Time for a second opinion?
Group captives should consider an independent review of operations
By Michael J. Moody, MBA, ARM
Not that many years ago, captives were considered by many as a risk transfer tool that was available exclusively to Fortune 500 corporations. Then mid-sized corpora-tions began to see the value of captive insurance companies. As a result, much of the recent growth in the captive industry and increases in captive formations have been driven by group captives.
Group captives have become the fastest growing area in the risk transfer industry. Much of this growth was fueled by hard market conditions in specialized lines of professional coverage that have occurred over the past 10 to 12 years. Many medical professional lines of coverage have had to turn to either group captives or risk retention groups (RRGs) just to have access to coverage. Much of the current captive growth still is driven by group programs.
Historical perspective
Forming a captive isn’t simple, but it is relatively easy. This is due in large part to captive promoters that have streamlined the formation process by using as few service providers as possible, thus providing for a turnkey approach to captive formation. This approach helps to accelerate the formation process and allows the owners to get up and running as quickly and efficiently as possible. Several large insurance brokers and captive managers have, over time, developed working relationships with key service providers so that the formation process is greatly consolidated and the actual operation of the captive can be more efficient. A more traditional group captive formation process is typically a very time-consuming process; so without question, the growth of the group captive movement has been greatly dependent on this more accelerated, turnkey approach.
However, in this post-Enron period, when major corporations are subject to Sarbanes-Oxley and other onerous regulations, Corporate America has been moving toward stronger corporate governance standards. The result is a general advancement toward more transparency and ethics in all of their business dealings. Additionally, boards of directors of any corpora-tion have also become more understanding of their fiduciary liability. Such is the case with many group captive boards of directors. As a result, once group captives begin to reach maturity (typically five to 10 years), the directors start to examine all of the operational aspects of the captive.
Case in point
Milestone Insurance Company (Milestone) is a heterogeneous captive that was formed by Artex Risk Solutions, Inc., about 10 years ago. Artex is a wholly owned subsidiary of Arthur J. Gallagher. Artex has been active in the formation of a number of group captives over the past 20 years, and Milestone is an example of this. Milestone currently writes workers compensation, general liability, and auto liability and physical damage for about 20 members. The captive was formed so companies that had a commitment to safety and had premiums greater than $500,000 had an alternative market option.
According to Catherine Duffin, CPCU, division chief operating officer for Artex Risk Solutions, “We have enjoyed a great relationship with Milestone, but their board realized they had a fiduciary responsibility to their members.” As a result, they began to review the captive’s overall operations and the competitiveness of their expense loading. At that point, with no relevant group captive historical data readily available, the captive had a limited number of ways to proceed. One option would be to write an RFP to obtain bids for similar services from competitive service providers. However, at this point, Duffin notes, the underwriting chairman realized that this would be very time consuming and still might not provide the results the directors desired. The underwriting chairman suggested that a better approach would be to retain an independent consultant to assist the board in determining the competitiveness of the captive’s expense loading.
Duffin indicated that Artex provided the board with a list of several independent consultants for consideration. Presentations were scheduled with each, and the board selected one of the independent consultants. The captive selected Dennis Silvia, CPCU, president of Cedar Consulting LLC, to perform the study.
The board wanted more than just a “rule of thumb” analysis, so Silvia decided to request expense factors from similar types of captives. In that regard, he was able to obtain comparable expense information from 27 similar group captives via seven different captive managers. The captives were heterogeneous groups located in Bermuda, Cayman Islands, Vermont and South Carolina. Information was obtained from the captives by use of a questionnaire. From the data supplied on the questionnaire, Silvia was able to obtain sufficient information to develop a comparative analysis of Milestone’s expenses as well as its actuarial accuracy and its collateral terms. In addition, Silvia points out that he was able to provide details regarding the captive’s fronting fees, reinsurance costs, claims handling costs, commissions, and other general and administrative expenses.
Proof is in the pudding
As a result of the analysis, Milestone found out that most of its costs were at or below average. The only exception was the fronting charges, which were higher than average. However, according to Silvia, “This is in large part due to the additional services that are offered by the fronting carrier.” In addition, Silvia noted that Milestone’s actuarial results “were in a very tight band indicating consistent and accurate actuarial results.”
Duffin says it is important for a captive board to be concerned about how well the captive is doing. “They should not take anything for granted.” At the end of the day, she notes, “Milestone’s board was happy they embarked on this exercise.” And, she points out, “even more importantly, they were happy with the results.”
“These kinds of reviews are critically important for any type of captive operation,” says Silvia. “In the Milestone case they were assured that they continued to enjoy a competitive cost environment. Other captives may have different reasons for performing a review. The risk financing landscape is constantly changing, and unless independent periodic reviews are conducted, the captive may not be performing as efficiently as it was at its creation.”
Conclusion
As a captive matures, it is only natural for its board members to be concerned about whether they are still on the right track, and, as Duffin says, “the captive is still working as effectively as it has in the past.” The biggest concern with embarking on a consulting project such as this, according to Duffin, is “to be sure the consultant makes an ‘apples to apples’ comparison.” And, as Milestone found out, “it is sometimes difficult to find an independent consultant capable of making this type of analysis.” She also states, “It is important to find a consultant that is able to communicate effectively with the board. We were fortunate to find a consultant to perform both those roles in Cedar.”
Today there is increased pressure on a captive insurance company’s directors to fulfill their fiduciary obligations. As time goes on, this drive for better transparency will only increase. Retaining an independent consultant who can assist the board with this task may well be the most cost-effective method of accomplishing this work. It is, however, extremely important to identify any potential conflicts of interest between the “independent” consultant and other captive services. Today, many consultants see these types of consulting assignments as the gateway to future involvement with the captive. Further, the “apples to apples” comparison is critical to obtaining an objective analysis.
When done properly, this type of review can be very beneficial to the board, as Milestone’s board found out. Duffin says, “They were proud of their results.” In the end, she says, “They confirmed they had a good captive with competitive expense factors.” And after the results were back, Duffin says the board “believed it was important to share this information with the insur-ance buying public.” As group captives become a more established part of the insurance industry, more group captives will need to consider a similar approach to this important matter. Early adopters such as Milestone will, however, gain a competitive advantage from their farsightedness. *