By M. Michael Zuckerman, JD, MBA
Department of Risk, Insurance and Healthcare Management
Fox School of Business and Management
(This is the second month of a two-part series on large deductible policies and captive insurance companies. In last month’s issue, Zuckerman discussed the basics about the two most popular options for risk financing: large deductible insurance plans and captive insurance companies. Part two of this report further explores captives and large deductibles, and it discusses how to reach a risk financing decision that suits your organization.)
There are pros and cons to each option when considering a large deductible policy or a captive insurance company for your organization. Deciding which is better will require assessing your particular organization’s needs, strengths, and weaknesses, and your willingness to accept risk. And you might be able to use a hybrid that offers the advantages of both.
Beginning with the captive insurance option, there are material disadvantages to employing a captive to fund risk that must be evaluated. As previously noted, the formation of a captive insurance company requires an investment of capital. The insured loses commercial insurance company services and must replace these services. Also, you might be required to use a commercial insurance company front (commonly known as a front) licensed or approved to do business in the insured’s state of operations so that the parent/insured can comply with regulatory, contractual, or bond covenants insurance requirements. If so, the front must be licensed or be an approved surplus insurance company and must carry a minimum required rating.
This arrangement requires a front fee that usually is a percentage of premium (e.g., 3% to 10% or higher). The parent or captive also must post collateral to protect the front’s credit risk and what we refer to as Schedule F requirements for admitted or approved assets to offset the liabilities created by the reinsured’s unearned premium and open loss reserves. The captive becomes a reinsurance captive reinsuring the front.
This reinsurance will be considered as a non-admitted asset by the front’s regulators, which requires collateral to offset the front’s credit risk and avoid a charge against its surplus. A major issue with fronting for the insured is that depending upon the front carrier, it might have to relinquish control over claims management, the level of reserve funding, or premium funding decisions to the front, but this situation is often negotiable.
Considering those potential downsides to a captive, many entities look instead to the large deductible insurance policy. This option offers significant advantages, starting with the fact that a large deductible does not require a front to comply with regulatory or business insurance requirements. Therefore, there is no front fee.
A large deductible also is an administratively easier path to risk retention because it does not require the insured to construct its own service infrastructure, and it does not require the need for board meetings, which usually require travel, and the development of best practices for captive governance.
That large deductible option can appeal to the younger, smaller organizations that must focus on immediate financial costs. But as an entity matures and grows financially stronger, a captive provides certain advantages over a large deductible program that might satisfy a growing risk appetite. The captive will satisfy the parent/insured’s desire to take control over underwriting, claims management, and coverage terms and conditions. Certainly, direct access to the global reinsurance market by the captive can provide for a more efficient transfer of catastrophic exposure to loss. Moreover, the insured gains the flexibility to develop a truly integrated risk financing plan to fund traditional insurable hazard and operational exposures to loss as well as financial and strategic risks, generally not insurable or difficult to insure. The captive can, therefore, become a platform for the development of the Strategic and Enterprise Risk Management Insurance Program.
This discussion of both alternative risk financing vehicles has just scratched the surface. There are issues, therefore, that need to be analyzed and managed to address the entity’s specific exposures to loss and risk environment. It is important to understand the differences between these two risk financing strategies, however, to do a proper feasibility study to determine which is more appropriate for your entity’s risk profile.
It might not, however, require a choice between a large deductible plan and a captive, understanding that the analysis might lead to the integration of a large deductible and captive into a single hybrid risk financing structure. This hybrid can take the best from both options to create a creative and flexible risk financing program. (For more information, see IRMI Online: England P, Beckie R, Anderson Kill & Olick, Insurance Services in New York. March 2009. Captive Insurance Company Reports, Fronting: The Good, the Bad and the Alternative. Dallas: International Risk Management Institute. Accessed at http://www.irmi.com.)
