the underwriting of risk has been dealt with effectively over the years by recognizing that if you prudently insure a large enough pool of risk that you will end up winning over time and making a profit. 

Credit risk is still a relatively new stand alone discipline and as a result it is still trying to get its footing on what has been a slippery economic slope.  Unlike their risk underwriting associates, credit underwriters don’t have the flexibility to get it wrong.  Credit underwriting to this standard would be like a risk underwriter looking for loss picks in the 90% actuarial range.  It stops being a pooling mechanism at that level and the client might as well completely self insure.  Combine this with the enhanced regulatory and compliance environment that we find ourselves in and we have a big problem when it comes to deductible and captive insurance programs.  Rather than assume a measured degree of credit risk this new breed of underwriter is seeking full collateralization of every deal. Its a bit like the joke that a banker won’t loan you money until you can prove that you really don’t need it.

The solution to this problem is for insurance credit underwriters to embrace the theory of large numbers and to recognize that they can assume a measured degree of risk and on an overall book of business end up being whole.  They, and their managers, must be willing to accept some degree of loss as a part of their cost of doing business.  Until that happens alternative risk program development will languish for all except those that don’t really need it!

Who can you trust?

At a time when the nation is being wracked by economic problems its difficult to decide who you can place your trust in.  The very companies that were the pillars of our economic strength have been exposed to reveal that  their foundations have been eaten away by the termites of greed and self dealing.  

We can’t just limit our concerns to specific companies either.  Entire industries-of-trust have been impacted.   One of the trust industries that impact our day-to-day lives the most is insurance.  Insurance in particular is an interesting example of a trust relationship.  In exchange for a relatively small premium the insurance company promises to pay subject losses.  It can make this promise because it can figure out how many losses will occur in a particular population of insureds and can charge an appropriate premium to be able to pay for those losses.  Premiums are invested until they are needed to pay losses and at the end of the day a profit is realized.  A symbiotic balance is struck.  Society is served by transferring the risk of loss and stockholders of the insurance company are served because they see a return on their investment.

The breach of trust in the insurance industry is not that the fundamentals have failed us, but rather that they have been ignored.  Management, in many cases, has put aside their responsibilities to stakeholders and have focused on what was best for themselves.

You would think that what is happening to our economy would be a damper to any kind of growth, but that has not been the case in the captive insurance industry.  My consulting practice is an affiliate of USA Risk Group and they reported 13 new captive formations during the month of December alone.  In my practice I am continually fielding questions about how a captive insurance initiative might be helpful for a company’s risk management strategy in the current economic environment.  This may seem inconsistent with what we hear on the news every day, but let me offer some thoughts on why this may be perfectly in sync with our economic woes.

When we are answering the question, “Who can you trust?” the most obvious answer is  you can trust yourself.  Captive insurance is a means of self insurance that allows a company to employ the basics of insurance pricing, claims management and investment control so that they all benefit the company.

Whenever there is a disastrous loss in the insurance market there is always a flurry of new insurance company formations immediately following.  We saw it with Hurricane Andrew, 9/11 and KRW (Hurricanes Katrina, Rita and Wilma).  After each of these events billions of dollars of insurance capacity was created because of the opportunity to compete with insurance companies that had legacy claims issues that they needed to price for. 

I think the most recent disaster, albeit man made, is seeing a similar flurry of activity, but this time it will be at the grass roots level.  Companies will be asking the question, “Who can I trust to deliver consistent insurance and risk management services?”  The answer will be, “ourselves”, and the method will be captive insurance.

Risk Selection- The Smelt Dip Dynamic

Dipping for smelt in frigid spring waters

First, let me offer my apologies for such a long time between posts.  No Excuses!

If you have never stood in freezing cold water up to your waist in the wee hours of the morning waiting for smelt to run you are much more sane than I!  I went to college in the Upper Peninsula of Michigan and smelt dipping is a tradition for the locals there.  Every night, just after the ice melts on Lake Superior, small sardine-like fish called rainbow smelt run up into the streams connected to the lake in the millions (yes millions).  When you stand in the middle of these streams in your waders you can literally feel them banging against your legs in waves. 

You catch these fish by using a 5 gallon plastic barrel with the bottom cut out and replaced with screen mesh.  The size of the gaps in the mesh is important because if its too small you catch too many fish that you can’t use.  If its too big you only get a small number of the biggest fish.  There is a dynamic that needs to balanced to catch enough fish to make it worthwhile to stand all night long in freezing water but not too many really small worthless fish.  Now, here is the insurance part of all this….Insurance companies have to balance this “Smelt Dip Dynamic” as they make decisions about risk selection.

