More companies are exploring captives as an alternative to traditional insurance. As premiums keep rising in the commercial market and risks evolve in the post-COVID world, risk managers are looking for more affordable and sustainable ways to control and stabilize their total cost of risk.
According to Marsh’s 2020 Captive Landscape Report, commercial insurance rates rose by an average of 19% in Q2 of 2020, the largest increase since 2012. As a result, 59% of captive owners said they planned to add more lines of coverage, increase retentions in their captive or form an additional captive. Captives offer a greater degree of control over risk mitigation strategies and financial flexibility that can help companies better cope with periods of uncertainty. Captives play a unique and important role in providing owners the ability to respond to market challenges and prepare for emerging risks, thus creating solutions for both short- and long-term strategic planning.
If you determine that forming a captive is the right choice for your company, no matter the type of captive, there are some red flags to be aware of that could be an indication of trouble in the future. The key is to catch them early, and better yet, prevent them from the start.
Assistant Director of Vermont’s Captive Insurance Division, Christine Brown, and Director of Examinations, Dan Petterson, have seen a lot during their time regulating captives in the largest captive domicile in the United States, the State of Vermont, and can spot warning signs early. They have identified a few of the top red flags to look out for and provided some tips for how to get back on track.
1) Lack of a Clear Risk Management Goal
Captives do offer advantages beyond greater control over losses, underwriting and pricing — but they shouldn’t be the main motivation behind the formation of a captive.
“Before we even get started in the application process, we want to make sure that the captive is being formed for the right reasons. When a company approaches us about forming a captive, one of the very first questions we ask is, ‘What insurance problem are you trying to solve?'” Brown said.
While a company may have a variety of reasons for forming a captive, a company should have a clearly defined purpose that revolves around risk management. “Our main purpose is to license and regulate insurance companies. It is concerning for us from the start if someone wants to form a captive solely for tax benefits or estate planning needs, for example,” said Petterson.
Vermont regulators believe that while there can be additional benefits, the primary purpose for setting up a captive should be improved risk management and greater control over losses, pricing stability, and flexibility in coverage. Captives that are not focused on risk management would likely not be licensed by the state and captives that shift their primary focus away from risk management can lead to issues down the line.
2) Insufficient Funding
A devotion to better risk management also demands long-term investment. While many companies might be feeling the pinch of rising premiums in the traditional insurance market, they shouldn’t view a captive as an escape from a hard market.
In addition to capital funding, captives are funded through premiums and investment income, which are relied on to cover operating expenses and losses. “The formation of a captive and the ongoing operation is a strategic initiative that takes significant resources. So, with a few exceptions, a captive should not be seen as a short-term fix, but rather a long-term commitment,” Petterson said.
“As part of our licensing process and typically with the assistance of an actuary, we assess preliminary and projected funding levels and determine if they are appropriate for the risks being assumed by the captive,” said Petterson. These funding levels are assessed routinely by Vermont regulators as part of their ongoing monitoring.
A new captive should be able to justify its pricing approach and demonstrate its ability to survive adverse scenarios.
Per Brown, “Premium pricing should be sufficient to cover expected losses, as determined by an actuary, and expenses with a built-in risk margin for adverse results. Additionally, a captive should have a prudent investment policy that addresses diversification and liquidity in relation to the coverage it is providing.”
It can be difficult for a captive to recover from inadequate pricing through prospective rate increases; therefore, it is important to price appropriately at the start and make regular adjustments based on actual experience.
3) Inadequate Reserves and Not Enough Capital
Given that loss reserves typically comprise the majority of liabilities for insurers, inadequate reserves can have a major impact on surplus levels. Vermont regulators expect a qualified actuary to be a part of the process of establishing reserves based on sound actuarial standards. The Department also utilizes an independent actuary to assist in their review to ensure the captive has adequate reserves and appropriate reserving practices.
“Insufficient funding and inadequate reserves can both lead to stressed capital levels,” said Brown. Brown and Petterson suggest various tools such as monitoring solvency ratios, including Risk Based Capital (RBC), to assess appropriate capital levels.
“Ratios are helpful for monitoring and assessing capital levels over time, but capital and surplus is there to provide a buffer in the event of difficult times or to provide flexibility in adding coverage or retention,” said Petterson. “Given the unique and diverse circumstances of capital arrangements, however, these tools may not provide adequate comfort.”
“We have minimum statutory capital requirements, but we always reiterate that this requirement is just the floor, before a captive is considered insolvent,” Brown said. “When you’re forming a captive, you want a cushion above that threshold in case things don’t go exactly as planned. You must be able to absorb some unexpected losses without causing the captive to dip below our required levels of surplus. This is especially important in the early years, when the captive hasn’t had time to build up surplus through operating income.”
