captive insurance is it the right choice for your insurance exposures?

Healthcare organizations should take into account many factors when considering whether to use a captive insurance company to provide insurance protection.

As healthcare organizations assume increased risk in today's environment of physician practice acquisitions and healthcare reform, they are challenged to find affordable ways to provide themselves with adequate insurance protection against that risk. Among the various available options, one self- insurance option commonly used in the healthcare industry is captive insurance.

Many organizations already have captive insurance companies (captives), but these may have been created decades ago. In such instances, management would be well advised to evaluate whether the captive is meeting the current needs of the organization, given that the risk profile or goals of the institution may have changed. For organizations that do not have captives in place, introducing a captive may be the most practical choice from a financial standpoint in today's environment of heightened risk.

Benefits of Captives

When considering any insurance program, it is important to look at benefits and disadvantages. Captives offer the following benefits.

Broader coverage. A captive offers the flexibility to develop coverage tailored to the unique needs and risks of the organization. The captive can choose policy terms and conditions. This adaptability is particularly useful for insuring risks that an organization typically would be unable to insure on its own, such as practice risks for nonemployed physicians. A captive also may fill any gaps in insurance that is not offered in the traditional marketplace.

Improved cash flow and stability. Relative to commercial insurance, cash flow in a captive can be enhanced by optimizing the timing of premium payments. Investment income can be generated from unearned premiums (premiums that are collected beforehand but for which protection is not yet provided) received by the captive. In addition, premiums are actuarially determined based on an organization's own experience, thereby avoiding the cyclical nature of pricing fluctuations that is seen in the insurance industry. (If an organization already is self-insured, or has large deductibles, there is no corresponding incremental benefit from a captive.)

Direct access to reinsurance markets. A captive is permitted to access reinsurance markets directly- i.e., to purchase coverage from other insurers to spread risk-because it is an insurance company. Having such access allows the captive to negotiate premiums and obtain possible savings in commissions by eliminating any middlemen. Also, the reinsurer will need to adhere to the coverage form, such as the occurrence basis or claims-made basis, and terms and conditions of the captive's policy-which, as noted above, can be customized, thereby allowing for reinsurance coverages that may not otherwise be available.

Tax advantages. Tax advantages of a captive are dependent on the tax laws of the domicile (i.e., the captive's primary jurisdiction). When the captive is structured properly, however, an organization may deduct insurance premiums upon payment. This benefit can be significant in long-tailed lines such as medical malpractice, where, in the absence of captive insurance, tax deductions occur only when losses are paid.

The tax advantages may be greater for a for-profit organization, such as a long-term care facility, than for a not-for-profit community hospital. A profit center can be created by segregating assets and liabilities, allowing for underwriting profits when premiums exceed expenditures. In traditional insurance, these profits would belong to the insurance company. The captive also may have less non-claims expenses and be able to avoid the markup in a traditional insurance company's rates that arises from profits and contingencies.

Better handling and control of risk management and claims. As a form of self-insurance, a captive arguably provides incentives to reduce claims through proactive risk control and allows for better claims defense strategies. The premium of the captive is based on the captive's own loss experience. Further savings from risk control may result when the allocation of costs to locations is derived from the captive's experience.

A captive also can establish its own claimshandling policies and procedures, which may result in expense savings if the captive is able to handle claims more efficiently than would the commercial market. Although these benefits can be achieved by a self-insurer that does not have a captive, having a separate subsidiary tends to better focus management on achieving these goals and benefits.

Drawbacks and Challenges of Captives

Healthcare organizations also should be aware of the potential disadvantages associated with captives.

Startup capitalization. A captive may require a substantial amount of initial capital to meet insurance capital requirements and to comply with insurance laws. When funding captives, organizations often start with a conservative approach to loss forecasts to avoid any future shortfall, which can result in higher expenditures than the organization would incur through traditional insurance. For example, a captive may be funded initially at the 75th percentile, whereas traditional insurance may not have the same contingency. There also is an opportunity cost, given that captives are rarely the best sources of ROI for capital investments. Taking these costs and ROI considerations into account, along with competing capital resource requirements, a smaller hospital or health system may find that a captive is not feasible.

Potential underwriting losses. Underwriting losses may result if a captive's loss experience exceeds its original funding. Such an outcome tends to occur more often with low-frequency, highseverity types of coverages, such as medical malpractice. In traditional insurance, this shortfall risk belongs to the insurance company, which pools risks across different industries and coverages. A captive, with less diversification in exposures and less credible loss experience, may be more exposed to fluctuations in loss estimates. Self-insurers are exposed to these same risks, but a captive, as a regulated entity, will be subject to formal action such as increasing reserves and/or increasing capital to meet minimum or other regulatory capital requirements in the event of material underwriting losses.

Administration and commitment. A captive requires an ongoing commitment and considerable expertise to run. Inexperienced management will have a learning curve. The captive owner is responsible for claims administration, loss control, underwriting, and contracting with service providers such as brokers, captive management, actuaries, attorneys, accountants, and auditors. Substantial skill is required even for plotting an exit strategy. These responsibilities can be a significant burden on an organization's resources and personnel.

