Captives: An Alternative Construction Risk Management Approach

Consider this construction risk management strategy to gain increased stability and control.

The captive insurance market has existed for more than 60 years, with the first formal captive established in the 1950s. Since the first captive, the market has grown substantially with at least 3,440 captives in operation, which reflects a major percentage of the overall global insurance market. New captives grew by 13 percent in 2011 (320 new captives) overall in major captive locations.

Companies that use captives as part of their risk management program range from Fortune 500 companies to small businesses participating in association captives. Contractors have embraced using a captive program with their risk management program since the 1980s, and this has grown significantly during the last 10 years. 

What Is a Captive?

A captive insures the risks of a parent company, subsidiary or a group of its shareholders. Towers Watson, a global professional services company that helps companies improve their workforce, risk and financial management, describes a captive as “a closely held insurance company whose insurance business is primarily supplied and provided by its owners, for which the insureds are principal beneficiaries.”

The different captive types can be separated into three main categories: single parent, group and rental captives.

A single parent captive insures the risks of its parent company or related subsidiaries. A group captive structure might include association captives, industry-specific captives, such as construction, or a risk retention group (RRG). And rental captives include many variations of a license structure including a protected cell company (PCC), segregated accounts company (SAC) and segregated portfolio company (SPC). 

For this discussion, we will focus primarily on group construction captives.

What Happened in 2011?

Despite many challenges including the recovering economy, a soft insurance market and increased regulatory review, the overall captive market growth was healthy in 2011 with new growth in various captive domiciles. Every major domicile either saw an increase in their overall captive number, or they stayed flat at worst. 

From a construction perspective, group captives continued a slow growth because many recognize captives as a strategic element of a construction risk management program.

The Outlook for 2012

With an improving economy and a potential hard commercial insurance market, many anticipate that 2012 will provide another strong year for captive growth. This should occur in new captives and existing group captives as contractors stabilize their risk management programs by transitioning to group captives.

Captive Benefits

Captives can provide reliability and control by helping contractors stabilize their long-term risk-financing costs more effectively than the commercial insurance market. They also help contractors design coverages to fit their unique construction exposures and have a greater influence on overall claims management. 

The Pros and Cons

Review the advantages and disadvantages before considering a captive.

Pros

• Reduced insurance costs
• Investment and underwriting income
• Improved claims control
• Enhanced coverage
• Access to the reinsurance market
• Participation in best practices
• Stability of insurance costs
• Possible tax advantages
• Wealth transfer vehicle

Cons

• Capital requirements
• Collateral requirements
• Change in existing relationships
• Increased management involvement
• Stability of service providers
• Possible shared risks

With a good understanding of these pros and cons, contractors can perform an initial analysis to determine if a captive might be a viable option for their long-term risk management program. For many firms, the disadvantages can be managed and do not overshadow the abundant advantages.

Evaluating the Captive Universe

If you decide to participate in a captive, the next critical step involves identifying the best group captive. Since this is a long-term decision that you need to be committed to for at least five years, you must find a suitable match for your company. 

Several successful construction group captives are available with different sponsors operating in different domiciles—determining the best fit for your company will be the challenge.

When evaluating different captives, be sure you understand the captive’s business plan to determine if it aligns with your company’s objectives. The captive’s business plan should address the following:

• Ownership structure
• Member premium criteria 
• Growth objectives
• Underwriting model and responsibility
• Eligible construction classes and restricted classes 
• Financial management and investment policy
• Risk financing model
• Risk sharing model
• Dividend distribution policies or expense sharing
• Corporate governance 
• Reinsurance structure 
• Financial pro formas

Funding

The captive must be adequately funded with sufficient capital and surplus, and it should have a fully developed underwriting model that develops adequate premiums for each member.

Construction-Specific

The captive should consist exclusively of other construction companies. Find out which industry sectors the companies primarily engage in within the construction industry. A construction-specific captive should be the preferred choice—this will allow you to capitalize on the best practices of loss control, claims management and risk management.

Geographic and Industry Diversification

A captive comprised of shareholders with geographic diversity will be a better choice than a regional captive. Diversity addresses regional economic issues, which could impact a captive financially if all members operate in a restricted area.

The same concern applies to construction industry diversification. A captive consisting of a single construction industry sector will be susceptible to sector downturns, which could create pressure on the captive if all members’ revenues decreased substantially at the same time. A captive with members from different construction industry sectors and a broad geographic spread will provide the best opportunity.

Shareholder Members

Find out about the captive’s other members and why they chose to be a member. Then, decide if your company will be compatible with them—is the premium size of your company consistent with the other captive members, and do the members have a long-term perspective and commitment to the captive?

Involvement in a captive can be compared to becoming a partner in a company. Many decisions will be made with the other member companies, and having a level of knowledge, understanding and comfort with each of them will be critical.

Expenses

While captives provide reduced insurance costs, these costs can be impacted by the captive’s expenses. Does the program’s expense structure lend itself to long-term success? Has the captive managed the overall expenses in a way that allows most premiums to be allocated to funding losses? 

Service Providers

The experience contractors have with a captive program will be greatly influenced by the service providers that deliver specialized services to the captive members. The quality and quantity of those services and the experience of the partner companies will not only impact your individual results but your ownership experience as well.

You need to know the key companies providing services to the captive, their levels of experience related to construction captives and the history of those captives. Consider the captive sponsor, captive manager, claims service provider and the loss control services.

Fronting Company and Reinsurance

Most group captives rely on a fronting company (an insurer) to issue the policies and reinsurance to support the overall captive.

Evaluate their experience within the construction industry, A.M. Best financial ratings and other construction captive experience.

Captive Success

Participating in a captive will not be the only solution to risk management, but it can be a core component of your risk management program. Becoming a member of a quality captive built for long-term success, staying committed to claims and loss control best practices and being a leader in the captive will provide a successful captive experience for your company. 

Construction Business Owner, May 2012