Middle Market: Why Group Captives Make Sense for the Midmarket
The advantages of managing corporate risk using a captive insurer are well-known: control over administrative costs, reduced or refunded premiums and, in many cases, tax-efficient capital usage. As is the case whenever a company retains its own risk, captives allow companies that invest in preventive risk management to accrue benefits. Generally speaking, however, captives have typically been used by larger companies because midmarket companies usually do not have sufficient premium volume to set up cost-effective single-parent captives.
Let's define the middle market as those companies with total premium volumes between $100,000 and $2.5 million. While it is true that captives are typically outside the reach of such companies, there are a few important exceptions to this rule.
For example, Internal Revenue Service section 831(b) allows insurance companies?including captives?collecting no more than $1.2 million dollars in annual premium the option of being taxed solely on investment income. Thus the captive pays no tax on the premium income even though the company paying the premium into the captive may be able to deduct it.
Such a strategy can be particularly effective for companies with risks that are unlikely to occur but for which insurance is either too expensive or simply doesn't exist. However, it's not just as easy as putting a million dollars in a bank account and calling it an insurance company--there are hurdles, put in place to prevent 831(b) from being used simply as a tax shelter.
One way to convince the IRS that the captive is really an insurance company is to insure someone else in addition to the parent company; but taking on the unrelated risk is, in a word, risky, especially for a small company.
Another exception involves companies "renting" space in a captive held by another organization. In this situation, the assets of each participant are separated from one another, yet there is some system in place whereby risks are shared.
Jurisdictions have names for such a system: rent-a-captive, protected cell captive, segregated account captive, sponsored captive and so on. These systems can be complex and often do not actually solve the "size" problem encountered by the middle market.
Finally, there are special provisions under the 2002 Terrorism Risk Insurance Act that can make establishing a captive attractive for midmarket insureds. TRIA is up for renewal this year, so the details may change.
Despite these exceptions, midmarket companies still lack the range of insurance options available to larger entities--meaning that the group captive strategy may be attractive to many of them.
A group captive is established by a group of like-minded companies rather than a single company. The companies are usually in the same or similar industries and need similar risk coverage. Through participation in a group captive, each member can achieve benefits that would not have been available had it tried to form its own captive. In order for the group as a whole to gain from the operation, its members should have a better risk profile than what is suggested by commercially available insurance premiums.
The captive premium, at least initially, could be similar to what is available commercially. If the group is better than average, it will get the money back. That said, companies that choose the group captive option solely due to an initial premium reduction are not ideal members, because they are more likely to leave the captive if commercial premiums drop.
THREE INSURANCE LAYERS
Group captives often operate with several layers of insurance--a layer of self-coverage that insures claims up to a certain amount (the "frequency fund"), a collective financing vehicle for claims that are higher than the threshold (the "severity fund"), and a third level of commercial reinsurance for claims beyond what the captive can bear. When a member joins and pays the premium, a particular amount goes into each fund.
For example, consider a group captive owned by five plumbing companies, into which each pays a premium of $400,000 (which includes $100,000 for administrative/claims management expenses). Furthermore, let's say that the remaining premiums, of $300,000 per member, are split evenly into the three types of funds.
The frequency fund covers payments on each claim up to a dollar amount. For example, if the frequency fund claim limit is $100,000, then payments up to $100,000 for each claim are taken out of the frequency fund. Each member has its own portion of the frequency fund and the risks are not shared.
In our example, each member contributes $100,000 to the frequency fund, and we assume that the frequency fund threshold is $100,000. Imagine that AAA Plumbing has three $10,000 claims in a year. Each claim is paid from AAA Plumbing's frequency fund, $70,000 less than AAA Plumbing's frequency fund premium.
Busy Bee Plumbing, on the other hand, has four claims of $25,000 each--and one more for $10,000. Since each claim is under $100,000, they are all taken from the frequency fund--but the total amount of claims exceeds the total of Busy Bee Plumbing's frequency fund contributions by $10,000. In this case, the captive pays the excess amount but bills the unlucky member at the end of the year.
Because of this setup, relatively small, controllable risks remain the responsibility of individual companies. If one company has poor safety practices that result in many small claims, the other members will not suffer. The frequency fund creates an incentive for members to reduce risks wherever possible and effectively serves as a deductible for each member.
Larger, less predictable claims are covered by the severity fund--as with the frequency fund, up to a predefined limit. In contrast to the frequency fund, however, the severity fund is pooled. Any claims made against it are paid from the pooled severity fund premiums for that policy year; any excess is billed to the members.
Going back to the example, our five companies each contributed $100,000, so the severity fund consists of $500,000. It would pay claims over $100,000 but under some other limit--let's say, $300,000. If Charles Plumbing has a claim for $225,000, the first $100,000 is paid by the frequency fund and the remaining $125,000 is paid in full from the severity fund, leaving $375,000 in the severity fund.
If it's a particularly unlucky year for plumbing companies, Delta Plumbing might have two additional claims: the first for $475,000, of which $100,000 goes to the frequency fund, $200,000 goes to the severity fund, with the balance being paid by the commercial reinsurance market, and the second claim for $300,000, of which $200,000 goes to the severity fund--causing the severity fund to go "into the red" by $25,000.
Because the portion of risk covered by the severity fund is truly shared, the $25,000 excess is billed back to the members in proportion to what they originally paid into the fund. If they each paid an equal amount, as in our case, this excess would be split equally among them. If some members paid larger premiums to begin with--representing a higher assumed level of risk--then they would be assessed a larger amount of the excess claims. While it may seem counterintuitive at first, any other arrangement probably would not represent pooled risk--and might not qualify as insurance at all.
The third level of the midmarket group captive is a commercial reinsurance policy. It covers claims above the severity fund limit--in our example, above $300,000. In addition, most group captives have an "aggregate," representing a total amount of claims above which the captive does not pay claims. The aggregate limit is typically some multiple of the frequency fund and/or severity fund premiums. If the total claims for a year exceed the aggregate, the members would be assessed the difference between the total premiums and the aggregate, and the commercial policy would pay the amount over the aggregate.
If it is well designed, the benefits of a group captive are similar to those gained by a single-parent captive. First, assuming the group captive's members have lower-than-average risk for their industry, they will have fewer or less expensive claims and they will save on premiums. If the claims are low enough over time, members may even get some of their premiums refunded in the form of dividends.
Of course, if the group turns out to have higher-than-expected risk, then the members will end up paying even more than they would have on the open market. Careful underwriting--or at least careful thought--is required to gather the right group of companies together.
Further savings come from the fact that group captives are tax-efficient. Just as if a member had purchased a full commercial insurance policy, the premiums paid to a group captive are usually tax-deductible.
Finally, group captives can be an effective way to protect against risks for which insurance is either prohibitively expensive or simply not available on the open market. Given the potential rewards for companies that manage risk better than the average for their industry--as well as for insurance companies looking to segment risk in an increasingly competitive marketplace--midmarket companies can derive a significant advantage from creative insurance vehicles.
LINDA NICHOLLS and JOEL CHANSKY are actuarial consultants with the Boston office of Milliman. Both specialize in alternative insurance vehicles.
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August 1, 2007
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