Choosing a Captive Site

Captive requirements vary by domicile. As always, it is wise to contact a trusted insurance broker, captive manager, or attorney to fully understand the specifics and the advantages and disadvantages of a domicile. Captive domiciles can be domestic or nondomestic, with the Cayman Islands, Bermuda, Hawaii, and Vermont among the longstanding popular choices. Recently, many more states in the United States have been entering the captive marketplace as domiciles, increasing the options for captive owners.

When deciding on the domicile of a captive, organizations should consider many factors. Organizations should seek out a regulatory environment that is responsive to the concerns of the captive. Initial capitalization requirements can vary, and there might be minimum solvency requirements, such as a premium-to-surplus ratio of between 3-to-1 and 5-to-i on both a gross and net basis.

The issue of taxes also can raise significant questions. A foreign captive may still be subject to U.S. taxation if it is doing business through a permanent establishment in the United States, unless it can prove its economic and legal independence from the establishment. Various strategies maybe available to limit, if not eliminate, the tax burden of a captive.

Other financial issues such as operating costs, annual fees, up-front costs, and taxes on premiums can vary by jurisdiction. Investment requirements also can vary, with some domiciles having less restrictive requirements and others mandating that policyholder surpluses be held in cash or U.S. government or exchange obligations. Geographic convenience and logistical issues have become concerns, given that institutions are looking to save money and meetings may have to be conducted where a captive is domiciled. Other practical factors include formation time, language, currency, laws, and the economic and political stability of the country.

Deciding on Coverage Offerings

Captives can be formed in almost any industry but are common in health care. Historically, captives have been used for property and casualty (P&C) coverages such as medical malpractice liability, general liability, workers' compensation, and auto liability. Healthcare entities have long used their captives to insure nonemployed physicians, especially when acquiring physicians, and to pick up prior acts or nose coverage (i.e., coverage for claims arising from medical procedures performed while the organization was covered under a previous policy).

Some captives also have been used to offer tail coverage (i.e., coverage for claims made against the insured after a policy has expired) to physicians at more affordable prices than are available through commercial insurance. Additional P&C coverages such as director and officer liability, errors and omissions insurance, and even cyber liability have become more common. Depending on the circumstances, even adding a warranty exposure such as for medical equipment may be appropriate and could save the entity money.

Recently, captives have expanded to include employee benefits such as medical and life insurance, accidental death and dismemberment, long-term disability, and retiree benefits. The Affordable Care Act has increased the need for medical stop-loss coverage for self-insurers by eliminating protections that employers historically built into plans-specifically, annual or lifetime maximums on the coverage provided to employees. Through a captive, employers can get medical stop-loss coverage from reinsurers, which can represent a significant savings compared with the cost of such coverage from traditional medical carriers and direct writers.

Risk diversification is an important consideration when selecting coverages to include in a captive. A captive can choose to have high-frequency, low-severity coverages or low-frequency, high-severity coverages-or a blend of the two. In addition, the captive can elect to have low or high coverage limits. All of these factors help maintain the pooling aspect of the captive.

Starting up a Captive

Some organizations are better suited than others to operate a captive. Captives are generally considered a long-term investment, with operations ideally extending at least 10 years. When transitioning to a captive from a traditional insurance program with guaranteed cost coverage, an organization requires financial involvement and must be willing to assume significant underwriting and investment risk-and it may need to have cash on hand and be willing to tie up capital and letters of credit over multiple years.

To achieve underwriting profits, the organization must be committed to risk management. Finally, it must be willing and able to maintain control of the risk-financing program, including cash flow, coverage wording, retentions, and limits.

Before initiating a captive, an organization should conduct a feasibility study, which typically requires the assistance of service providers such as brokers, captive managers, actuaries, and attorneys. Management can use the resulting report during discussions with captive regulators and to identify any tax issues.

The study should have the following objectives:

* Identify potential coverages to be written by the captive

* Determine premiums and retentions/limits for the proposed coverages

* Decide which service providers will be needed

* Determine captive ownership and capitalization

* Identify the captive's domicile and source of regulatory oversight

* Develop pro forma financials (including loss projections, operating costs, and sensitivity analyses)

The final step is to obtain a license for the captive. From there, the captive will be subject to ongoing regulations of the selected domicile.

Getting Started

Considerable insight is required for healthcare organizations that are seeking to explore options in captives. Determining what makes the most financial sense for an organization's insurance exposures requires a deep understanding of all options-and gaining that understanding requires a commitment to learning and considerable due diligence in weighing each option. Clearly, management should reach out to trusted service providers for insight, and they should contact more than one provider to best understand all the circumstances and different perspectives. But no organization should pursue a captive, with all of its subtleties and complexities, until its management has strong knowledge of what's involved.

