Cyber risk, climate change, new pharmaceutical therapies—as companies look for ways to manage increasing costs and unforeseen exposures, captives are a popular mechanism to insure against the unexpected. Around since the 1950s, today there are more than 7,000 captive insurers worldwide, with many headquartered in Vermont, Bermuda, and the Cayman Islands. As these insurance vehicles grow in popularity, Milliman experts answer the top questions everyone’s asking about captives.

Transcript

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Mike Meehan: Hello and welcome to Critical Point, brought to you by Milliman. I'm Mike Meehan, I'm a principal with Milliman's Boston office, and I'll be your host today. On this episode of Critical Point, we're going to talk about captive insurance companies.

Captives have been around for decades, but new market challenges, such as pricing and capacity concerns, particularly with respect to property, cyber, and other liability coverages, are driving many companies to think of captives as a possible risk-financing solution for their organization. So today we're going to answer some of the top captive related-questions, such as how captives work, what are some of their costs and benefits, and hopefully much more.

Today, I've got two fellow captive experts here with me to tackle these important questions. Kim Guerriero is a principal and consulting actuary who does a lot of captive work in the property and casualty space. Welcome, Kim.

Kim Guerriero: Thanks, Mike. Thanks for having me.

Mike Meehan: And Rob Bachler is a principal and consulting actuary working in the healthcare market, primarily on the medical stop-loss side. Welcome, Rob.

Rob Bachler: Hello, Mike.

What are captive insurance companies? What sorts of organizations are using them?

Mike Meehan: Thank you both for joining me. And with that, let's jump right in. So Kim, I want to start with you. Let's kick things off with the basics here. What exactly is a captive insurance company, and what types of organizations are utilizing them?

Kim Guerriero: Thanks, Mike. Yeah, so I'm going to be a little bit technical, and then I'll break it down. So per captive.com, a great website, by the way, a great resource, “a captive insurer is generally defined as an insurance company that is wholly owned and controlled by its insureds, and its primary purpose is to insure the risks of its owners.” So breaking that down a little bit, first off, there are a few different types of captives. And the most common type of captive that I work with, and the one that I'm going to focus on throughout today's podcast, is known as a single-parent captive.

For example, let's take a large grocery store chain. It has a few hundred stores across several states, so it's going to need to get workers' compensation to cover its employees if they get hurt on the job, it's going to need general liability (GL) to cover any slip and fall accidents or any accidents that happen on the premises. And then more often than not, it's going to have trucks to be able to bring the groceries from the warehouses to the actual grocery stores. Using those three coverages—so we’ve got workers' comp, GL, auto liability—that organization could go to the commercial market and buy those three coverages in the commercial market, or it could look to form a captive. And so that captive is going to operate like any other insurance company. It's going to earn premium. It's going to pay losses, it does claims handling, it does underwriting. The difference, though, is that it is only insuring the risks of that grocery store chain.

To answer the second part of your question—what types of organizations are utilizing them—the captives are there to fill holes in the insurance market, in the commercial insurance market. And so given the state of the commercial market over the years, with the hard markets that we've seen, I think most large corporations and companies are self-insuring in some form. And I think a lot of them are doing it through captives. In terms of industries, we have retail, restaurants, manufacturing, telecommunications, just to name a few. There's really no one industry that is specific to captives, and at the same time, there's no one industry where captives are not there. I would say they're across all different industries.

Mike Meehan: Okay, so they cover the spectrum, like such as healthcare as well. Would that be a good example?

Kim Guerriero: Yeah, that's a great example of hospitals, doctors, they have professional liability.

How do group captive programs work?

Mike Meehan: Okay, great. Thank you, Kim. So Rob, I understand that your work involves group captive programs. Can you talk a little bit about those?

Rob Bachler: Yeah, sure. Every group captive is a little bit different, but I tend to think of them as two different camps. One would be a relatively small number of similar groups, right? So you may have a handful of local construction companies, or you mentioned healthcare, right? So a handful of local doctors’ offices, or maybe practices that have a few different docs in them. And they get together and form the group captive there. They're really all a part of the captive, equal partners, that kind of thing.

And then you've got other group captive programs that are, I think, predominantly in the medical stop-loss space, which is my area, where you've got a company that forms the captive, and then they invite groups to come in just to get the coverage. But the initial founder, developer, owner, whatever, is kind of driving the thing. It's just available as a means to provide stop-loss coverage to those other services, related to the coverage, like medical management, things like that, but just to provide those services to the new members, who are more like customers than partners in my mind.

Mike Meehan: Great, Rob. So you mentioned for the group programs, I'm not sure what size those necessarily are. And Kim, you mentioned earlier the single-parent captive in a large grocery chain. Kim, do you think there's room for captives for a group program for property casualty exposures, maybe a homogeneous type of group?

