Posts Tagged ‘captives’

Will a Financial Tsunami Hit the World’s Insurance Markets?

March 17, 2011


By now no one on the planet is a stranger to the disaster in Japan that continues to unfold as I write this.  A devastating 9.0 earthquake that triggered a massive tsunami has inflicted on northern Japan a disaster of biblical proportion.  Even now unfolding are potential disasters at 4 nuclear reactors impacted by the earthquake.  Fuel rods have been left exposed, the containment chambers cracked open, and radioactive gasses are leaking into the atmosphere.  The magnitude of the disaster continues to grow by the hour.  Deaths are conservatively being estimated at 15,000 people although there are whole towns that are unaccounted for and this number will likely climb.

As bad as this is for the Japanese people, it will soon have a ripple effect across the planet.  Japan is the third largest world-wide economy and its government, businesses and people are one of the largest investors in the United States.  Those investments are being called back to begin funding the rebuilding of Japan’s infrastructure.  With that lending capacity out of the market the cost of borrowing will start to rise.  Boston-based AIR Worldwide, an insurance catastrophe modeling firm, has estimated the insurance costs associated with just the earthquake to be upwards of $35 Billion.  The overall costs will go up when the effects of the tsunami and the potential for radioactive leakage from the troubled nuclear plants are factored in.   Herein lies the second impact on the global economy.

Insurance analyst had estimated that it would take a $50B event or combination of events this year to turn the insurance market away from its decade-long pricing slide and trigger a hard market response.    The last 4 months have seen a $10B earthquake in New Zealand and another $10B in losses associated with continued unrest in the Middle East.  The Japanese earthquake and tsunami will easily tip the scales above $50B in just the first quarter of 2011.  If indeed the analyst are right we may see an unprecedented increase in insurance prices due to capacity problems with the global reinsurance market.

Captive insurance programs have often served as a refuge when overall insurance market prices increase.  The critical aspect to involvement in a captive insurance program now is the timing.   In order to derive maximum value to a captive program you must initiate it ahead of the crisis.  Businesses that have historically been at the forefront of risk financing instability like transportation, energy, manufacturing and medical professional liability need to take immediate action if they want to mitigate the impact of this global shift in insurance costs.  Captives, and other alternative risk structures, can provide insurance capacity where there is none in the market.  They can also mitigate your exposure to rising insurance costs.

If you are interested in discussing how an alternative risk program can benefit your organization we have a team of consultants and advisors ready to meet with you.  Contact us at 440-264-9992 so that we can direct you to one of our team members.


House of Cards- 831(b) Small Insurance Companies

April 5, 2010

Don’t get me wrong….I’m a big fan of 831(b) Small Insurance Company structures.  Under this unique IRS rule the underwriting income for certain small insurance companies is tax-free to the insurance company.  Provided the ceded premium to the company is under $1.2M annually and there is real insurance risk transfer and risk distribution happening,  the company would only pay taxes on its investment income.

The difficulty isn’t in the structure, its how its being used.

The ancestor of 831(b) was the 501(c)(15) insurance company.  Provided there was real risk transfer and distribution and the ceded premium was less than $600K per year this company paid no taxes on its underwriting or investment income.  A nice structure for legitimate insurance transactions.  The structure was abused be zealous financial planners who “stuffed” millions of dollars of capital into the insurance company to support a small amount risk premium.  It wasn’t about insurance at all, but a mechanism to defer taxes on investments.  At the end of the day the IRS nailed down the abuses in 501(c)(15) companies and they have faded in popularity as a result.  This same crowd sees an opportunity in 831(b) to defer income on the underwriting of business risk.  It has become the financial wealth management tool de jour, only there are some problems associated it.

Typically these programs are put together upside down.  What I mean by that is that they are created primarily for the purpose of deferring taxation and not for any legitimate risk management purpose.  In order to make this financial planning tool work the consultants that use them must overcome two hurdles.  How do I create a risk coverage that I honestly hope will never have a loss and how do I create a risk sharing mechanism so that my client’s program satisfies the letter of the law regarding real insurance?   The first question is answered by creating coverages like terrorism coverage for medical practices or pandemic coverage for a manufacturer or stubbed my toe on the first Thursday of the month coverage (I made that one up!).  See, the question isn’t whether or not it could ever happen and if it did would it represent a significant risk to the policy holder, but rather that there is a policy that has been issued that I can put premium into my captive for.  Remember, this isn’t about risk management, it’s about tax and wealth management.

The second question is answered by allowing all the 831(b) companies that I have put together to share risk with each other on these sham policies.  Here is where the dangerous upper levels of the house of cards is built.  Should just a couple  of the coverages in one of the programs be challenged it could literally take down every one of the captives that share that questionable coverage’s risk.

I know, it doesn’t really sound like I’m really a big fan of 831(b) structures at all does it!  Well, I am, under certain conditions.  831(b) is an insurance company.  It’s business should be conducted like an insurance company; assuming real risk in exchange for a reasonable premium and for a legitimate purpose.  The process should start with risk and insurance and if there is some tax deferral advantages as an aside, then all the better.  It has to be built right side up and not purely as a scheme to beat the tax man.  We saw how well that went for the owners of 501(c)(15) companies, and if we think that the IRS won’t be looking at abuses in 831(b) as a means to enhance revenue we are only fooling ourselves.  If 831(b) is going to stand up to IRS scrutiny it has to be built on a foundation that is rock solid, with legitimate insurance coverages that can be shared without worry with other similarly structured captive insurance entities.

