SMEs
Small companies are fuelling captives growth
In the not-too-distant past, captives seemed to be the exclusive domain of industry giants. But, with a hardening market, there are new players on the scene: SMEs. Captive International examines some of the best options for smaller companies to make captives work for them.
Large companies have traditionally fuelled the growth of captives, with the majority of companies on the FTSE 100 and Fortune 500 using captives.
Matthew Queen, owner of The Queen Firm, says: “Small companies rarely had the scale to achieve meaningful savings with captives given the soft market from 2001 to 2019. Currently, the rates are hard enough across enough lines of business that a captive makes sense as a cost-saving mechanism as well as a risk management financing strategy.”
In the past, smaller companies shied away from forming their own captives, given the cost of entry and a lack of knowledge on the available options.
“While the cost to evaluate, form and operate a captive varies based on size, there is a minimum cost to accomplish each task and as such this cost for smaller captive programmes may eliminate most of the potential financial benefits of establishing the captive,” explains Patrick Theriault, managing director at Strategic Risk Solutions.
He adds that while there are smaller viable captive programmes, in most cases unless annual captive premiums can reach $1 million or more, from a pure financial perspective there is often little benefit to establishing a captive.
However, times are changing. In the coming years, much of the expected growth in captives is expected to be driven by small and medium-sized enterprises (SMEs).
“That said, the interest in captives from smaller organisations is certainly much greater today than it was seven to 10 years ago. The main drivers for this include increased domicile, captive structure and service provider options, each having increased competition and therefore reducing cost of entry,” says Theriault.
“There is also a much better understanding of the benefits of captives in the brokerage and risk consultant community which services small to mid-size organisations.”
Finally, he adds, the growth of the captive insurance industry has resulted in a material increase in the number of cell captive facilities (rent-a-captives) and group captive programmes focused on smaller organisations, “making the captive concept more available to the sector”.
“By joining a group captive, smaller entities can pool their risk to increase their premium base.”
Patrick Theriault, Strategic Risk Solutions
Pooling risk
Captives have long been popular with large companies, given the range of benefits available.
Smaller organisations can experience the same benefits, but there are some advantages more specific to SMEs that take advantage of captives.
According to Theriault, SMEs can obtain lower rates through group purchasing power. Smaller organisations often pay higher rates than large organisations due to “minimum premium thresholds and their inability to take higher retentions”, he says.
“However, by joining a group captive, smaller entities can pool their risk to increase their premium base and provide a vehicle through which they are able to take larger retentions via group-sharing, making them more appealing risk to the commercial market,” adds Theriault.
He explains that this has been experienced for many years with traditional property and casualty lines, but it has encountered renewed interest with the hardening market.
This situation has become more prevalent in the employee medical risk space. Many employers that are not large enough to become self-insured (buying a commercial stop loss) are able to get many of the benefits of a self-insured programme by joining a group captive, he says.
Second, smaller companies have many low frequency and high severity risks that are uninsurable or unaffordable in the commercial market.
“With a single parent captive, these smaller companies could structure manuscripted policies tailored to their situation to prefund for these infrequent large events over time,” says Theriault.
He adds: “Using a captive provides for funding on an actuarially sound basis via a regulated entity and if structured appropriately can be more tax-efficient than self-insurance (ie, a captive taxed as an insurance company for tax purposes under either section 831[a] or 831[b] of the tax code if meeting the necessary requirements).
“This provides these smaller entities with a much stronger risk position over time—balance sheet strengthening.”
“Many new insurtech startups are coming from non-traditional backgrounds.”
Matthew Queen, The Queen Firm
Emerging patterns
Captives, which allow vendors and operators to finance risk, present an opportunity to enter a new market.
“This not only captures the underwriting profits lost to commercial carriers, but also opens the door to competing in the insurance industry. Many new insurtech startups are coming from non-traditional backgrounds,” says Queen.
He cites Tesla, although it is not a small company, as a prime example.