Kim Guerriero: Oh, absolutely. Yeah, I mean, I know I mentioned in my answer it's mostly large companies and corporations, but definitely, we're seeing the mid-sized companies as well coming in, both in the single-parent side and in the group captive side.

Mike Meehan: Great. So it sounds like captives are a solution for organizations of a variety of different sizes. That's great context.

Rob Bachler: Let me throw in, you said something about size for the group captives from my response. I mean, I've worked with a group captive that has four groups in it. I've worked with group captives that have 20, 25 groups. And the second type I mentioned, where you’ve got the founder that kind of brings groups in, a couple of them have hundreds of millions of dollars in stop-loss premium, so they're huge, you know with hundreds, maybe even thousands, of groups.

Why would an organization form a captive insurance company?

Mike Meehan: Okay, so captives can really cover the spectrum here. Excellent. Okay. So with all these different types of captives, why would an organization consider forming a captive? What are some of the benefits that an organization could realize through financing its risk through a captive?

Kim Guerriero: Yeah, I can jump in here, Mike. I think there are a number of reasons why an organization could consider forming a captive. One of them just may be out of pure necessity. And what I mean by that is that a captive is really there to create capacity where there is none. So if we take cyber, for example, going back to the hard market we saw in 2021, 2022, there were some huge rate increases. There was also forced large retention. I had one client that had $1,000 deductible on their cyber program; come renewal, it was increased to $250,000. So that was a huge jump in their deductible, a huge risk that they were now faced with—how can they handle it? Also responding to adverse pricing conditions, using commercial auto, the large rate increases we're seeing there. So it may just be responding out of necessity to what's happening in the commercial market.

Another reason is that they may want to take a more active role in their risk management. They want to be more hands-on in their insurance program, more hands-on in the day-to-day operations of their risk management.

And then another reason I'll mention is that the company may not feel like they're getting the benefit of their good risk-management program in the commercial market. For example, a construction company may have a new safety program that's highly effective at preventing their workers from getting injured, and the company may not feel like that's being recognized with the pricing that they're getting from the commercial market. So in that instance, or that example, they could look to insure workers’ comp in their captive.

Mike Meehan: I would imagine that having a captive insurance company, and now it's a really, it's a more formalized risk-financing program, it's really a good opportunity to really get an understanding of what your total cost of risk is. I think that sometimes, in my experience, an organization can sometimes lose sight of that because they're paying, you know, deductibles and things out of different pots of money. A captive is a really good way to maybe keep track of all the dollars that are being spent to get that understanding of the organization's total cost of risk, so thank you for that, Kim.

From workers’ comp to cyber risk, what coverages can be insured by a captive?

Mike Meehan: Kim, in your previous supermarket example, you noted workers' compensation, general liability, and auto liability coverages that can be insured by a captive. Are there any other coverages? You just mentioned cyber. Are there any other coverages that you're seeing fairly often, or newer trends that you've come across recently?

Kim Guerriero: Yeah, so I mean, you mentioned earlier, I mean, it's really just looking at any industry and what risks are there. So any risk that a company has, it can be insured in their captive. You mentioned, you know, hospitals before, the healthcare space, hospitals, physicians, they have professional liability. Thinking of the banking industry, they have lots of nuanced coverages like fiduciary and bond. I'm seeing some of my captives looking to put some of their management liability, so your D&O and your E&O, into the captive as well. And then another coverage we're seeing with the hard market on the property side is captives considering putting property into their captive. Property, similar to cyber, can be a little bit tricky because of the way that it's usually either a full-limits loss or it's what we call a low-frequency, high-severity type of coverage where it either never happens or it's a full-limits loss, and they tend to pay out pretty quickly. So those coverages can be tricky because you need to make sure that you have enough cash on hand to be able to pay out a full limit or a large claim quickly.

Mike Meehan: I think the property is a great example, Kim. I think all of us when we turn on the news these days, we're seeing more and more, you know, climate-related or natural disaster sort of instances where the claims are of a significant magnitude. So that's a great example, thank you for that.

What are some trends in the medical stop-loss area?

Mike Meehan: Rob, with your focus on medical stop loss, have you noticed any recent trends?

Rob Bachler: Maybe a couple of-- I'm answering the question a little bit differently than what Kim was there, but certainly just the inclusion of medical stop loss in captives is something of a trend. I mean, four years ago, maybe, I don't think I had a single captive client because it just-- medical stop loss in captives wasn't much of a thing, aside from those really large group captives, but more and more companies are looking to put it in. I think there's a diversifying risk within their captive, and when you combine it with all the coverages Kim mentioned, you can get some benefits of including the medical stop-loss risk in there. So that's one.