AT A GLANCE

Potential benefits of a captive insurance company include:

* Broader coverage

* Improved cash flow and stability

* Direct access to reinsurance markets

* Tax advantages

* Better handling and control of risk management and claims

Potential drawbacks and challenges include:

* Startup capitalization

* Underwriting losses

* Administration and commitment

About Captives

Captives have existed in concept since the mid-1800s, with significant growth in the last 40 years. Many healthcare institutions started self-insurance programs, including captives, during the 1970s as a result of the nation's first medical malpractice "crisis.'' They also established trust funds, mainly because Medicare payment required actuarially certified funding for the self-insured expense to be considered an allowable cost. Later crises, such as those in the mid-1980s and early 2000s, created additional demand for captives.

In essence, a captive is an insurance subsidiary of an organization that serves to insure the risks of its parent. The insured organization has ownership and control of the captive, and it invests its own capital. Captives often are used as an alternative to traditional insurance.

Captives can be structured in several different ways. Four structures are the most commonly used:

* Single-parent (Le., pure) captive. The most popular option, this type of captive typically covers only the risks of the parent company and its affiliates in a corporate family.

* Industrial(i.e., group) captive. This structure is used to insure the risks of several entities in a similar industry with homogenous risk sharing or joint-group ownership.

* Association captive. This type of captive is used to insure an association of related members that may be outside a corporate family, such as member companies of a trade organization.

* Segregated-cellcaptives (or rent-a-captives). This type of captive is sponsored by an insurer and may have individual segregated/protected cells that can be "rented" to insure risks for a fee.

Rent-a-captives are a common choice for organizations that cannot handle the up-front capital investment of a captive and do not want to spend time and money on management and governance of the captive. However, this option offers the least amount of control over captive costs.

In recent years, the popularity of Internal Revenue Code Section 831(b), which covers "small" property and casualty (P&C) captives, has increased. As long as annual premiums are $1.2 million or less, the captive does not pay federal income tax on underwriting profits, while investment income is taxable at graduated corporate rates, with any dividends from the captive taxed at long-term capital gains rates for qualified dividends. "Section 831(b) captives" are growing in popularity as more insurance and financial service providers become aware of the potential advantages and of changes in the definition of small P&C insurers stemming from 2003 tax reform.

Shutting Down a Captive

A captive may outlive its usefulness and purpose. Some organizations let a captive lie dormant and incur costs, while others use it as a pass-through to obtain reinsurance. Still others want to avoid the start-up costs of a new captive and decide to maintain the current captive in the event that it is needed in the future.

Shutting down a captive may be viable strategically, such as under the following circumstances:

* The insurance market is soft and insurance prices are reasonable.

* A merger between two companies occurs, and only one captive is needed going forward.

* An organization wants to eliminate its risk and prefers premiums with guaranteed cost coverage.

* Administrative costs are becoming excessive compared with the risk in the captive.

* An organization wants to reduce capital requirements.

* An organization wants to eliminate troubled noncore businesses.

Exiting a captive requires many management decisions. The first is whether to simply let the captive's obligations gradually run off or to transfer the obligations to another party. Such transactions, each of which has its own advantages and disadvantages, might include selling the captive, entering into a loss-portfolio transfer insurance deal, or entering into a novation/commutation agreement. There also are many legal considerations and discussions to be held with regulatory officials, policyholders, and other interested parties, such as reinsurers. The due diligence process can be intensive and consuming, involving all captive service providers.

Actuarial Analysis for Loss Projections

Actuarial estimates are critical for getting the captive off to a good start and maintaining appropriate funding. Management should begin by looking for actuarial estimates that are unbiased and fully transparent. An independent actuary can provide an outside perspective if the actuary has experience with the coverages that are part of the captive (medical malpractice coverages, for example, are unique and can be complex). Actuarial models that work well in other insurance coverages may not be appropriate or may need to be altered and tailored.

The actuary also should understand the organization's jurisdiction, which affects the reporting, development, and payment of losses. The actuary should have a firm and clear understanding of the data provided, including losses, utilization statistics, physician rosters and retentions, and the limits of the program. Any financial-reporting decisions-e.g., presenting results on a discounted basis for the time value of money, presenting results gross or net of reinsurance, and showing results with a contingency margin such as at the 75th percentile-also should be discussed with the actuary.

Actuarial estimates should give as much weight to a program's own experience as possible. Management should have discussions with the actuary about any change in the reporting, reserving, settling, or paying of claims, especially when a change is deliberately made by management. Management should share all factors that could affect future loss estimates, such as a new acquisition, improved safety measures, or even tort reform. The actuary should be able to explain any selections made within a model, including loss development factors, tail factors, trend factors, and any inherent conservatism in estimates.

At the start of the process, management should establish expectations with the actuary and inform the actuary of any strategic goals to ensure all parties are on the same page. Scope, deadlines, and the role of the actuary should be clearly outlined. Having frequent conversations with the actuary is encouraged.

About the author

Richard C. Frese, FCAS, MAAA, Is a consulting actuary, Milliman Inc., Chicago ([email protected]).