The whole process for developing a risk financing program begins with the entity’s risk financing goals such as meeting the parent’s ability to:
- make prompt payment of losses;
- maintain liquidity to be able to pay losses as they come due;
- manage cash flow uncertainty and variability of actual losses from expected losses;
- manage/minimize the total cost of risk;
- comply with regulatory, contract, and bond covenant insurance requirements;
- present the right “face” to key constituents, including bond holders, capital markets, shareholders, community, patients, and business partners.
Normally, an entity will use the large deductible concept to move down the risk financing continuum and begin to self-insure or retain risk to gain cash flow advantages without losing the security of commercial insurance services and protection against catastrophic loss, including variability in the aggregate actual losses from expected losses. Then the entity can move onto a captive as its risk appetite grows, and it can seek to take more control over its risk management/financing program. The question then is whether there is an opportunity to integrate a commercial large deductible insurance plan into a captive risk financing program to exploit the best of both.
The answer is “yes,” and it can be referred to as a captive issued deductible reimbursement policy, or a deductible buy-down policy.
Deductible buy down
Here is how it works (assuming workers’ compensation but the plan can work with other exposures to loss):
The insured purchases a large deductible program from a commercial insurance company such as, for example, $500,000 to $1 million per occurrence. A larger deductible might provide an opportunity to “unbundle” claims and loss prevention services, which allows the insured to take control by bringing them in house or employing a third-party administrator. The large deductible insurance carrier, again, will require collateral to secure its credit risk within the deductible. There also is a cost to this program known as the deductible insurance premium, which includes a credit for the deductible. The premium includes the Basic (insurer’s expenses and insurance charge for catastrophe coverage) and charges for Terrorism coverage, Taxes, Boards and Bureaus (state assessments).
The large deductible plan premium also includes a variable cost for claims management known as the loss conversion factor if the carrier manages the claims within the deductible.
The captive is used to issue a deductible reimbursement policy or deductible buy-down policy for a portion or all of the commercial insurance deductible. The insured must pay a premium to the captive for this coverage. A lower premium paid to the large deductible insurer will reduce state taxes and assessments because more of the premium is going to the captive. As discussed, there are also no fronting fees because the large deductible carrier provides compliance within the insured’s state(s) of operations. There might be Federal Excise Tax for premiums paid off shore, however.
The higher the deductible, therefore, the greater the savings from lower fixed costs will be. And the fixed costs of the large deductible program should be less than the costs of a fronting policy, especially when the cost of insurance coverage received from the large deductible carrier is factored into this equation. State assessments will not apply to the captive’s deductible or deductible buy-down policy. And if claims management is unbundled from the large deductible program, then the insured avoids interference in how claims are reserved and settled, which often is insisted upon by the front carrier.
In this program scheme, the insured has complied with its state’s workers’ compensation insurance requirements. For multi- state operations, this program scheme obviates the need to qualify as a self-insured under state regulation in multiple states.
If claims management is unbundled, then the insured gains control over this critical risk management function. The captive provides a funding source for its workers’ compensation retention and access to the global reinsurance markets to minimize its exposure to loss, if the deductible is higher than the insured/parent’s risk appetite would permit, which enables the captive to gain surplus relief and smooth its variation in actual loss experience over time. Similar benefits will accrue for other exposures to loss.
Learning how to self-fund
Finally, the captive is available to fund traditional insurable and non-insurable exposures to loss that might not require a front such as managed care liability (assumed via an accountable care organization), pandemic, cyber, and reputational risk. Often these exposures are difficult to measure and forecast, but the captive provides an opportunity to begin learning how best to self-fund while transferring the catastrophic risk, or uncertainty, which provides time to learn more about these emerging exposures to loss.
The analysis of cash flows and the qualitative issues would require a more detailed analysis. The real issue is that risk managers need to look beyond the differences between large deductible plans and captives. It is not necessarily always an analysis of which is more appropriate or more cost-efficient than the other. It can be a decision about how they can be used in concert to build the framework for financing risks on an integrated basis.
And when a front is required, it might be better to integrate these two risk financing techniques to blunt the often adverse impact of a front while gaining the benefit of a captive that can be used to fund a broader base of exposures to loss within the Enterprise Risk Management Framework.