The other is really more of a broad medical trend that captive owners need to have some awareness of because it could impact their captive, and that's the increase in the number of high-cost drugs and cell and gene therapies that are present now in the healthcare world. You know, again, four years ago, that just wasn't a thing, a high-cost drug was something that was $100,000 a year, and now you've got some that are multiple hundreds of thousands a year. You've got cell and gene therapies that are as much as $3 million. Most captives will have reinsurance to cover those really high-dollar claims, but, you know, that's something you need to consider that could happen. So if you are going to have medical stop loss in a captive, you need to have protection against those types of occurrences.

What should a company think about as it investigates forming a captive?

Mike Meehan: I think that's great, because earlier we addressed forming captives to address challenges in the commercial insurance market. And your point is, well, they can also be used to address issues with regards to business risks as well, changes in the industry risks themselves, so I think that's a great point.

So what are some of the considerations? If I'm a risk manager now or an organization assigned to think about forming a captive insurance company, what are some of the considerations? What are some of the things I need to think about as I go through that process of investigating forming a captive? Kim, you want to start us out?

Kim Guerriero: Sure. Yeah, I can kick us off. I'm actually going to answer your question by asking a couple of questions, the first of which is, what insurance risks does the organization face? What coverages are they buying in the commercial market, are they looking to buy in the commercial market? And then the second question is, where are the pain points? Where are they seeing higher rate changes, where are they having trouble getting coverage in the excess market? Where are they being forced, like the cyber example I gave, where are they being forced to take a much larger retention? Once an organization is able to identify the coverages they want to cover and then the pain points that they have, then you want to consider the diversity of those coverages that you're putting into the captive.

Rob mentioned earlier the benefit of putting medical stop loss into a captive with the added benefit of all those other coverages. And I think that's a great point because you want to make sure that you have a diversity of coverages where you have, if you have a long-tail coverage like workers’ comp, maybe consider that some of your shorter-tail coverages like property or like medical stop loss. There's also something to consider is that, and this doesn't always happen, but if one of your coverages is having a bad year, hopefully some of the other coverages are having favorable years to help offset that overall loss ratio.

Then once you've identified the coverages that you want to put in, I think the next thing to consider is how much risk do you want to retain? And this is going to be based on a variety of factors. One of which is, you know, what is the excess market allowing for, or where are you getting favorable rates? At what attachment points are you getting favorable rates? It's also going to depend on the risk appetite of the actual organization, so how much risk are they willing to put into the captive? And then how much surplus? If it's a longstanding, well-tenured captive, are they looking to put in a new coverage? Is there enough surplus to take on that coverage? Or if it's a new captive, how much surplus is the parent going to put into the captive to be able to fund those losses?

What should you consider in terms of financing the captive?

Mike Meehan: That's a great point, Kim, because I think, you know, you have an insurance company, right, so you mentioned sort of diversifying your book of business, which is what an insurance company would often look to do, but also it's the tying up of some capital. So you've got to have funds for that rainy day, like an insurance company would, so there is a cost of capital, you're using capital, tying up from other things with the business. So that's a great point. Rob, anything to add there?

Rob Bachler: Yeah. One is just, you know, there'll be some effort required to gather the data that's needed to do a feasibility study, to understand the risk that the captive is taking. And, you know, sometimes you may not even know where that data is. So just recognize there's going to be some effort required there.

Second thing is I think you need to consider what will we do as an organization if the captive loses money in the first year? Are we going to, you know, throw our hands up and, “Oh, this was a horrible idea and we can't do this”? Or are you going to recognize that that's the whole point of insurance—bad years, good years, good years, bad years—and how are you going to react to that?

And the last is probably more—definitely more relevant for group captives—and that’s, if you want to set up a group captive with multiple similar groups, and I think this is more important in medical than maybe in some other coverages, where if you've got a bunch of grocery stores, their liability covers and risks are fairly similar. The medical risks of your employees may be very different. And what are you going to do about, how do you share that risk? If there's one group that you expect to cost more, are we just all in this together, or are we going to share the costs based on our expected risk or expected cost? Are we even going to exclude groups if their risk is too great? Those are the types of things you need to figure out before you start the captive, not once you're in it and having to make a decision.

Mike Meehan: So it sounds like upfront planning, and a significant amount of effort should go into that before groups of organizations and maybe an individual goes down that road. Kim, a comment?

Kim Guerriero: Yeah, I think Rob raised a really good point about the bad first year and what are you going to do? And that reminded me of another consideration I think that's really important, and that’s having the right service provider team in place. Making sure that you have a captive manager, but then making sure that all of your other service providers—your auditor, your lawyer, your actuary, your broker—all of those service providers are knowledgeable about the captive industry and they can help you through that situation. I mean, they can help you through a number of situations, but they're there to be seen as your strategic advisors. And so it's really important, because captive insurance is unique, to make sure that you have the right team in place to help you through the good times and potentially the bad times.

