authored by Allen R. Prunty, Robinson & McElwee PLLC


West Virginia employers have new options to reduce their workers’ compensation costs. The transition to an open marketplace for workers’ compensation insurance was complete on July 1, 2008. This new environment enables many employers to negotiate with different insurance companies in an effort to lower their premiums. Competition among insurance companies has resulted in savings for many employers. Captive insurance is another option to reduce workers’ compensation costs.

A captive insurance company (“captive”) is owned by a single company or a group of companies. Captives provide insurance to their owners. Captives frequently insure workers’ compensation, general liability, automobile liability, professional liability, officers and directors liability, and employment practices. There are no limitations on the risks that can be insured by captives.

Captive insurance is not a new concept. R. Wesley Sierk, III, in his book Taken Captive (2008), reports that the roots of captive insurance date back to the 1800s. There are today more than 6,000 captive insurance companies worldwide. According to Mr. Sierk, these companies underwrite $300 billion in risk, collect more than $50 billion in premiums, and hold more than $60 billion in capital and surplus.

Why consider forming a captive?

• Captives avoid swings in the traditional insurance market and lower insurance costs.

The insurance industry is cyclical. The market is considered “soft” when coverage is readily available, which increases competition for clients and drives down premiums. The flip side is a “hard” market. During a hard market premiums rise and some insureds can not obtain or afford insurance coverage. Hard markets typically follow catastrophic events such as Hurricane Katrina or 9/11, and big investment losses caused by events such as the WorldCom bankruptcy.

Captives take advantage of a soft market by reinsuring a greater percentage of their liability, which results in increased reserves and investment income. During a hard market, captives retain a greater percentage of their risk to minimize the effect of increased reinsurance premiums, and they maintain coverage for owners who find traditional insurance unavailable or prohibitively expensive. Over the long-term, these practices result in stable premiums that are less than what a captive owner would pay to a traditional insurance company.

Traditional insurance companies must account for a broader market than captives, which means that the premiums paid by companies with good loss histories are inflated in order to subsidize higher risk companies. Captive premiums, which are deductable as a business expense, reflect the claims experience of captive owners instead of subsidizing companies with a less favorable loss history. At least 90% of a captive owner’s premium is based on its own loss history.

•Captives capture the profits earned by commercial insurance companies.

There is a reason why the insurance industry is at the core of Warren Buffett’s fortune. Healthy insurance companies are very profitable. They profit from their underwriting business and from the “float” of that portion of premiums reserved to pay claims. A 25% return on the investment of this premium float is common. Mature captives (i.e., more than 5 years old) can earn additional income by selling insurance to third parties. The income earned by a captive can be used either to reduce future premiums paid by its owners or returned to the owners as dividends.

• Captives provide customized policies and have direct access to the reinsurance market.

Traditional insurance often fails to meet all of the specific needs of businesses because of standardized policy terms, policy exclusions, and coverage limitations. Captives, on the other hand, have the flexibility to provide custom-made policies. Captive owners know their business better than a commercial insurance company and so they can individually tailor their policies to meet their unique needs. The coverage available from a captive is limited only by the needs and imagination of its owners. For example, captive policies can cover unrelated risks and risks that a traditional carrier will not cover.

A captive’s flexibility is due in part to its direct access to the reinsurance market. This access avoids middleman costs, which reduces the premiums paid by captive owners. Captive owners usually purchase individual umbrella coverage for catastrophic losses in excess of the captive’s loss reserves and reinsurance limits.

• Captive owners control claims administration and litigation policies.

Captive owners define the captive’s underwriting, claims management, litigation, and settlement policies. A captive management company provides guidance on these issues and usually manages the day-to-day operations. Captive owners do not have to worry about fighting with their insurance carrier over coverage issues because they have defined the scope of their insurance coverage.

Captive owners have a strong incentive to focus on loss prevention and control. All of the owners of a captive are motivated to keep losses to a minimum because effective risk management (e.g., mandatory safety programs, drug and alcohol testing, and effective claims reporting and closure policies) contribute to lower premiums and more investment income.

Even self-insured companies should consider captive insurance.

There are several reasons why a self-insured business may want to consider a captive. Captive owners deduct their premiums as a business expense. Captives take a tax deduction for the entirety of their reserves, which is a significant tax advantage over self-insurance. Self-insured businesses must carry reserves on their books ad infinitum, while captive owners pay their premiums and “walk away" from their risk. Self-insured businesses do not have direct access to the reinsurance market. Finally, a captive can take up lines of insurance for which a self-insured business is paying premiums to a commercial carrier.

Conclusion

Captive insurance is not a viable alternative for every business. A capital investment and fronting costs must be considered, although there are ways to eliminate these requirements. Captive owners must be financially sound with good risk management practices, better than average loss histories, and a long-term view toward managing their insurance costs. Businesses with loss histories that are more than 35% of their premiums are not the best candidates for a captive. Captives have been established with a total premium volume of $500,000, although $1 million in premiums is more realistic. Individual companies interested in forming a group captive should have at least $200,000 in annual premiums. This premium volume can be reached by adding general liability and auto coverage to the workers’ compensation premium.

With all of this said, companies interested in the captive insurance concept should contact a qualified consultant to discuss a feasibility study. It is likely that captive insurance is the right choice for many West Virginia employers.