The captive alternative: a basic fiduciary obligation: once considered the exclusive domain of larger companies, capitves are now emerging as a cost-sensible long-term solution for smaller and mid-sized enterprises, too.

Keeping major financial risks adequately funded is one of a financial executive's basic fiduciary obligations, yet many are finding their ability to fulfill this obligation seriously handicapped. As exposures in certain areas have skyrocketed, some of the most vital lines of insurance--from professional liability insurance to workers compensation coverage--have become scarcer or extremely expensive in the traditional property-casualty insurance market.

Annual premiums in some insurance lines have soared as much as 200 percent over the past few years. Many insurers will no longer underwrite certain lines--or have become financially insolvent, which makes an effective transfer of some risks in the conventional way essentially impossible.

This situation not only presents a major professional challenge--it places senior finance executives and their boardroom colleagues squarely in the path of significant personal liability. The failure to properly insure or self-fund critical financial exposures could damage an organization's balance sheet and quickly mire management in costly securities litigation.

Worse yet, this predicament could arise without the financial safety net expected from a directors & officers (D&O) liability insurance policy, since D&O insurance contracts expressly exclude claims arising from failure to maintain proper levels of insurance. That means that in the event of litigation, an individual's personal assets could be on the line.

To avoid this scenario, all financial managers must perform extensive due diligence in assessing and funding significant financial risks. With the scarcity and expense of some traditional risk transfer insurance hampering many companies' ability to address certain exposures, this due diligence process is leading many financial managers to examine insurance alternatives. As a result, the alternative risk transfer (ART) market is expected to encompass nearly half of the U.S. commercial insurance market by yearend 2003.

Captives are the most popular of the alternative options available. Once considered the exclusive domain of larger companies, captives are now emerging as a cost-sensible long-term solution for smaller and mid-sized enterprises, too.

What exactly is a captive? What can it do for individuals and an organization's financial health?

Many Answers

If you ask 20 savvy financial executives "what is a captive?" you can expect 20 different answers. All would agree that a captive is an insurance company, but then definitions would diverge. The following outlines the basic components and benefits of captives and provides some idea about how they work.

The most common types of captives are: 1) a single parent-owned captive, which is structured to provide efficient insurance expressly for its parent; 2) a group captive, which is established by a homogeneous group of organizations that share a common risk challenge and "pool" their capital, resources and risks to fund and operate the captive (a group captive might, say, pool the risks of physicians' groups unable to afford quality professional liability insurance in the distressed medical malpractice insurance marketplace); and 3) a "rent-a-captive," an entity established and capitalized by a larger operation (usually an insurer), which offers advantages similar to those of a single parent-owned captive but requires no capital and resource commitment. You pay to lease capital and resources as an expense within the program.

Why should your company establish its own insurance enterprise, when a mammoth insurance industry exists to assume risk? There are at least six reasons why a captive may make sense. A captive can:

1) Allow transferring risks that are difficult, if not impossible, to transfer in the traditional insurance market.

2) Improve a company's cash flow.

3) Provide additional incentives for aggressive loss control.

4) Generate investment income to fund losses.

5) Lessen volatility and bring greater long-term stability to a company's insurance program--and balance sheet.

6) Potentially reduce operating costs.

A wisely structured captive can efficiently provide the coverage a company needs this year--and the next and the next. Unlike the commercial insurance market, there is some predictability. Done right, a captive can insulate a company's balance sheet from hard-to-insure losses and shield a company's insurance budget from the inevitable ups and downs of the property and casualty insurance industry. When a captive is financially stable and adequately funded, it will make vital, cost-effective coverage available through insurance market cycles.

Partner or Write Direct?

For business or regulatory reasons, many captives do not underwrite policies directly, but rather arrange for policies to be underwritten by a licensed insurance carrier. In this situation, a company's captive serves as a reinsurer, paying claims through the policy-issuing carrier. Since this carrier is already licensed, the captive avoids the extensive administration and expense associated with securing insurance licenses state-by-state.