And then one other thing I'll mention is the domicile, I think that's another thing to consider is where the captive is being domiciled. So there are— the sky's the limit, I think, these days in terms of picking your domicile, I think almost close to 40 states in the U.S. are captive domiciles. Several of the islands are, so Bermuda, the Cayman Islands, Barbados, just to name a few. There are a couple up in Canada, and there are a few in Europe. So, and again, that's where your service providers can help as well, helping you choose the domicile, because you want to make sure it's a good fit for your captive and for your program.

Mike Meehan: Great. So it sounds like all of this does go back to the fundamental concept of making sure you—well, one, pick the right service team, but two, make sure you have enough upfront planning to have a successful captive program. So excellent. Excellent. Thank you very much.

How long does it take to form a captive insurance company?

Mike Meehan: So if you had an organization that was considering forming a captive today, how long could they expect that process to take really from concept? I don't mean an individual at a firm sort of thinking about it casually. I mean, the organization is going to take a directed look or consider forming a captive insurance company. How long does it take to get from that point to actually implementing it and writing business in the insurance company?

Kim Guerriero: That's a good question, Mike, and I think it depends on the type of captive. For a single-parent captive, to your point, the organization is ready to consider utilizing the captive, they've had the internal discussions, they've had buy-in from management. I think for a single-parent captive, we're talking about four to six months. For other types of captives, like a cell captive, I know we had talked about that, but that's where the structure is mostly in place, usually that takes a little bit shorter than that timeframe I gave. And then I'll defer to Rob for group captives.

Rob Bachler: Yeah. For group captives, I think it depends on the kind of structure you're looking at and the number of groups, right? If you've got two, three, four groups, they're all mentally aligned, I don't think it takes much longer than a single-parent captive. If you're talking about a situation where there's a large number of groups involved and everybody kind of wants their say, or maybe there's two or three like-minded entities that are forming this group captive and then want to go out and pull in another 10 to make it larger, so there's kind of a sales process almost, then it can take quite a bit longer, maybe double the time if you're looking to get to a certain scale before you actually start. So I guess double would be what, eight to 12 months, in that case.

Mike Meehan: Okay. So using that as an example, so an organization, once they complete their renewal, I think typically you may find that risk manager sitting back and just sort of exhaling, right? We finished our renewal, but it sounds like they shouldn't wait too long if they want to consider a captive for the next year, getting it up and running in time for the next year's renewal, because those typically start three to four months out. So really you need to start early on in the process, right after the beginning of your policy year starts if you want to get a captive up and running for the start of the next year. Does that seem about right then?

Rob Bachler: Yeah, I would say so, yeah, you don't want to do it last minute because it'll end up starting the year after you want it to start.

What’s your single piece of advice to organizations who might form a captive?

Mike Meehan: Great, okay. So thank you very much. As we look to wrap up, I have one final question for you both. If you had a single piece of advice to offer an organization that was considering forming a captive today, what would it be? And Kim, why don't you go first?

Kim Guerriero: I actually think you already said it. I think it's the upfront planning. So allow yourself time to do it right. So our host, Mike Meehan, who is a well-known expert in the captive industry, early in my career, I remember he explained a captive to me is it's a long-term venture, and so that means you really want to make sure that you set it up correctly. And so that includes ensuring you have the right team in place to maximize the benefit of the captives. Going back to referencing the service providers, making sure you have the whole right team of all your service providers, experts in the captive industry, and then also allowing yourself the time to learn about captives. There are a number of industry events around the country, a lot of domiciles have their own captive conferences. Some of them are in person, some of them are virtual, but all of them, that's where you can learn about captives, you can learn about industry trends. And then if you do attend ones in person, that's where you can network with the service providers and build your base, build your group.

Mike Meehan: Great, thank you. Well said, Kim. And Rob?

Rob Bachler: Yeah, I guess I'm going on the other end here. Kim was talking about beforehand. I'm going to say something she said, and we've hinted at this as we've talked, you’ve got to think long term. And I'll use examples from medical stop loss, but I know this ports over to others. There are going to be some years when you would have been better off, from a pure premium standpoint, not having a captive and just getting the coverage in the market, right? Because it's a soft market, or maybe you had a bad year or whatever, but you need to look at it over the long term, that over the long term, we should be able to save money because we're not passing profit margin along to carriers. We're able to create a structure that, as you talked about, Mike, we can manage the risk over the long-term. We're putting a lot of time into the planning and the setup of this thing, so we need to look at it as a long-term investment. If you're going to be bouncing around from, “This is a great idea, this is a horrible idea, why did we do this,” it's not going to work.

Mike Meehan: Great, well said. So with that, I want to thank Kim and Rob for joining me today. You can read some of our thought leadership on captive insurance companies at our website, milliman.com.