So, how is insurance like a roller coaster?
Coming back to the office from a visit with a client today I drove by Geauga Lake Amusement Park. Living and working in close proximity of a noisy venue like this one has had its ups and downs (no pun intended). The park is full of history. In 1887 it was a popular picnic and fishing spot accessible by trolley from Cleveland. The old rail station stood on Depot Road around the corner from the office until just a few years ago when it was demolished. In 1925 the park boasted the largest wooden roller coaster in the world. In 1927 Johnny Weissmuller (Tarzan) broke the 220 yd world freestyle swimming record in the newly opened Olympic swimming pool. In the 30’s a dance hall was added where big bands like Guy Lombardo regularly entertained pre-war crowds. The park closed at the end of last summer and the rides are being sold off and the grounds and the lake are on the auction block. Not a very glamorous end for an historic landmark.
So what does all this have to do with captives? The traditional insurance market is subject to pricing cycles. We are currently experiencing the bottom of the soft market, but any insurance professional who has been around longer than 10 years knows that the hard market is coming. Insurance buyers might say that the soft markets are good and hard markets are bad, but I would like to suggest that any deviation from the average makes for a difficult environment to plan strategically and manage a business.
Market pricing swings are like the roller coasters at amusement parks (I told you I would make a connection!). Exciting for some, bearable for others, and if you’re like me they are enough to lose your lunch over. Who needs that kind of excitement when it comes to running a business?
Traditional insurance cycles are deep because for the most part insurance companies don’t learn from the past. They chase market prices down hoping to accumulate market share efficiencies and offset undewriting loss with investment income. The investment market goes south and all of a sudden they are bleeding cash. These conditions are sometimes compounded by some type of catastrophic loss scenario that really catches them by surprise. (911, Katrina/Rita/Wilma) The reaction is to knee jerk prices and we start the upward trend of hard market pricing.
Why is a captive a different situation? The largest single component for insurance pricing, about 60% of the total depending on retention, is the loss funding element. The loss funding is determined by considering the account’s specific loss history for the past five years or so and applying standard trending and development factors. The remaining costs are for administrative services and there is little variability in them other than for wage inflation. Notice that we haven’t said anything about competitive market pressures yet! If you read yesterday’s post you know that above average risks are best suited for a captive mechanism. Their loss history already affords a “discount” price so without compromising loss funding we have a competitive product that is prepared to pay losses at the historic levels. Thus we end up with a very stable pricing platform that may have dips and curves but more like the ones in kiddy land than the ones on the Big Dipper. If the account happens to have a bad year it’s impact is mitigated by the other 4 years in the loss analysis.
Wait a minute you say! Doesn’t a captive have to buy reinsurance, and isn’t reinsurance subject to the wild gyrations of the rest of the insurance market? Well, yes. But lets look at the math. Let’s assume a $1M liability limit and the captive retains the first $250K per occurrence. Depending on the line of business the reinsurance cost for $750 XS $250 might be 15% of premium. A 50% increase in a 15% line item only changes the overall pricing by a factor of 7.5%. Even a 50% increase is pretty unrealistic since this is a reinsurer that you have a longstanding relationship with and who has probably done very well on your risk.
While the market lows may not be as low as the traditional market, the highs won’t be either. The pricing swings are modulated and through a captive you can offer your clients a much more predictable environment to run their business in.