Self-Insurance - Getting It Right

This article first appeared in the Captive Review’s How to Start a Captive 2020 supplement.

Robert Gagliardi of AIG explains why self-insurance should be thought of as a long-term solution, not a knee-jerk response to rising commercial insurance rates.

Commercial insurance rates in the US continue to harden, with pricing up by an overall average of 18% in the fourth quarter of 2019, according to Marsh. The impact of natural catastrophe losses and increasing concern over litigation trends are key drivers behind the upward trend.

There are certain pockets within professional liability, healthcare and directors’ and officers’ liability where prices have increased by more than 20%, making it even more challenging for insureds to secure the coverage they need from the commercial market.

Increased captive formations were particularly evident during the workers’ compensation and medical malpractice crises of the 1970s and 1980s, where the absence of capacity and punitively high rates drove the formation of captives in centres such as Bermuda, Barbados and the Cayman Islands. The market correction that followed Hurricane Andrew in 1992 is another example of a change in market conditions that prompted growth of large singleparent captives.

No magic bullet

Following this most recent trend, AIG’s captive solutions team has seen an uptick in enquiries from mid-market companies and brokers interested in its captive services offerings over the past 18 months. While some of those enquiries have been prompted by rising commercial insurance pricing, it is clear that captives are no longer considered a temporary risk financing tool for managing peaks within the insurance cycle.

In fact, the past two decades have shown that captive formations occur during all phases of the insurance cycle and through throughout varying economic climates. The traditional reasons for self-insurance – including pricing corrections in the commercial market – remain relevant drivers for captive formations. However, alternative risk transfer has developed into a longer-term, more strategic tool for sophisticated companies to benefit from financial and coverage benefits over time.

Existing captive owners are likely to expand the use of their captives during a hard insurance market, particularly for distressed and difficult-to-place classes of business. But the benefits of self-insurance (including having greater control over group risk financing and risk management, as well as customisation of loss control and claims mitigation strategies) remain relevant when prices soften again.

While current conditions are certainly ripe for considering the benefits of self-insurance, it is important to emphasise that captive insurance is not a magic bullet with which to circumvent hard market conditions. Certainly the most successful insurance programmes maintain a balance of traditional and alternative risk transfer, with a strategy that adapts to changing market cycles. During the recent soft market cycle for instance, captives were used to incubate emerging risks, such as cyber and environmental liability.

Many captive options

Captive insurance is not a solution that suits all companies. Those considering a wholly owned captive need a loss record that is considerably above average for their peer group and a mature approach to risk management. Nearly all Fortune 500 companies maintain captives as these companies typically have the scale, diversification of risk and loss history that make a single-parent captive an attractive risk financing strategy.

Certainly, while the captive market is more mature for large multinationals, there are thousands of organisations operating in slightly smaller footprints that may not have considered self-insurance in the past. For those companies that are not ready to justify the commitments involved with forming their own captive, a cell captive structure may provide a simpler, more cost-effective alternative. Cell captives have lowered barriers to entry and also made self-insurance an attractive option for a wider pool of organisations.

Unlike wholly-owned captives, cell captives generally require a considerably smaller investment from a time, resource, compliance and capital perspective. Typically, cell captive facilities are formed and managed by captive management firms, such as AIG, which ‘rent’ the individual cells to their clients. The captive manager then takes on the bulk of the administrative burden on their clients’ behalf.

There are more domiciles around the world with captive legislation in place than ever before, offering choice and geographical proximity to the parent company if desired. However, established onshore locations such as Vermont and offshore locations such as Bermuda and the Cayman Islands continue to be popular choices, as they provide regulatory experience and local infrastructure that newer, less established domiciles may not yet offer.

As the captive concept has evolved, self-insurance has become more appealing and risk financing strategies have moved beyond just wholly-owned captives. Self-insurance can offer benefits to financially robust companies of different sizes from a broad range of industries, assuming they have a mature approach to operational risk and insurance management. Whatever the background, these attributes will enable a careful and considered long-term approach when it comes to self-insurance.

“The past two decades have shown that captive formations occur during all phases of the insurance cycle and throughout varying economic climates”

Choosing the right partner

There is a tendency for insureds to underestimate the complexity of forming a captive. For those contemplating whether to undergo a feasibility study, it is important to understand the due diligence and set-up process involved in captive formation and the benefits of partnering with a seasoned captive manager.

A feasibility study will form the basis of a comprehensive business plan for the potential captive or cell captive structure. It involves a detailed study and financial analysis to identify likely set-up costs, capitalisation requirements, possible suitable Working with a global insurance organisation like AIG offers a number of advantages for firms that are new to captives as they navigate the process. As a worldwide insurance company with an in-house captive management group, AIG is uniquely placed to offer the full range of services, including fronting, traditional risk transfer coverage, reinsurance and captive management, to our captive clients. Our global captive management portfolio ranges from single-parent insurance and reinsurance captives, associations, risk retention and group captives, to cell captives within one of AIG’s cell captive facilities domiciled in Vermont and Bermuda.

Cell captives are an increasingly popular option for mid-sized companies that may be looking to retain more of their insurance risks without taking on the costs and administrative burdens that can come with wholly-owned captives. As risk management strategies have become more sophisticated there has been a shift in recent decades to more companies considering risk financing and risk retention at earlier stages of their development. 

While small-to medium-sized companies may not be able to commit the capital and resources required to form and manage their own captives, many can reap the same benefits from self-insurance as their larger multinational peers by considering a cell captive. Cell captives can (re)insure virtually all lines of business separate and apart from other cells within the overall cell facility. Moreover, it is relatively easy to convert a cell captive into a standalone captive if the parent organisation later determines that a standalone captive would make more sense.

For over 100 years, captive insurance has proven to be a useful supplemental tool to traditional risk transfer insurance, particularly during times of significant commercial insurance rate increases. That said, any form of self-insurance needs to make sense financially and strategically for the long term in both hard and soft insurance markets, with captives or cell captives complementing other forms of risk financing.