Loss control: Mission critical for captives
The loss control program will determine the future viability of any captive
By Michael J. Moody, MBA, ARM
Interest continues to grow with regard to captive insurance company formations, despite the current soft insurance market. Business owners have found that captive insurance companies can provide a viable risk-financing vehicle by offering a more cost-effective approach than the traditional commercial insurance market. Captives can provide their owners with a mechanism to avoid the peaks and valleys of the commercial insurance market and ultimately allow the owners to “control their own destiny.” Additionally, captives can often provide cost and coverage advantages over the commercial insurance market.
Obviously, any owner wants his or her captive to succeed. And there are a number of things that owners can do to tip the scales in their favor.
• Any captive owner must view the captive as a long-term venture that is designed to take maximum advantage of the overall market conditions, while adding stability to budgeting and planning.
• The owner must also be committed to adequate funding levels of both capital and surplus.
• Additionally, for group captives, risk-sharing and risk-pooling features are extremely important for the long-term success of the captive, as are profit-sharing methodology and underwriting criteria.
In many cases, the captive will achieve built-in expense reductions that will result in annual savings for the owners. This is typically easy to accomplish since a number of expense items can be eliminated through the use of a captive. While some of these savings may occur quickly, during start-up mode, other efficiencies will occur later in the process, depending on the structure and role of the captive.
But there is one factor above all others that is certain to advance the success of any captive—the captive will serve as the focal point of a proactive loss control program. It is so important, in fact, that a captive owner can eliminate a few of the above referenced factors and still be able to achieve a successful captive. However, without a long-term commitment to loss control, the captive’s likelihood of success is compromised.
Job one
Obviously, it should be noted that there are significant differences between the loss control strategies for single-parent captives and group captives. Accordingly, the informa-tion provided will, of necessity, be general in nature but the key factors will generally apply to both types of captives.
Preparation—As with most programs, providing the proper preparation will serve as the foundation for a proactive loss control program. In this case, says Randall Moon, vice president, Global Risk Control Service, ESIS, Inc., “Preparation includes the initial steps that need to be taken in order to perform the subsequent analysis and evaluation.” From the start, it is important to keep in mind the needs and expectations of the captive and its business owner(s). In that regard, it is important to understand the specific issues that the industry segment traditionally faces. As a result, a fundamental requirement is a strong understanding of the loss exposures and hazards of the operations that are to be evaluated. For that reason, says Moon, it is important to retain industry-specific specialists that know not only the loss control aspect of the owners’ business, but the overall business and operational intimacies as well.
According to Moon, from a loss control standpoint, “A captive, whether single parent or group captive, should be able to maximize the returns from loss control efforts.”
This is a premise that is echoed by Carol A. Frey, vice president, national captive practice leader, ACE Risk Management. She points out that one of the primary motivations for an organization to pursue a captive structure is control. “Business owners today want to control their own destiny,” and she says captives are an excellent alternative to accomplish that goal.
Analysis—The purpose of the analysis is to determine the nature and magnitude of the loss experience scenarios and to identify potential mitigation strategies to correct this. One of the initial steps is to complete a loss/incident trend analysis, based on the actual experience of the captive owner. This will determine potential loss/incident trends and reveal significant patterns in the occurrence of losses. Frey points out that, frequently, the actual loss experience will be blended with industry-specific experience to determine the collateral requirements. This may be particularly true when the actual loss experience data is still gaining credibility, or when recently established loss control programs have not yet materialized.
Frey also indicates that the trend analysis is important so that the captive owner can “see the impact on the financials of the parent organization.” She says that “once the owner sees the cost savings from endorsing and managing loss control applications, frequently the owner will gain confidence and consider taking on measurably higher retentions and/or aggregates.” This, she points out, really highlights the importance of a strong loss control program since it will have a direct bearing of the purchasing of reinsurance and other retention limits deemed financially responsible to protect the captive’s balance sheet.
Evaluation— The evaluation step is usually done via a combination of thorough communication, review of records, and physical evaluation for the purpose of verification, Moon points out. One of the key concerns is the capability of insured’s management. Accordingly, there is a need to assess the capability of management to operate a safe, efficient and profitable business. In order to determine this, the following should be evaluated:
• The skill in managing the specific operation being considered
• The track record of management in controlling loss exposures and losses
• The insured’s organizational structure and key decision makers
It is important that any unsafe conditions and/or practices (typically accounting for 10% of the losses) that contribute to losses are evaluated. However, it is also important to evaluate any inadequacies in management control (which account for 90% of losses) that could be responsible for the existence of the conditions or practices. Moon says that since management controls are the fundamental method of controlling loss, their evaluation is the single most important step in the evaluation process.
Implementation—As with any management-directed program, as they say, “The proof is in the pudding.” Despite the fact that any captive owner should be focused on controlling losses, for a variety of reasons, that does not always happen. Therefore, it is important that the loss control program monitor the implementation of the program at the operational side of the business.
Periodic reviews of loss and incident reports should be a routine aspect of the loss control program. Corrective consultations, Moon says, should be held with captive owners that have less than desirable results, as well as discussion of the financial ramifications.
It is important to keep in mind that loss control is not just another item to be checked off when the captive is in start-up mode. Rather, it should be part of an ongoing business philosophy or culture that is supported from the top to the bottom of an organization. And since the business owner will now begin to “have skin in the game,” he or she may be compelled to put additional emphasis on an already successful loss control program. Over time, the captive owner can begin to see that the captive may be able to strengthen its loss control practices, resulting in greater financial savings for the business.
Conclusion
Now that over 50% of the commercial insurance marketplace has implemented some form of alternative risk transfer program, it is important to provide business owners with the tools that can better help them develop and maintain successful programs. For many business owners, captives are becoming the alternative of choice. And while many aspects of the captive are important, only one is critical—loss control.
Frey says that the real key to the success of a captive is to be able to incorporate state-of-the-art loss control techniques and practices. “Unlike purchasers of traditional insurance company products, who are typically limited to whatever loss control is available to support underwriting, captive owners will demand to unbundle their services in order to retain the best and most suitable loss control services.”
Moon says that the captive owner “should find a loss control service provider that combines an intimate knowledge of the specific industry operations with comprehensive knowledge of typical exposures and interventions. That provider will then conduct a comparative analysis of actual losses against expected by frequency, severity and location. Existing management programs, dedication to prevention and current policies and procedures are reviewed against known best practices.” Then, he points out, the loss control program can be enhanced and formalized with specific measurable objectives providing the captive and its owners the best chance of long-term success. *