By Matthew Brodsky
"We could write a whole book," said Julie Boucher, managing director of Marsh, when asked about how the use of captives has developed over four decades in Vermont.
Perhaps the book would begin like a corporate bedtime story: A long, long time ago, captives were far from mainstream. And of course the book would have with a happy ending: Now, captives are clearly a very important part of the risk management and financing strategy for many companies, large and middle market. Corporate America has seen the light, you see.
"[Captive insurance] is no longer the shadow market. It's really part of the major market," said Tom Jones, the captive tax guru and partner at McDermott Will & Emery, whose oldest captive client is 31 years old.
In the first years, said Boucher, captives were limited to primary casualty coverages, at low levels of self-insured retention or deductibles for traditional policies. Then market forces intervened, when the traditional market offered risk managers better pricing if they took on larger and larger deductibles (in their captives). Captive owners also took the initiative. They saw the value in bringing in larger dollar amounts of risk into the captives, only buying insurance for exposure outside of a predictable layer of risk.
Today, the average captive, Boucher estimated, might write a few million in coverage. But a small group of mega-captives, perhaps making up 10 percent to 20 percent of the market, have burgeoned into billion-dollar enterprises.
"Their growth is exponential," Boucher said.
Alcoa moved its offshore captives onshore in 1983, two years after Vermont's captive laws hit the books. Three Rivers Insurance Co. was captive license No. 8.
Current President John E. Wilson arrived at the captive in 1990, when it held under $10 million in capital and wrote the manufacturer's property program. His arrival coincided with the gradual blossoming of the captive, with first general liability being underwritten, then workers' compensation. The next significant step was for the captive to write employee benefits -- life insurance. They tested the water, and HR's tolerance, with an international pool in the mid-2000s. Then it did the same for domestic employees. By 2007, Three Rivers was branching out into writing personal-lines coverages for its employees, homeowners' and auto.
Wilson drove this innovation and sought out outside expertise to make it happen.
"I sort of had to search around to find somebody," he recalled about the life insurance and personal lines programs.
Part of his self-reliance comes from the fact that he is the acting captive manager -- Alcoa does not hire out to vendors -- for both Three Rivers and St. George Insurance Co., a second captive that Alcoa inherited from Reynolds Aluminum, which it uses occasionally for added capacity.
Still, Alcoa's property program is the captives' "900-pound gorilla in the room." In 1990, the captive insured up to the first $175,000 for every occurrence. After Sept. 11, 2001, the captive was taking the first $50 million per occurrence.
"We stuck our necks out," Wilson said.
And it's worked. The captive now has a net worth in excess of $100 million and wrote $62 million in premium in 2012.
Captives traditionally underwrite general liability, professional liability, workers' compensation, property and auto liability coverages. Today's captives continue into more exotic uses.
Bob Gagliardi, managing director of AIG Insurance Management Services, sees captives now writing affinity programs and employee risks.
"The types of coverage that find their way into captives keeps expanding as well as the types of companies that access the market," said Dan Towle, director of financial services for Vermont's Department of Economic Development.
"Terrorism and cyber coverage are expanding, and nanotech coverage is a new frontier.
Example: Telecom Insurance Group
The Telecom Insurance Group formed 31 years ago as the third license holder overall in Vermont to write those standard lines such as property, crime, GL, auto and workers' compensation, according to its current president, Peter Elliott. It was a successful, albeit perhaps sleepy, captive, up until some problems arose in 2001. Its fronting carrier of 13 years decided to end the relationship, and its next fronting carrier terminated its arrangement within a year. This coincided with the first hard spike in insurance in a long time. The captive gained Great American as its next fronting insurance company, but it found itself in uncertain waters.
"All of a sudden, we had to re-engineer everything," said Elliott, who became CEO and president in 2002 in the midst of it all. They had to reduce expenses, alter staffing levels and management, and reconfigure its claims process.
"We not only survived in that time period, we started to thrive," he said.
The goal for the captive became differentiating its coverages and services versus traditional market insurers and others in the captive space. On the services front, the captive continues to mine data to put forward actionable intelligence to insureds and prospects, to help them know when to maintain risk, accept risk or push risk to a third party.
On the coverage side, Telecom Insurance Group became a pioneer in network security data liability and errors & omissions, which it has written for four years and now packages together in a modular approach.
Can't Operate Without It
Jim Girardin, president at boutique firm Amethyst Captive Insurance Solutions, also said that "hidden risks" and "operational risks" are driving this evolution.
Girardin said risk managers used to talk about operational risks: "It would be discussed at renewal and put to bed." Now, it is an everyday discussion. Risk managers are looking for operational exposures that can be quantified and baked into the captive -- everything from supply chain, cyber, tax liability, regulatory and compliance risks, management talent risks and emerging technology risks.
Risk management and finance are now "joined at the hip these days," he explained.
Though Girardin added that perhaps only 10 percent of captive owners are including integrated risk in their captives, he said it is driving the discussion for larger companies.
William W. Johnson, risk financing manager for Hallmark Cards Inc., is humble when it comes to that company's captive, which was formed in the mid-'80s.