When it is determined by the company or regulator that capital levels can’t support the level of risk being assumed, adjustments need to be made either through additional capital contributions or through increased premiums.
4) Poor Governance and Minimal Oversight
Governance is an ongoing process that takes intention throughout the life of the captive and should not be viewed as meeting a requirement in a static point in time. Lack of strong leadership and corporate governance indicates potential for trouble. This can manifest itself in a few different ways.
Vermont regulators like to see strong and involved parent companies sponsors directors, management, business partners, and service providers. It helps when there is a history of experience with operating an insurance company; however, many companies do not have this experience. The robust captive insurance infrastructure in Vermont can help fill this gap. Where experience is lacking, regulators suggest utilizing expert service providers skilled at providing advice to guide the captive in achieving its goals.
“We want management to be proactive, with top-down engagement. The formation and operation of a captive involves stakeholders from many areas within an organization, including risk management, legal, finance, and buy-in from company leadership, too. We like to see all of these parties involved and on the same page throughout the process to avoid complications later on,” Brown said.
There are a variety of warning signs that could raise concerns about the proper governance and oversight, such as missing regulatory requirements, delays or errors in filings, and lack of documentation, including meeting minutes, signed contracts, or other important agreements.
“It’s a red flag if a company says one thing and does another. Fortunately, that doesn’t happen very often, but this clearly puts us on high alert,” said Petterson. This leads us to their final red flag, poor communication.
5) Lack of Communication with Your Regulator
Vermont regulators say many issues laid out in this article can be rectified sooner with timely communication to the regulator. “The sooner we know, the more time we have to work with companies in steering the ship back on course,” said Petterson.
“The captive can be a source of capital for the parent if it is available, but it shouldn’t be at the expense of not being able to cover claims and operating expenses of the captive,” said Petterson. For that reason, Vermont regulators monitor the health of parent companies as best as possible.
“We spend a great deal of time monitoring captives, but we also rely on companies and captive managers to notify us of issues in a timely manner,” said Brown. “Managers are our first line of defense. They regularly talk with their clients and are the first to hear about new ideas, issues or positive developments and are also the first to see financial results. Captive mangers and service providers are the conduit for open and constructive communication between the VT DFR and the captives we regulate, which results in effective and efficient regulation.”
Vermont regulators have found that many captives in Vermont want to provide timely and quality information to their regulator and alert them to issues arising as they recognize that timely communication leads to quality regulation and that is key to the company’s success. Vermont regulators truly are experts in their field and although they cannot advise, they can discuss options with a company before a bigger issue results.
How Vermont Manages these Challenges to Enable Businesses to Succeed
Whatever the case, catching issues as early as possible is key. Time is valuable. The longer problems can grow, the more significant the course correction could potentially become later on. While Vermont regulators don’t get involved with managerial aspects of running the captives, they do have a variety of ways they work with companies to help them succeed. Vermont regulators are consistent, fair, and adaptable and it’s for these reasons, that Vermont is commonly referred to as “the Gold Standard” domicile.
“Even before a company submits their application, we sit down with them and ask a lot of questions. The questions continue throughout the life cycle of the captive,” said Brown.
Quality monitoring is one contribution to ensuring companies are successful. Vermont’s monitoring processes consist of surveillance, examinations, business plan monitoring, and of course, ongoing communication.
“During exams and surveillance, we point out areas for improvement, whether it be non-compliance, operating issues, or simply just best practices, and we try to add value where we can,” said Petterson. “We communicate regularly with the companies and their service providers to make sure everything is on track and we always reach out early if we see something that concerns us.”
Short-term issues can generally heal themselves with time, and maybe some additional capital, but with a game plan in place Vermont regulators can monitor their progress. Some systemic issues may require significant course corrections for a particular captive, but even in these severe cases, Vermont regulators make every effort to work with the company to resolve the issues if possible.
The Vermont Captive Insurance Division is made up of 32 staff members, all dedicated to the licensing and regulation of captive insurance companies, which allows them to dedicate their time to growing their knowledge of captives. “We ensure that our people have what they need to be an effective regulatory team. Training, coaching, mentoring, and personal and professional development are all important to the ongoing successs of our team,” said Brown.
Vermont is celebrating its 40th anniversary in the captive industry this year and currently has over 1200 captives licensed to date. Vermont’s success is also attributed to the supportive leadership within the Vermont legislature and state government through the passage of annual bills to provide ongoing improvements that are critical to the success of the industry.
“Nobody wants to see a captive fail. Our team puts a lot of time and effort into ensuring we have the skills to oversee our industry and that we can work with companies to help them succeed. It doesn’t always work out, but there have been far more companies that have rebounded from short-term setbacks and gone on to become success stories than there have been companies that haven’t made it,” said Petterson.