One of the most critical issues associated with the profitability of any insurance program, captive or traditional, is the selection of the participating risks in the group of insureds.  How you set the criteria for selection determines the quality of risk and the number of risks that might qualify.  This decision process has a lot of moving parts. Insurance theory has several, often competing, criteria that all come together to form the operational characteristics of an insurance company.  On one hand the theory of large numbers says that you have to have a lot if risk units mixed together in order to have predictable loss results.  On the other hand we know that some risk units just don’t have the loss control characteristics that make them good risks.

One approach to risk selection would be to accept only a very exclusive group made up of accounts representing the very best loss ratios.  This might work if you have a large enough group of acceptable risks in the group.  Beside the statistical shortcomings of a small group of insureds there are the fixed costs of an insurance program that must be covered as one of the expenses of the program.  In order to cover costs and alleviate some of the statistical problems of a small group we would have to raise prices but then these excellent risks might be able to go somewhere else and get a better price.

Another approach would be to take all comers and build a very large risk group that would have very predictable statistical performance but because there were no criteria to entry would end up with some very bad players in the pool.  The experience of the good loss performers would offset the cost of the poorer performers but the overall premiums would have to be higher to compensate for the bad risks.  Again, good risk could find a cheaper deal and the bad risk wouldn’t be able to find a better price anywhere.  The result, adverse selection.

Enter “The Smelt Dip Dynamic”.  Imagine that the risk selection criteria is correlated to the size of the mesh in the bottom of our 5 gallon plastic barrel.  It needs to be wide enough to let the very bad accounts flow through without being captured, but small enough to catch enough good fish to make the process worthwhile, both from a cost perspective and from a statistical perspective. 

Captives differ from traditional insurance programs in how they determine how big to make the mesh.  Because captive participants are typically larger accounts that take a significant share of frequency layer losses they already have a larger statistical base to predict losses on.  Captives also have a lower expense load than a traditional insurer so there is less cost that has to be distributed in the program.  The end result is that a captive can pick and choose the very best risk to be a participant in the program and still maintain a reasonable degree of statistical credibility.

In our analogy, captives are only after the biggest and best fish they can find and they set their underwriting criteria to ensure that happens.  

Archimedes had it Right!

Archimedes, a Greek mathematician c. 250 BC, was the first to explain the principle of the lever explaining how a large weight could be lifted by a relatively small weight by the use of a rigid lever and a properly positioned fulcrum.  The process was called leverage.  Archimedes, recognizing the power of leverage was quoted as saying, “Give me a place to stand and with a lever I will move the whole world.”

Well, the concept of leverage has made its way into our world in many ways, mechanical and conceptual.  Insurance companies use a form of financial leverage in order to conduct their day-to-day businesses.  In exchange for a relatively small premium someone with risk can insure against the loss involved with that risk by utilizing insurance.   In this example the insurance company is the lever, the fulcrum is the degree of risk, the premium is the smaller weight doing the work and the weight being lifted is the loss potential.  Depending on how risky the deal is determines where the fulcrum is placed which determines how much premium needs to be applied to “lift” the weight of the potential loss payment.

Leverage is used within the insurance company as well.  Insurance companies would be very inefficient risk takers if they had to maintain a dollar of surplus for every dollar of risk they assume.  Instead, insurance companies are allowed to leverage their surplus to allow for a multiple of premium to be written.  Just how much “leverage” can be applied is a matter of prudent financial planning and in most cases is limited by regulatory action in their chosen domicile and the review and comment of rating companies like AM Best.

Most traditional US companies are limited to a 2:1 Premium to Surplus ratio.  Much more than 2:1 leverage and the insurer’s financial wherewithal is questioned.  Granted, based on the types of coverage and the clientele of traditional insurers that is probably a good leverage ratio.  Regulators want to protect the unsophisticated insurance buying public.  But when you enter the realm of sophisticated risk-managed large deductible insurance buyers these protections are much less necessary, but still imposed.

Captive insurance arrangements typically allow for higher leverage ratios depending on the domicile for the risk.  Some domiciles apply risk-based analysis  in order to determine Premium to Surplus ratios and often are in the 3:1 or higher range.  Other domiciles have prescribed Premium:Surplus ratios up to 5:1.

If part of the cost of insurance involves a charge for the surplus tied up to write a coverage, which mechanism would provide the most efficient, less costly surplus charge?  Obviously the one that allowed for the most leverage, a captive insurance product.  If you combine this with the fact that a captive typically assumes the higher frequency layer of insurance costs which represent about 60% of the loss funding in an insurance program the magnitude of capital tied up to support risk can be dramatically reduced in a captive.

