ENTERPRISE RISK MANAGEMENT

GROUP SOLUTIONS PART I

Group captives can offer small and mid-sized
companies an escape from hard market hikes

By Michael J. Moody, MBA, ARM

The current hard market continues to worsen, and as it does, it is creating renewed interest in alternative risk transfer (ART) programs. A recent press release from the Council of Insurance Agents and Brokers confirms that pricing has continued to harden over the past six months, and they claim that premiums "will continue to rise and spread financial distress into the U.S. economy." The Council's Commercial Insurance Market Index for the first quarter of 2002 notes that, while most insureds are seeing 10% to 50% increases, some insureds are facing triple-digit increases. This is when they can find coverage at all.

This pricing pressure is causing insureds of all sizes to begin considering alternatives to traditional insurance coverage. In general, it has been the smaller accounts that have taken the brunt of current pricing increases. These increases, coupled with the fact that the smaller companies can usually least afford these increases or the higher retentions that are accompanying today's renewals, are putting enormous pressure on their balance sheets.

To make matters worse, many of the alternative market solutions available to larger companies are not available to smaller firms on their own. However, smaller companies can band together in order to implement some forms of alternative programs. And many are exploring their options.

Agents and brokers, legal counsels and association executive directors are all looking at group options for their members. Agents and brokers who have developed profitable niche markets over the past few years are now in danger of losing them and are searching for methods to maintain this profitable business. And association executive directors who are hearing from their membership about insurance-related problems are looking for ways to ease the pressure on their members. Other service providers that deal with specialized groups are also investigating the feasibility of group programs. From group captives to group self-insured pools, the options are varied and each has its own advantages and disadvantages.

Practical considerations

While there are a number of potential solutions for smaller insureds, each solution will have practical considerations and limitations attached to it. One of the first things to consider is the coverage(s) involved. For example, solutions that may work for property coverage may not be available for workers compensation, or workers compensation solutions for employers in a single state may not work for multi-state operations. Accordingly, any feasibility analysis should determine what specific coverages and territories must be addressed, and any limitations need to be noted.

In the past, ART solutions for groups were typically developed for a single line of coverage: medical malpractice, workers compensation, or products liability, for example. However, due to the breadth of the current insurance problems, it is believed that many of the group solutions developed today will be much more aggressive in the scope of coverage offered. Consideration of multi-coverage application also will need to be part of the analysis.

Basically, groups come in two types: those comprised of members in related industries (homogeneous groups) or those in unrelated industries (heterogeneous groups). There are examples of successful group programs using either type; however, most experts agree that, in order to structure a group program that derives its maximum potential, homogeneous groups offer the highest possibility of success for the following reasons:

* Industry-specific safety and loss control programs can be developed to reduce the frequency and severity of claims.

* Claims management services can be tailored to the needs of the group.

* Underwriting criteria can be written that recognize industry uniquenesses.

Another consideration is the fact that in today's marketplace, many reinsurers and/or fronting carriers are demanding that startup operations be made up of homogeneous exposures. The risk retention group (RRG) option is also available only to homogeneous groups.

Captives

Before moving on to discussing group captives, it is helpful to define what a captive is. While the exact definition will vary somewhat, most people would agree that a captive is an insurance company that is developed by a non-insurance entity and used to write the business of its owner(s). Among the types of captives in general use today, only the single parent captive is developed for the exclusive use of a sole owner. Other types of captives that are used for group solutions are group captives, agency captives, rent-a-captives, and protected cell captives.

During the last hard insurance market (i.e., mid-1980s) the risk management consultants at Tillinghast developed a list of 10 key success factors for group captives. Over the years, the validity of these factors has been reaffirmed time and time again. For those organizations or their trusted advisors that are considering the group captive option, it may be beneficial to review these factors.

1. Timing--As anyone who has tried to get a group captive going over the past 15 years can attest, timing is everything. Today's insurance marketplace presents one of the most receptive environments for group captive formations. Timing means that the insurance situation has the attention of the group, which is certainly the case today. For the most part, timing can be described as a "sense of urgency." History has shown that this sense of urgency is a prerequisite for all of the other factors for success.

2. Careful underwriting--The development and maintenance of stringent underwriting requirements is critical to the success of a group captive, or any insurance company for that matter. Included as part of the underwriting process are hazard recognition, evaluation, and the determination of policy terms and conditions. Underwriting standards must be designed so that the captive group is constantly working towards eliminating adverse selection. This can be one of the thorniest issues for sponsoring associations, because frequently those members who need the coverage the most are not the best risks. As a result, the captive must have the freedom to determine if a potential insured is the kind of account that will benefit the group on a long-term basis. Association executive directors need to be prepared to defend the integrity of the captive.

3. Common interest--Any group that bands together to explore the possibility of a group insurance solution must have certain common characteristics if it wishes to increase its chance of success. Two of these required common traits are similarity of exposures and a commitment to participate in the operation of the captive. The criteria of similar businesses are basic to the acceptance of each member's risks by the group.