More importantly, some insurers--but not all--dramatically enhance the creditworthiness of a captive insurance program. They can also bring the benefits of world-class risk management experience and expertise to a captive. The value (and cost) of such a policy-issuing arrangement is commensurate with the financial strength and expertise the issuing carrier provides to your operation.

Still, financial executives are right to be wary before diving into the insurance business, for several reasons. First, the initial cash outlay required to establish and fund a captive is substantial--$500,000 is a reasonable ballpark figure to start with. Numerous "frictional" costs are associated with managing a captive, including ongoing claim administration. Hence, a captive typically makes economic sense only when a company is paying premiums of at least $5 million to $10 million in a given line.

Moreover, a substantial amount of expertise is required to manage the risks a captive assumes, meet regulatory requirements and keep the captive properly capitalized over the long term. In some lines--particularly the litigious, "long-tail" ones like medical malpractice or lawyer's professional liability--maintaining the financial fortitude to pay losses is challenging. It requires skill, knowledge and an extremely strong balance sheet year after year.

So while a captive can be many things, it is not a way to avoid paying higher insurance premiums. Just ask those financial managers that sought to move their D&O insurance into a captive--then found when it came time to shield their personal assets in a claim, that the captive's coverage was already exhausted by paying the company's losses.

Mitigating the Risk

A captive is not to be entered into lightly, but if your company is ready to make a long-term commitment to bring greater control, stability and efficiency to its insurance program, it is worth investigating. Some of the risks associated with a captive can be mitigated through a prudent approach to evaluating, structuring and managing the captive. Such an approach, in broad strokes, would involve four major steps:

1. Evaluating captive feasibility. The first step must be a captive feasibility study that weighs the cost of establishing a captive versus the cost of securing coverage (if available) through the standard insurance marketplace. It also outlines the operational and organizational issues associated with a captive.

2. Choosing the best advisors. If the decision is made to proceed, experienced legal, investment, actuarial and accounting resources should be brought in to assist with the many decisions associated with structuring the captive.

This includes everything from selecting the captive's directors and officers, to drafting business plans and financial projections, to settling on a captive domicile. Don't skimp at this stage; a captive's ultimate success rests largely on a sound start, with strong partners.

3. Policy issuance. If you are concerned about the long-term creditworthiness and stability of your insurance program, consider a policy-issuing carrier. Partner with a carrier holding an AAA rating from Standard & Poor's, and you will automatically infuse your insurance program with the benefits of recognized policy paper backed by the highest creditworthiness available. Moreover, since the policy-issuing carrier has a significant stake in ensuring that your captive is adequately funded, it will likely hold your captive to the same high funding standards as its own operations.

Also, be sure that your policy-issuing carrier has the risk management experience to be a truly valuable financial partner, contributing substantial expertise as well as financial strength. The carrier needs to know your business. And be sure your policy-issuing carrier is committed for the long term: Many jump in and out of the business, rocking the stability of the captive and adding substantial costs.

4. Managing the captive. Ongoing management requires extensive administration--everything from premium collection, billing and policy issuance, to reinsurance placement, underwriting, statutory filings and claim adjustment. You can build these resources within your captive or hire a third party that focuses expressly on captive management. Either way, aligning your organization with experienced resources is critical.

Most importantly, any captive participation requires ongoing, hands-on involvement by a company's financial leaders. Only you can say, after a thorough evaluation, whether it is the right alternative. However, financial managers at the majority of companies that ultimately establish a captive never look back. If your captive is done right, you won't have to worry whether your due diligence in funding a critical corporate risk will be questioned by shareholders--or cost you personally in court.

William G. Whitehead is a Vice President with Lexington Insurance Co., and leads the Captive and Alternative Risk Transfer (ART) Programs. He can be contacted at [e-mail] or 617.443.4630.