Archimedes had it right.  Give me a captive insurance company and a good domicile and I’ll cover the risk of the world!

   

 

Cedar Consulting LLC to offer Virtual University of Online CE Courses

 

This is great news for those who are interested in earning their required Continuing Education requirements for their Property and Casualty and Life and Health Insurance licenses as well as CPE for Certified Public Accountants.  In conjunction with 360training.com, a recognized leader in professional education delivered in an online environment, we are now able to deliver a large catalog of insurance and accountancy courses. 

Not only is the coursework approved to meet the annual and bi-annual continuing education requirements in every state, it does so in a cost effective and convenient way.  Online education saves you time and money.  You can take classes whenever and wherever you want and with a large library of available course titles you are investing your time in something constructive; learning and not just doing time to finish your requirements.

Cedar is currently developing coursework for Captive Insurance, Risk Purchasing and Risk Retention Groups topics.  In the very near future we will have these courses available through its Virtual University, fully approved for CE credit in all the states.

Cedar Consulting’s Virtual University can be found online at http://cedarconsulting.360training.com 

Bermuda Captive Conference- Cedar/USA Risk Group Announcment

All this week the captive community has descended on the Southampton Princess for the Bermuda Captive Conference.  In its fourth year now the conference is well attended with about 500 captive professionals.   The conference includes a specific track for Healthcare captive issues which is curious since for many years Bermuda neglected this market segment, essentially putting Cayman into the healthcare captive business.  Perhaps this is an indication that Bermuda is now welcoming this segment into the ranks of the largest global captive domicile with nearly $30B in captive insurance and reinsurance premium during 2007.

My own company, Cedar Management Limited and Cedar Consulting LLC had a big announcement just before the beginning of the conference.  We have reached agreement with USA Risk Group, Burlington, VT for them to purchase a controlling interest in our companies.  The original partners of Cedar will retain a significant ownership percentage and the companies will continue to trade in the US and Bermuda under the Cedar name.  We are very excited about the opportunities that this presents for our company and our clients.

More news from Bermuda to come over the next few days. 

 

Timing is Everything

Rocky Mountains, 1957

When the topic of alternative risk transfer programs comes up in conversation I am politely reminded by the other party that we are in the midst of a soft market and now is not the time to be dragging all that captive stuff out for clients who aren’t feeling any insurance pain.  After all, captives are the stuff of hard markets. 

The Story

Let me beg to differ by telling a little story from my past.  Let me say that this story is the substance of serious family lore.   Outside of weddings and reunions the whole story has never been told, up until today.  While I was a participant in the events I have had to rely on my father for the details.  He was quite a story teller so the exact facts may have been stretched a bit, although my mother, who often corrected the exaggerated details of my father’s tall tales, had little to say about this story in particular.   They have both passed on so the details are now etched in stone.

I grew up an Air Force brat and for those of you that have never been in a military family what that means is that your life is turned upside down every couple of years as you move from one base to another.  I learned this lesson at a very young age when we were transferred from my birthplace of Loring AFB in Limestone Maine to Clark Field in the Philippine Islands.  My father was to fly from Sacramento to Manila to report for duty while my mother and I were to follow by Navy ship from San Francisco (that’s another story!).   It was the spring of 1957 and we packed up the 1952 Mercury Monterrey and started the Maine to California trek.  Remember, this was long before most of the Interstate Highway system as we know it was completed.  This was the Ultimate Road Trip.

The weather during our cross country trip was unseasonable warm and while the Monterrey was a comfortable ride with a powerful 8 cylinder engine it did not have air conditioning.  After several days on the road I wasn’t feeling too well and the hot car ride just wasn’t helping.  Remember, this is 1957 and that means cloth diapers.  You know, the kind you save in a bag and then wash and reuse.  Let your imagination wander a bit here.  Hot car, sick baby, soiled cloth diapers piling up in a bag.

My father was not a patient man, and even less so as the day went on.  Somewhere in the mountains of Colorado on a twisting and turning section of road he reached his limit.  “Get rid of those dirty diapers”, he boomed.  “What do you want me to do with them?”, asked my mother.  “I don’t care, throw them out the window, just get rid of them!”  My mother reached into the bag and grabbed the worst offenders and rolled down the window.  My father, looking in the rear-view mirror said, “OK, toss them.” and just as my mother’s fingers lost their grip on the rolled up cloth he yelled, “STOP!”.  A car had come round the bend right behind us and my father watched in horror as the dirty diapers hit the windshield of the car and stuck there.  The shocked driver turned on his wipers, making matters worse as the diaper, apparently hung up on the wiper, smeared its contents across the windshield.  Timing is everything!

