Let’s Talk Insurance: Do Captives Really Work for Carriers?
January 1, 2005
Lately, we've been hearing about an insurance alternative called "captives." A captive is a group of businesses that try to self-insure their own risks. This means getting together with some of your competitors and pooling funds to pay for claims...
Lately, we’ve been hearing about an insurance alternative called “captives.” A captive is a group of businesses that try to self-insure their own risks. This means getting together with some of your competitors and pooling funds to pay for claims – in essence, becoming your own insurance company. Captives can work in some industries, but don’t make sense in others.
In which industries do captives make sense? Basically, there are three tests. First, there is no insurance available for your type of business through a traditional insurance company. Second, your industry isn’t subject to large and extremely volatile losses. Last, your industry’s loss experience is historically very low, where traditional insurers have operated at 20-30 per cent loss ratios.
How does long-haul trucking stack up? It fails on all three tests: there are several insurers who provide trucking insurance; long-haul trucking is a highly volatile industry that suffers regular multi-million dollar losses; and the industry’s loss experience has been wildly unprofitable. In fact, long-haul trucking insurance is one of the most unprofitable types of insurance in Canada. Just look at all the trucking insurers that lost their shirts over the years. And, these were companies that had the tools to attempt this difficult type of insurance.
Captives can be a cash flow nightmare
In a captive, not only do you have to put up money for your insurance premiums every year, just as you would with a regular insurance company, but you also have to put up a lot of money at the outset to fund the captive’s formation. And, this capital is locked-in for years. But it can get even worse.
If your premiums aren’t enough to cover ongoing costs (claims, middlemen’s commissions and fees, reinsurance, etc.), you can be subject to substantial and unexpected “cash calls” at any time.
A traditional insurer who gets the price wrong can’t come back to you and ask for more money. In a captive, there’s no such protection.
In addition to cash calls, watch out for one particular captive sales tactic – a lowball insurance quote in year one just to get you in.
Once you’re in, and your capital’s locked in for years, your subsequent insurance rates can get jacked up dramatically.
As the saying goes, if it looks too good to be true, it probably is. There’s no magic formula.
Many more mouths to feed
So why are we hearing people pushing captives? Well, it’s an alternative. No one’s enjoyed the rising cost of insurance over the past few years, which makes any alternative sound interesting. But whose best interests do captives really serve?
Some captives have layers of middlemen, compared to a traditional insurance company where there’s just an insurance broker between you and the insurer. Captive middlemen may include the insurance broker, a wholesale broker, a captive consulting company, an offshore captive manager, actuarial companies and a fronting insurance company – to name just a few – all of whom take a guaranteed payment off the top. Compared to a traditional insurance company, there will actually be less money left in the captive “pie” to pay for claims.
Remember, the middlemen pushing the captive take none of the risk. You do! What they get is their commission income and fees essentially guaranteed for the three-plus years your money’s locked in. Contrast that with a regular insurance company – there’s only one intermediary, the insurance broker, and the broker’s commission is guaranteed for only one year. Wouldn’t you like to have your income guaranteed for three-plus years? That’s a heck of a reason for a broker or middleman to sell you on a new “alternative.”
The captive also has to pay for outsourced claims and safety management companies on top of everything else. Regular insurers pay their staff a salary. So too do the outsourced companies a captive is forced to use. However, outsourced companies also charge the captive for their marked-up profit margin – on top of their employees’ salaries. And, just like the captive’s salespeople and middlemen, these outsourced services take none of the captive’s risks. As a captive trucker, your pie just keeps getting smaller and smaller.
Captives will likely cost more
So, once the sales pitch is over you have less of your money left to pay for the actual claims costs after all the middlemen and outsourced fees are paid, and more volatility from big losses – even with reinsurance – all in an industry with one of the worst insurance track records.
Put simply, captives don’t work in long-haul trucking. Your decisions are driven by profit and flexibility. With locked-in terms and multiple levels of commissions and fees, you actually have less control of your insurance in a captive, which locks you into a structure that can ultimately cost you a lot more. Guess who’s left holding the bag?
– Mark J. Ram is president and CEO of Markel Insurance Company of Canada. Please send your questions, feedback and commentary about this column to firstname.lastname@example.org. For more information about Markel visit www.markel.ca.