"We are squarely at the low end of the sophistication chart," he wrote in an email to Risk & Insurance®.
"As a corporation, we like to maintain a low profile and do not seek to develop sexy, cutting-edge programs unless they offer a clear and material advantage over other options."
But he did help one Hallmark subsidiary with stop-loss coverage for its employee benefits program. It also wrote a one-off program for lawyers E&O for its staff lawyers.
What he considers the everyday activity at its captive is also worth a look. Most of the captive's premium comes in the form of retention buy-down coverage for its subsidiaries.
"It allows us to achieve the economies of scale of placing all our operations in high-deductible corporate programs while at the same time providing smaller subsidiaries with balance sheet protection from high retentions," Johnson explained.
The more fluid and surprising aspect of captive usage is the one-off applicability. With Marsh clients, for instance, Boucher has seen captive owners approach any business issue with the captive in mind as the solution.
"There's a lot of discussion now of 'what else can I do with my captive' and a lot of sharing of ideas," Boucher said. "They see very few limits to what the captive can do."
And this move toward problem-solving is driven more than ever by risk managers bringing a need to the market, Jones said.
Example: Tall Pines
Tall Pines Insurance Co. was formed 27 years ago as Vermont Captive License No. 16 with $250,000 in original capitalization, said its president Steve McElhiney. Since then, it's grown to $9 million in capital net of dividends, with a 14 percent compound annual growth rate. That accretion of capital tells a success story in itself.
The other aspect is the captive's flexible nature. Its primary job is to provide global manuscripted property/casualty insurance programs for the subsidiary's parent company, industrial conglomerate NL Industries. But as McElhiney explained, he and his team are always looking for ways to retain new risks when the cost-benefit makes sense.
For instance, in 2010, they used the captive to put in place an appeal bond to handle a corporate verdict appeal. The appeal ran its course, and after the proverbial dust settled on this one-off captive usage, the captive got its money back and saved the corporation $200,000.
"I think that's illustrative of how we approach our captive," McElhiney said -- to maximize the use of what he considers a modestly sized captive.
A Healthy Leap Forward
Evolution often occurs incrementally, but in captives, as in nature, great leaps forward do occur. Jones in particular sees a speeding up over the last five years, with the potential for even more velocity going forward.
He points to health care reform. Not only will employers be turning to captives in greater degree to handle the changes -- case in point again, those stop-loss captives -- but the health care industry itself will drive innovation and growth in captives.
For instance, the setting up of accountable care organizations (ACOs), as part of health care reform, as tools to provide quality care to Medicare recipients, will require a risk management standard across the ACO, which will drive more active and larger captives. After all, Jones said, health care reform at its core is about better care at cheaper prices. And captives at their core are designed to improve loss histories and to do it less expensively.
Humana is in its fourth decade of operating a captive, and into its third as the epic poster child for standing up to the IRS. As Carolyn Snow, director of insurance risk management, reminded us in an email, Humana is the "IRS case for captives," which pitted the company against the tax man in the mid-'80s.
But as Snow and George Bauernfeind, vice president of tax for Humana, shared, the captive has grown with its parent. Humana started with hospitals and employer providers, and the captive started by underwriting medical malpractice, GL and E&O. In the mid-1980s Humana entered the health insurance business, and the captive expanded too.
"With our acquisition of clinics, work site solution and urgent care companies, as well as primary care practices, the business model now moves towards integrated health care delivery. Our exposure and the captive will change accordingly," they wrote.
"The flexibility of a captive allows us to grow our business and make acquisitions without major market or coverage concerns," Snow and Bauernfeind wrote.
Who has made this industry growth possible? Part of the success of the evolution has been the fact that captive insurance is a community.
"There is a lot of cross-pollination," said Jones. "The captive industry is a collaborative group in general."
A lot of this intellectual ferment comes from the captive owners, but as Vermont's Towle is quick to point out, the Green Mountain state has maintained its status as an industry leader because of the intellectual capital of the industry infrastructure -- the regulators, attorneys, accountants, managers and other consultants and service providers.
Another way to think of the captive industry is to liken it to a skyscraper.
"I think owners have been getting more and more sophisticated, primarily because the foundation has been poured by those that came before them," said Mike Meehan, a consultant at Milliman.
"Essentially, for those captives that are just being formed, the options available to them at start up, both in what lines of business they will insure, and where they will domicile, have grown substantially."
The rapid expansion of captives into the middle market (discussed in more detail in The State of the Market on page A10) -- with owners tapping complex structures like pools and cells and even writing third-party risk to assist with IRS rules, as reported by many experts -- can largely be credited to the hard work and innovation of the captive pioneers.
"With middle market clients finding ways to achieve their goals and structure the programs in ways to meet IRS requirements, I believe by default the industry is becoming far more sophisticated and complex," said Daniel J. Kusaila, a tax partner at accountancy Saslow Lufkin & Buggy LLP.
Don't expect that trajectory to end any time soon.
MATTHEW BRODSKY is the editor of Wharton Magazine.
April 12, 2013
Copyright 2013© LRP Publications