Private Insurance Companies, or captives, are very simple in concept. Instead of sending your money to “Big Insurance”, you form your own Private Insurance Company and keep the net profits after losses. The details are, of course, a little more complex. Some of the key concerns include what coverages to insure in your new insurance company, and how premiums will be determined.
First, let’s explore the coverage selection question. Captives will generally insure your Enterprise Risks i.e. those risks that don’t occur often, but when they do they could be business destroyers: loss of your key supplier, customer or key talent; lawsuits; data breaches; branding damage; regulatory changes. These “existential” risks can be insured in a captive. The essence of a captive strategy is strategic risk financing i.e. building up a surplus fund to protect your business against catastrophe. A captive can be used to supplement coverages you obtain through a commercial carrier, such as workers’ comp and general liability. These are regular, more predictable, risks that don’t offer the potential profitability for your Private Insurance Company.
The second question to address is ‘what should the premiums be?’ Some potential captive owners still use a rule of thumb 5% or 10% of revenue, however, this is the wrong way to look at this process. Premiums should be developed at arms-length actuarially from a range of factors. Different coverages are affected by different base factors. For example, defense costs might be heavily influenced by industry type and size, whereas, loss of key customer is based on largest customers and revenue at risk. Simple percentages never tell the full picture and can mislead potential captive owners; it is simply a bad idea to start with the premium and back into the coverage.
At CapAlt, we follow several specific principles to determine coverage and pricing:
Thorough Underwriting Process – we educate prospective captive owners on the premium development process. We conduct an underwriting review of the client’s business to help highlight potential coverages, augmented by gaps and limitations in a client’s commercial coverages. We then compile a potential list of coverages and bring in the Actuary.
Outsource Actuarial Work – we don’t believe in using simplistic internal spreadsheet models to determine our clients’ premium. We use a professional actuarial firm with carefully developed pricing models that take account of industry factors, unique business characteristics and available commercial market benchmarks. For each coverage, we calculate “expected losses” for the policy year based on the insured’s specific exposure information. For coverages that are more commonly available on the commercial market, we use actual rate filings, which are available in the public domain, for the coverages filed by leading commercial insurers. We then add in a “risk margin” of some additional funding to account for the fact that the captive must rely on its relatively small amount of premiums to stay solvent.
For coverages not commonly found in the commercial market, we use a combination of the insured’s loss experience for the risk being covered, and both qualitative and quantitative insured-specific information that describe the level of risk of a loss and how expensive a given loss might be. We use this information typically to estimate a frequency and severity, which we can multiply together to calculate expected losses. For coverage types that “fill in holes” of the client’s existing commercial coverages, such as Gap/Difference in Conditions coverages, Excess Layer coverages, and Deductible Reimbursement coverages, the client’s actual commercial premiums and coverage adjustment factors from comparable rate filings are used to calculate the expected losses for the “hole” that we are filling with the captive coverage.
Here’s a recent example of why using simple percentage of revenue is generally the wrong approach:
- Company revenue was $120 million.
- Client expectations were that premium might be in the $5 to $7 million range (they had a rule of thumb expectation.)
- In fact, the premium came in at less than $1 million.
- Why? Well, the client was a leading-edge virtual company with just 10 staff under age 30. So, no significant Key Person risks. The company had significant Cyber Risk and Brand Damage exposure, but revenue became less of a factor than maximum Legal coverage limits. Industry class put the business in the lowest category for Defense Costs and Regulatory Issues exposure.
- We still were able to create a new Protected Captive, after we explained the process and the detailed buildup of coverage and premiums. The client understood that these were the premium levels that were defensible to regulatory review, and appropriate to the size and complexity of this business. The client is now embarked on the risk management journey to independence from “Big Insurance”.
So, before we can say “The Price is Right!”, we need to do a lot of homework. The captive pricing must be defensible to fully justify deduction as a business expense. But, just as important, it must be viable for the proposed captive. Once a captive has built up several years of solid surplus, the risk management options open up even further to start transitioning other commercial lines of coverages.