4. Political support--For the captive to have a better-than-even chance to succeed, it must have the political support within the association. The majority of influential decision makers, the executive director, legal counsel, insurance broker and current officers and directors must be behind this effort. Since many associations view a captive as a value-added service to its membership, this should be easy to do. Additionally, if structured properly, the captive also can be an excellent source of non-dues revenue for the association. From the very beginning, it is important that the captive be viewed as a "winner."

5. Reduced expenses--Generally, whenever goods or services are purchased in bulk, a corresponding savings occurs. The same is true for the captive. The captive should be able to reduce or eliminate some traditional insurance company operating expenses. These savings would flow to the bottom line.

6. Loss forecasting--Prudent loss forecasting and risk funding also are important to the long-term success of the captive. In order to obtain the most statistically correct forecast, actuaries will require complete claims history on each potential member, as well as the proper exposure bases that correlate to the losses. These kinds of quality data will allow an actuary to analyze the aggregate claims experience for the group and determine appropriate rates based on the group's past loss profile.

7. Risk sharing--Most successful group funding vehicles incorporate true pooling and risk sharing. Those programs that utilize as many elements of risk sharing as possible will establish a common sense of purpose. Failure to establish this common sense of purpose has resulted in some group captives losing members and disbanding during soft markets.

8. Risk management approach--This approach strongly endorses the systematic process of identifying, evaluating and addressing risks. Among the primary components to the risk management approach is superior risk assessment, development of high standards of risk control, as well as methods for assuring adherence to those standards. A thorough knowledge of the specific industry exposures and the ability to properly assess them is at the heart of this approach. The commitment to a high standard of risk control is one area which typically sets a group captive apart from traditional insurance programs. By designing loss control programs that are tailored to the specific needs of the industry, the captive can greatly influence the claims activity of the group. Reducing the actual number of claims may be the greatest long-term advantage of the group captive.

9. Long-term commitment--While group captives represent a viable option to the vagaries and instability of the insurance marketplace, members must realize that, by their very nature, they are not intended to be short-term solutions. As a result, successful group captives are able to instill a mindset in the participants that they are now in the insurance business. Additionally, the captive bylaws should incorporate a three- to five-year contractual commitment from each member.

10. Profit allocation--In their haste to set up group solutions, many organizers neglect to consider the long-term future of the captive. As a result, little time is spent considering how to properly allocate profits or losses generated by the captive. Accordingly, an important step to the long-term survival of the group captive is the development of an equitable distribution of profits and losses. The distribution system should be clearly spelled out from the inception of the program so that all participants are aware of the potential benefits and risks of joining the captive.

While it is sometimes impossible to implement all of the above factors in a startup captive, the more of these factors that can be incorporated into the operational plans, the better the chances are for the captive's long-term success.

Risk retention groups

One key group captive approach that will receive significant attention over the coming years are risk retention groups (RRGs). RRGs were established by federal legislation that was originally passed in 1981. The original law was limited to products liability and completed operations. As a result of its narrow focus and implementation during a soft market cycle, it had limited success. However, during the hard market of the mid-1980s, Congress expanded the scope of the act to cover most liability areas, and RRGs grew accordingly. In fact, the establishment of RRGs was one of the most effective methods of dealing with the hardening market during this period.

According to the January 2002 issue of the Risk Retention Reporter, there are currently 69 active risk retention groups nationwide, although 142 have been formed since the enactment of the law. Over half of these have stopped operating for a variety of reasons. While RRGs have been neglected recently due to the soft insurance market, one would assume that they will see much more attention over the next few years. The hardening insurance market will play a big role in this increasing interest; however, the primary reason is the direct result of the contracting availability of fronting carriers.

While group captives can be formed onshore (there are currently 20 states plus the District of Columbia and the U.S. possessions of Guam and the U.S. Virgin Islands that can serve as domiciles for captives; and this number grows monthly) or offshore, a traditional requirement is obtaining a fronting carrier to provide policy issuance and regulatory compliance in the individual states. However, fronting facilities have been greatly reduced over the past few years. Long-time fronting carriers such as Reliance National and Frontier have gone out of business. Further, one of the most active fronting carriers, Legion, has encountered rating problems recently. Fronting costs that early last year were running around 7% to 8%, are currently in the 10% to 12% range--when you can find a fronting carrier. A properly designed RRG that is licensed in one state can operate in all 50 states, thus precluding the necessity of a fronting carrier. As a result, the RRGs' future use as a solution for group programs appears bright.

Additional interest has been generated by the recent announcement by the National Risk Retention Association (NRRA) that they were beginning to lobby Congress to expand the scope of the RRG legislation. The NRRA would like to amend the law to include property coverage. This would appear to be a natural for this important group alternative.

Other options

As mentioned above, several other group captive solutions are available to small and mid-sized accounts. Among the more popular options are agency captives, rent-a-captives and protected cell captives. In addition, group self-insurance has proven to be an effective alternative for mid-sized employers. We will discuss these options in next month's column and look at how they can fit into a company's enterprise risk management program.

The author

Michael J. Moody, ARM, is managing director of Strategic Risk Financing, Inc. (SuRF). SuRF is an independent consulting firm that has been established to advance the practice of enterprise risk management. The primary goal of SuRF is to actively promote the concept of enterprise risk management by providing current, objective information about the concept, the structures being used, and the players involved.