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By M. Michael Zuckerman, JD, MBA
Assistant Professor and Academic Director
Master of Science in Risk Management and Insurance
Department of Risk, Insurance and Healthcare Management
Fox School of Business and Management
(Editor’s note: The first part of this two-part column explores some fundamentals of captives and large deductible insurance policies. In next month’s issue of Healthcare Risk Management, part two of this special report will further explore captives and large deductibles, and it also will explore how to reach a risk financing decision that suits your healthcare organization.)
Risk financing is critical to enterprise risk management, but many healthcare administrators, including risk managers, can get lost in the financial details and decisions to be made. With the right background, a risk manager can assess all the options and make the right choice for the organization.
Let’s start with the basics about the two most popular options for risk financing.
Risk financing begins with first-dollar risk transfer, also known as buying insurance, and ends with transferring risk to the capital markets. Along the risk financing continuum are large deductible insurance plans and captive insurance companies. These are two very common and efficacious methods with which healthcare providers, small and large, for-profit and not-for-profit, employ to fund exposures to loss such as workers’ compensation, automobile, general, and professional liability.
A large deductible plan is just as it sounds. A large deductible plan can be characterized as self-insurance without giving up the benefits of commercial insurance. The insured organization buys an insurance policy that allows it to retain loss up to certain dollar amount on a per-occurrence or per-loss basis, with an annual aggregate cap on losses retained. The insurance company provides claims management and loss consulting services. The insured is able to retain that portion of the loss that is predictable, usually high frequency and low to moderate severity based upon its risk appetite.
Large deductibles are most commonly associated with workers’ compensation but also can be used for automobile, general, and even professional liability.
The key benefits of a large deductible program for the insured include the ability to employ self-insurance without regulatory approval in order to seek more control over losses, with the goal of reducing cost of risk while retaining traditional commercial company services. Moreover, the insured usually remains compliant with any state regulation, contract, or bond covenant requiring it to show evidence of commercial insurance. In addition, the large deductible insurance carrier provides a financial hedge against a catastrophic loss.
There are, however, some important disadvantages to a large deductible plan. First, the insured might have to collateralize open loss reserves. The commercial insurance company remains ultimately responsible for all loss covered under the policy’s terms and conditions. It then bills the insured for losses within the deductible, which can include indemnity and allocated loss adjustment expenses. This liability is collateralized to protect the insurer from its credit exposure: the event for which the insured cannot reimburse it for the deductible losses.
If the insured is seeking to take more control over claims management as it takes more risk, then it might be frustrated because the large deductible carrier will retain control and even resist material input from the insured into how its deductible claims are managed, reserved, and settled. I would also assert that because the large deductible carrier manages the claims within the deductible, it is responsible for Medicare Secondary Payer Reporting Requirements, unless claims management is unbundled.
The other commonly used option is a captive insurance company (captive), a wholly owned insurance subsidiary incorporated for the purpose of insuring the risks of the parent(s). Most healthcare provider-owned captives are single-parent pure captives. In other words, they insure the "related" exposure to loss of the parent. The captive requires greater administrative commitment and expense than a large deductible plan.
There are three critical characteristics that must be understood before committing to a captive.
First, it requires a commitment of capital that is dependent upon the captive’s domicile and the nature of the risk retained. Second, the captive operates outside of the commercial market place. It is not regulated as a commercial carrier requiring the parent to establish best practices for its governance. Third and most importantly, it must fulfill a risk financing goal, or why bother?!
A captive requires the parent as shareholder to elect a board usually from its senior management. The parent also must construct an infrastructure to manage the program that includes hiring a captive manager to maintain financial records and keep the captive compliant with the domicile regulations. The insurance/reinsurance broker and consultant are needed to provide technical support and Excess of Loss/Aggregate Stop Loss coverage. Other professionals to support or serve the captive include:
an actuary to certify loss reserves and promulgate premiums;
an auditor because captive financial statements must be audited prior to filing with the domicile regulator;
an insurance company lawyer to address regulatory, compliance, and coverage issues;
an investment manager to implement the approved investment policy when investing surplus and reserves.
A captive comes with no traditional commercial insurance services because it has no employees. The following services also must be replaced by the parent or by employing a third-party administrator or vendor to perform:
underwrite to set premium by exposure unit or allocate premium funding;
provide any loss prevention and mitigation consulting previously provided by an insurer;
manage asserted and un-asserted claims. (The captive usually indemnifies the insured with no duty or obligation to defend the claim.)
A captive insurance company provides several key benefits for the parent/insured, including control over how claims are managed and the provision of coverage terms and conditions, i.e., manuscripting policy coverage language to meet the needs of the insured.
Other benefits include control over how the risks are underwritten (premium development or cost allocation) and access to reinsurance to cap catastrophic losses on a specific excess of loss basis and possibly in the aggregate as well.
Depending on the risk, aggregated stop loss coverage might be very expensive, thus offering an unreasonable attachment value and providing dubious benefit. Finally, a captive enables the insured to smooth its cost of risk for high frequency and low- to moderate-severity losses over time.
The captive insurance company provides a flexible vehicle to finance exposures to loss including unrelated (third-party risk), which allows the parent to attain a strategic goal such as addressing a key stakeholders’ need for affordable insurance coverage, such as professional liability coverage to affiliates or voluntary medical staff.
This basic understanding of the two options still leaves much to be said about the pros and cons.