If you are contemplating this kind of structure at least seek out the services of an insurance professional who can point you in the right direction from a risk management perspective.  831(b) is a powerful tool when used properly, but if will only yield frustration and heartache if it is abused.

The Broomball Coefficient of Anticipation

January 18, 2010

I graduated with my BS in Business from Lake Superior State University in Sault Ste. Marie, MI.  Located in the north-eastern most corner of Michigan’s Upper Peninsula, it is a place of serious winter and unless you figure out things to do when it’s cold out you will never venture far from your dorm for months at a time.  The history of broomball is sketchy, but it is enough to say that it is one of those ideas that creative folks in cold places hatch to have fun in an otherwise hostile environment.

Broomball is played on the ice and has goals similar to hockey.  The players wear tennis shoes and use what looks like a corn broom cut off at the stitches to direct a small ball into the goal.  The action is much like hockey with one notable exception.  Tennis shoes don’t get any traction on ice.  That lack of precision in movement contributes to a need for planning plays that goes beyond anything in hockey.  Beside the typical dynamics at play in any sport, now you have the reduced ability to execute precisely.  You must introduce a “factor” into each play that actually causes you to execute before the precise moment you would normally execute the play because the ice is slippery.  In order to figure out just how much anticipation is needed you spend a lot of time on your butt or sliding past the goal or shooting and missing altogether.

Sounds like the real world doesn’t it!

When you are planning risk transfer and risk financing mechanisms there are numerous financial, actuarial and catastrophic loss models that can help you to make sound decisions; but at the end of the day there is a lot which cannot be completely controlled.  I call this the “Broomball Coefficient of Anticipation”.

The reason why insurance is a prime example of this coefficient in action is that its modeling is almost exclusively retrospective.  Insurers price off of historic loss histories, expectations of future catastrophic loss are based on where they have happened in the past, essentially navigating forward by looking in the rear view mirror.  Don’t get me wrong, since none of us have crystal balls to predict the future we have to have something to hang out hats on and, at least statistically, the past has been a pretty good indication of future events.

If we were operating in an environment where we had the sure footing of a manicured baseball diamond or the turf of a football stadium or the pitch of a soccer field we could execute our plays instantaneously and with precision.  But in insurance we are playing on ice in our sneakers.  One of the tenets of the “Broomball Coefficient of Anticipation” is that if you wait until all the scientific loss models show its time to execute, it’s already too late.  That’s why you see the insurance industry as a whole constantly being reactive instead of proactive with just a few exceptions.

Of all the segments of the insurance industry, alternative risk is the most likely candidate to take the Broomball Coefficient and use it to best effect.  Captive insurance companies are the most efficiently capitalized, agile and responsive insurance mechanisms in the industry.  Because they are responsible for serving the needs of a single client or a very small clientele they can quickly execute on initiatives to meet strategic goals and can often do so in anticipation of need as opposed to in response to a need.

The only thing lacking to most captive insurers is a partner that knows how to execute while running full speed on ice in sneakers.

Email me at if you would like to discuss this more.

Education is Key to Execution

January 8, 2010

Education is the key to being able to effectively implement and execute a sophisticated risk management regime like a captive insurance program.  This doesn’t only apply to the accounting and insurance professionals that are involved in the day-to-day operations of these types of programs.   It also applies to the risk managers who represent companies that own them and to insurance producers that help to set them up.

There are several venues to learn about captives and how they are used.  The International Center for Captive Insurance Education (ICCIE) provides an online platform of coursework that leads to the Associate in Captive Insurance (ACI) designation.  I am on the faculty for this program and it is an excellent course of study for accounting, insurance and business professionals to get a solid foundation of captive insurance concepts.  You can find more information at

Several associations provide annual conference opportunities that are full of great educational content.  The Vermont Captive Insurance Association, the Bermuda Captive Conference and the Cayman Captive Conference are all venue-oriented educational experiences and are excellent for delivering timely information on emerging industry issues.

For more general insurance and underwriting educational topics there are several continuing education websites that can provide the ongoing training needed to maintain licenses and credentials.  I sponsor one of these websites at

Finally, industry service providers organize conferences that have client education as their primary purpose.  USA Risk Group (, the largest independent captive services company, sponsors an annual educational conference for captive industry participants.  This type of conference is typically more focused on the practical nuts and bolts issues of captive insurance and the smaller group results in better access to speakers and service providers.   The conference is highly rated by participants.  This year’s conference will be held in Charlotte, NC at the Ballantyne Resort, May 26th-27th, 2010.  You can contact me by email at for specifics on registration for this event.

Education in and of itself is worthless.  It’s not in the knowing, but rather in the application of the knowledge that yields results.  These educational opportunities will give you what you need not only to understand the concepts of captive insurance but to apply them to your circumstances.

Execution is always the factor that divides the successful and the wannabe.  Gain the knowledge you need but don’t forget to deploy that knowledge in a meaningful way to solve risk related problems for your organization.

Blowing the Dust Off Your Captive’s Business Plan

September 30, 2009

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 and I would be happy to contact you to discuss it.

All Your Eggs in One Basket

September 4, 2009

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

April 29, 2009

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!

Risk Selection- The Smelt Dip Dynamic

August 20, 2008

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.

Riding the Roller Coaster

March 27, 2008

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.