There are many reasons why an insured might consider being involved in a captive insurance program. Over the next few days I’ll try to unpack those reasons in a way that makes sense. Today I want to address the potential premium advantages of a captive.
I think one of the most frustrating things about captive insurance is that it is so misunderstood. There is a sense of smoke and mirror magic about how a captive might solve the risk financing ills of an insured and often captives come out of the agent’s bag of tricks as a means of reducing premium for loss-distressed clients. Let’s try to debunk some of the mystery around who should be involved in these kinds of insurance programs in today’s post.
In any insurance product offering, captive or traditional, there are several elements to cost that are standard. There is a cost associated with paying claimants for loss and the costs associated with adjusting those claims. There is a cost to the administrative work associated with the underwriting and issuance of policies and to the maintenance of compliance and regulatory issues associated with licensing in the various states. There are premium taxes, boards, bureaus and assigned risk charges levied on the policy’s premiums. While the litany of frictional costs on an insurance program are standard, the percentage that each of these items consume is relative.
Assuming that a traditional insurer has made his frictional cost as efficient as possible the one cost that has a sense of uncertainty is the costs associated with the payment to claimants for damages they sustain through the fault of insureds. Actuarial work is either Voodoo or science depending on who you talk to, but it is an insurer’s best method for determining the correct price to charge for the loss cost element of a policy. Actuaries pour over loss data and determine statistically, based on a specific set of circumstances, what the correct costs per exposure unit should be for risk in a particular market. The “Theory of Large Numbers” is the basis of actuarial accuracy. It says that the more data you pour into the analysis the more accurate the results will be for the insurance company taking risk on those results. Herein lies the good news for captive insurance!
The Dart Board Theory
If insurance companies price their products based on pooling a large database of losses in a particular industry then their pricing is an “average” for that industry. If you are an average risk then you are paying the right amount of premium based on the risk you present. If you are below average then you are getting a deal and if you are above average, you are paying more than you should be. Obviously insurance companies mitigate this inequity by offering credits and debits off of the standard price for accounts with certain attributes. These adjustments are most prevalent when there is a lot of competitive pressure either because of a soft insurance market or a lot of demand on the part of insurance companies for the type of risk being considered. If your client is in a market segment that is not highly sought after by insurance companies they can often be left behind in the pricing rush.
Back to our dartboard. Imagine a horizontal line across the center of the board. Any darts above the line are above average and any darts below the line below average. The problem here is that the pricing for all the darts is essentially the same within +/- 20%. The over-pricing for the really good accounts is being used to offset the under-pricing for the not-so-good accounts. From the insurance company’s perspective the result is good, on average just what they expected, and the actuarial staff will probably get a great bonus. The insured’s perspective depends on where they fall on the dartboard. Poor risk management is rewarded and good risk management is punished.
So, what have learned about the best clients for a captive program? They are the ones that are consistently good performers, above average from a risk management perspective and typically involved in activity that the insurance market does not actively compete for. Think trucking, medical malpractice, residential construction etc…. Now, here is where agents get it wrong. Not ALL companies in these industries should be involved in alternative risk structures, only those who have earned their chops from a risk management perspective. Certainly no client with a history of poor loss control and risk management results should consider an alternative risk structure until they have fixed their problems and seen positive result trends.
By assuming risk where there is a relatively high frequency of low severity loss potential a good risk is able to leverage their investment in risk management and loss control to reduce the cost of risk financing by a factor equal to the amount that they are better than the industry average price.