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Dynamic forces driving group captive formation.

While the technical obstacles to structuring, forming and operating a captive can be extraordinarily complex, they can be overcome if the crucial conditions for its formation are in place. If those conditions are absent, the chances of the captive being formed successfully decrease, and even solving the technical problems will not be enough to put the captive on the right course.

The past decade witnessed the development of several successful group captives. Those that failed seldom did so because of faulty technique. Rather, these failures occurred because the motivation for forming the captive was wrong; the captive owners or management lost sight of the captive's original purpose and sought more profitable activities for the captive; the captive was formed too early or too late; or its leadership was not strong enough to avoid being caught up in the flush of early success.

Why Form a Captive?

The factors that contribute to a captive's success include a homogeneous group of insureds, successful underwriting of risks, stable premiums, development of loss prevention and reinsurance support. A captive formed to serve only the short-term interests of its insureds will almost certainly fail. if its only goal is to reduce premium, the captive-even if successfully formed-will be nothing more than an insolvency waiting to happen.

The best reason to start a group captive is to create affordable coverage in lines of insurance that are expensive or not readily available. Particularly good candidates for captive lines are long tail coverages, including professional liability, product liability and excess coverages, which are volatile, unpredictable and have, at times, been difficult to obtain at a reasonable price, if at all.

Preferring to avoid the volatility of these lines, commercial insurers, in hard markets, charge high premiums or opt to place their capital in insurance lines in which costs and profits are more reliable. Yet in soft markets competition can be intense in these lines of business. As a result, the commercial market does not provide continuity of capacity and price stability in long tail lines.

As the commercial market's ability to determine the cost of insuring a particular risk is reduced, so is its incentive to distinguish among risk profiles of particular groups that want to buy coverage. Instead, commercial carriers need to spread risk by generating premium that covers all eventualities. Distinguishing between average and better-than-average risks on unpredictable business is time consuming and difficult. It is easier and more economical to emphasize increased cash flow.

Cash Flow Underwriting

The need to generate revenue is largely the explanation given for utilizing cash flow underwriting, a phenomena that in soft markets permits insurers to write volatile risks at low premiums. They do this even when anticipating an underwriting loss in the hope that investment earnings will turn a profit. This practice leads to price instability and withdrawal from the market of marginal participants as underwriting losses inevitably begin to develop and the market hardens.

High premiums, when risks are volatile and unpredictable, are not necessarily wrong if one's focus is on the entire universe of potential insureds. Given the cyclical nature of the commercial market, high premiums, in the long run, are partially if not wholly offset by low premiums for the insured risks. Wild premium swings, particularly toward the high side as losses proliferate, are made more likely if the spectrum of insureds includes the entire range from the worst to the best risks, without pricing distinctions.

A group captive consisting of insureds with common risk profiles and characteristics, particularly if they are preferred risks, can outperform commercial market competitors. With support from those insureds, it can create additional insurance capacity in a tight market, provide pricing stability and distinguish its insureds from the rest of the market in a way that is impossible for commercial carriers subject to different economic pressures.

If the captive achieves these goals, operating efficiencies and successful underwriting results may enable it to reduce costs to its insureds through lower premiums or dividend payments. A captive can only grow and prosper, serving the needs of its insureds, if those insureds have a long-term commitment. The captive must provide coverage when needed at prices that are as uniform and predictable as possible. Other benefits are the result of a successful captive, not the measure of its success.

A 'Committed Core'

The optimum time to form a group captive is before the market hardens and required capacity starts to disappear. Do not wait until the captive is needed; by then it may be too late. On the other hand, the optimum time to attract participants into a group captive is when they are angriest at the commercial market; when their premiums are high and market capacity is restricted. Once the market softens, memories fade quickly and short-term cash flow, rather than long-term best interests, often become paramount. It takes time to structure a captive, and being forced by adverse market conditions to get a facility into place quickly may lead to dangerous, if not fatal, structural weaknesses.

Probably the most difficult aspect of forming a captive is raising sufficient capital, whether from eligible participants or through the use of reinsurance, which is in effect a substitute for investment capital. A broad base of potential insureds may be less willing to provide capital in a soft market. However, that is exactly the time when reinsurers, with capacity to spare and plenty of competition for existing business, may be willing to support a new captive. This is particularly true if the captive can be sold as a preferred risk facility. If sufficient alternate capital in the form of reinsurance is available, the captive can start operations with a smaller base of insureds contributing "real" capital, and position itself to be there when the market inevitably hardens and people are desperate enough to provide the necessary broad base insured support.

One of the most successful group captives was formed by a small group of angry insurance consumers at the peak of a hard market cycle. The group worked for more than a year to develop a captive proposal with broad appeal to potential insureds and commercial reinsurers. However, as soon as the captive went to market with its proposal, premiums, which had been at an all time high, started to fall precipitously.

Nevertheless, the captive's initial foray into the market was successful. It attracted just enough insureds to start operations. Over the next several years, the captive slowly grew. Its premium rates were above market, and that, combined with the required capital contribution, put it into a difficult competitive position. Yet its initial group of committed insureds and reinsurers persevered, and when the market hardened four years later its growth was unprecedented. The captive quadrupled in size in two years, and is today the dominant force in its particular market.

The point is: Timing is everything. While there may be an apparent contradiction between the best time and the easiest time to form a group captive, if a committed core of patient individuals can get a well-designed captive into place, the market will eventually create the conditions that make it successful. The key factor initially is loyalty to the concept. Immediate, overwhelming success is not necessary and expecting it is often unrealistic.

Providing the Spark

While the assistance of brokers and legal advisers is vital to structuring and operating a captive, they will not usually be the key to successfully forming a captive. Exceptions to that rule include such broker-inspired facilities as A.C.E. Insurance Co. Ltd. and X.L. Insurance Co. Ltd. in Bermuda.

Perhaps the most frustrating part of captive formation is convincing potential insureds that it is in their best interests to support the captive and provide the capital base. Professional advisers, unless they are themselves potential insureds, usually do not, standing alone, have enough "feel" for the needs of the group to provide the necessary spark.

That spark must come from the core of potential insureds itself. It provides an understanding of the needs that the captive must serve, who will participate, under what conditions they will participate and how to best develop support. It also provides a base for creating the loyal initial group of insureds that will support and stay with the captive until the rest of the potential insured group recognizes that its short- and long-term interests are also served by supporting the captive. Donald S. Breakstone is a partner in the Chicago-based law firm Mayer, Brown & Platt.
COPYRIGHT 1991 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Author:Breakstone, Donald S.
Publication:Risk Management
Date:Sep 1, 1991
Previous Article:Using financial insurance for predictable losses.
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