My father pulled the overdrive lever on the Mercury and we sped away as quickly as he could negotiate the curves and didn’t stop until we reached that night’s motel.  I am convinced that somewhere in the world there is a reciprocal story being told around the tables of family gatherings about the day some lunatic with Maine plates nearly caused grandpa to drive off the road when a dirty diaper hit his car!  What a day it would be to meet that person!

Timing is everything!

So the point of this story, other than perhaps to make you smile, is that timing is everything.  If we wait until a hard market to pull out the hard market solutions, then its really too late.  If hard markets were like hurricanes, tornadoes or dirty diapers (we know they happen but not when and where) then we could be satisfied with a reactionary solution, but history tells us that insurance pricing moves in a cycle, its predictable, and we know that while in the depths of a soft market is exactly when we need to be making plans for the next hard market. 

If you are a risk manager or an agent/broker, don’t get enamored with the insurance market pricing and conditions you have today.  Take advantage of them, but at least look to the future and decide how you will handle the changes that we know are sure to come and then put into action a plan to start to develop those solutions today.   A captive insurance initiative may be the solution you need.

Captives and Flight School

 

 

 

CEDAR AIR

This is your intrepid blogger preparing for yet another death defying trip into the ether in pursuit of his private pilot’s certificate.  I’m really close to finishing my studies and hopefully will be taking my “checkride” in the next few weeks.  Flying has some curious similarities to putting together a captive insurance initiative. (I know, everything has to relate to captives!)

Preflight  Advanced planning of the route of travel, the landmarks along the way, the physical conditions at the destination airport typically occur hours, even days, in advance of even showing up at the airport.  During the preflight preparation a pilot has to secure information relative to the environment that the flight will be conducted in.  Weather is an obvious factor, but that considers much more than just rain, clouds and storms.  Barometric pressure, wind speed and direction and temperatures all play a major role in flight planning.  Next comes a systems check of the aircraft.  Everything is inspected in detail to try and mitigate any in-flight conditions that would be dangerous because of a systems failure.  In order to successfully plan a captive insurance initiative we have to understand where we are trying to go and the environment in which we will be operating in so that contingencies can be planned and a go/no go decision can be made with confidence.  Planning is paramount to a successful flight as well as a successful captive launch.

Engine Start and Final Checklist  Once the engine in a small aircraft is started all the flight systems are checked again to make sure that they operate correctly from within the cockpit.  The engine function is checked at various power settings and configurations to make sure it will operate as expected during all the phases of flight.  Finally, you sit at the end of the runway, apply power and then utilize all the “stick and rudder” skills you have acquired to make the plane fly.  Once the design work of a captive is completed it is time to launch it and to start to conduct business with it.  This doesn’t happen on “auto-pilot”, it has to be watched and skillfully monitored as it takes flight.

Check points and Map References   As we turn to the compass heading we planned for to reach our destination we have laid out our course on a map that shows ground features that we can spot from the air to verify we are on course.  Planned in advance of flying we know how long it will take us to reach each of these checkpoints based on wind speed and direction.  Often things don’t turn out exactly as planned and it is necessary to adjust heading directions and power settings in order to stay on track to the destination.  In a captive initiative it is important to have the plan laid out carefully, but it is just as important to monitor progress and make adjustments as the program matures.  This is a step that so many captives fail to take.  A captive insurance program operates in a dynamic environment and that environment must always be compensated for.  Think about driving a car on a well marked highway versus flying a plane in three dimensional space with no “rumble strip” when you get off course!

Arrival at Destination  Assuming that you have been paying attention to all the details up until this point you should arrive at your destination on time, with plenty of fuel to spare and with confidence in your knowledge of the conditions you will  encounter when you get.  Its only because of careful planning, attention to detail and the adjustments made en route that you reached the destination in the first place.  A successful captive insurance initiate reaches its planned destination in the same way.  Monitoring the progress in relationship to the plan helps the captive manager and owner make tweaks to the program that will help the captive arrive at its planned goal.

So often I come across captive insurance programs that that are “off the shelf” cookie cutter solutions to general insurance problems.  In a static world they are sufficient solutions to single issue insurance buyers.  They work a lot like a AAA road trip map.  As long as you don’t encounter any difficulties or detours along the way you should be able to reach your destination.  That’s not the current business or insurance environment however.  Change is measured by the hour in some segments and it is critically important that a captive be designed to be able to change along with the environment.

Good planning, execution and monitoring and feedback will lead to a successful flight as well as a successful captive insurance program.