It’s the Tail that Wags the Dog
Some coverages fit a captive program better than others. There are two revenue streams from a captive program. Underwriting revenue is earned when the losses and expenses in a program are less than the premium paid. Investment revenue is earned based on the investment of the loss funding until it is needed to pay losses.
If a captive insurance program attempts to minimize the premium paid by its parent for coverages then eventually any excess premium will be wrung out of the deal and there should only be enough premium to pay costs and losses, in other words underwriting income will become zero. This makes the potential of investment income an important issue.
In insurance parlance the “liability tail” is the length of time it takes to bring a claim from reporting to paying a claimant. Some coverages have a very short tail. For instance, if you experience a kitchen fire in your home you are very interested in getting the repair work done quickly so that you can move back in. The shorter the time to effect repairs the better. Property coverages then have a very short tail. Liability coverages like Workers’ Compensation, Auto, General and Professional all have relatively long tails.
If your captive passes tax muster as a “real” insurer then you are able to recognize reserves for losses as an expense. Combine this with the fact that you still hold the cash for these expensed losses and that the cash is invested until it is needed to pay the claimant. The longer you hold that cash the better the investment return, hence the reason why Its the Tail that Wags the Captive Dog!
Now, does this mean that you should never include property coverages in your captive? No, not at all. There may be other very good reasons for property to be included that have to do with an overall strategic risk management plan. I’ll post on that sometime in the future.