“Tesla entered into the auto insurance market because its telematics capture so much data in relation to the rest of the market that it has a better view of risk than admitted carriers,” adds Queen. Similar patterns are occurring in construction, healthcare, and cyber protection.
With the hard market expected to continue in the short term, interest in the captive insurance space is gaining traction.
Theriault is seeing a large interest in what are considered more traditional captives insuring primary lines such as auto and general liability and workers’ compensation.
“Property risk, as well as directors and officers and cyber are very difficult lines with many looking for captive options. With this focus on more traditional lines the interest in group captives is high. Many existing group captives are seeing material growth in premium and membership,” he adds.
Historically, healthcare has been the largest sector for captives usage but, says Theriault, the use of captives has been declining recently after many years of soft market conditions.
“Safe to say that this has ended and the hard market has hit this sector—well—hard! While the sector in general is feeling it, long-term care organisations have been hit the hardest in part due to COVID-19. We are seeing more new healthcare captive formations this year than I can remember. Most of these programmes are set up as single parent captives,” he adds.
Group medical stop loss programmes continue to be very active. Theriault does not see a slowdown there in the short term, with several new players entering the sector such as brokers, managing general agents, and third party administrators, and others establishing captive insurance structures to participate in the growing industry.
A Goldilocks situation
For companies wishing to secure the benefits of a captive without the expenses associated with launching their own single parent structure, options include single parent captives, group captives, and cell captives.
“Group captives provide group purchasing power, and the ability to share operating expenses, and provide a level of true risk transfer via risk-sharing with other participants, but participants are subject to the group rules and regulations as well as the adverse claims experience of other participants,” says Theriault.
He adds that there is often zero to little cost of entry and capital requirements may be shared with other participants.
Alternatively, single parent captives offer the most control for a captive owner, allowing them to make all of the underwriting, investment and service provider decisions.
Theriault explains: “The captive owner will share fully in its good experience and is able to easily return profits to support the organisation if needed. However, a single parent captive does not provide any real risk transfer (unless maybe if they are purchasing reinsurance).”
He warns that a single parent captive will also be more expensive to operate as a one-time formation cost will be incurred. A higher capital commitment is also likely and operating expenses are not shared.
The cell captive could be the Goldilocks solution for many captives owners. Indeed, Queen says, most companies leverage protected cell companies because they “require the smallest collateral and have the lightest regulatory oversight”.
The cell captive sits somewhere between a group captive and a single parent captive. Similar to a group captive, says Theriault, “a cell captive provides for some cost and capital-sharing, it is quicker to form and has less ongoing time commitment, similar to a group captive”.
He adds: “It operates typically more like a single parent captive with no risk-sharing and a higher level of control than a group programme. Cells are sometimes seen as a way for someone to get their feet wet and get comfortable with the captive insurance concept before migrating to a single parent structure.”
It will come as no surprise that cell captives have been the fastest growing type of captives over the past three to four years, according to Theriault. Many smaller to mid-size organisations are establishing cell programmes to finance their increasing deductibles/self-insured retentions due to the hardening market.
In agreement, Queen says that protected cells are going to drive captive insurance in the near future. He adds: “With the availability of capital in the market, there are more opportunities for non-traditional players to enter the risk financing game. Cells provide the quickest and cheapest way to get an insurance company off of the ground.”
While the opportunities to be seized by SMEs are bountiful, Queen provides a word of warning related to data and the changing market.
“Data is everything. Tracking and capturing data is very difficult and will only get harder as lawsuits over data ownership make their ways through the American court system. With proper data, non-intuitive indicators of risks can be flagged and mitigated before claims arise,” he says.
But, without a data strategy, the captive will be competing on price like the rest of the industry.
“That means that the captive insurance solution will be abandoned as soon as market conditions change (eg, the underwriting cycle restores the soft market),” he cautions.
“However, data-centric captive models provide a runway for growing a captive into a dynamic insurance enterprise with a deep moat and few competitors.”
