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The use of captive insurance companies has recently jumped across a number of lines as the coronavirus pandemic’s ushering in of lower interest rates and higher premiums made captive insurance comparatively cheaper, and its growth could continue as companies embrace its other benefits.
Captive insurance companies are insurance companies set up and owned by a parent company for the purpose of offering insurance to the parent and paying for losses the parent has decided to have insured by the captive. They operate like any commercial insurance company, underwriting their parent companies’ risks, investing the premiums received and complying with state regulatory requirements. Besides self-insurance, captives are sometimes used to offer third-party insurance to entities besides the parent company.
Captives are often used by parent companies to insure risks that commercial insurers are unwilling to insure, to permit access to the reinsurance market, or to allow companies more control over the claims process and the capital in the captive.
In the past two years, there has been unprecedented growth in the use of captives, from the creation of new captive companies to the increased use of existing captives. Marsh Captive Solutions, the world’s largest provider of captive management services, formed over 200 captives during the two-year period from 2020 to 2021, higher than any other two-year period in the company’s history, Mike Serricchio, managing director at Marsh Captive, told Law360.
Beyond the rate of formations, captive use also increased in lines of insurance that previously did not see widespread captive use, such as cyber, directors and officers and medical stop-loss insurance. The amount of premiums written by captives for cyberinsurance increased 54%, from $41 million to $63 million, from 2019 to 2020; the premium for medical stop-loss increased 81%, from 1.4 billion to $2.6 billion during the same period; and the premium for directors and officers liability went from $55 million to $83 million, a 50% increase, according to a Marsh report based on information from 1,300 of the company’s managed captives. There are about 7,000 captives globally, according to the AM Best Captive Center.
The growth in captives’ popularity can be largely attributed to their potential to provide premiums savings as traditional insurers across many lines began to increase their premiums or lower capacity over the past two years, in many cases due to factors related to the coronavirus pandemic. As the pandemic amplified downward pressure on interest rates, insurers in general became focused on “getting risk premium for their capacity,” Dan Ryan, a senior director with AM Best, told Law360.
When interest rates are low, insurers’ fixed-income investments generally experience weaker returns, resulting in lower profitability. As a result, many markets experienced price increases as insurers realized that investment income might be insufficient to offset underwriting losses, Ryan said.
Beyond its widespread impact through low interest rates, the pandemic also exacerbated factors driving price increases in the cyberinsurance sector specifically. As remote work became increasingly popular, the risks of cyberattacks rose as cyber criminals gained more opportunities to strike, further rocking a market already reeling from rapidly evolving ransomware threats.
There were also non-pandemic factors coinciding with the pandemic that influenced premium increases in other lines. For example, claims inflation and trends in litigation growth resulted in insurers raising premiums for financial and professional lines, including directors and officers liability, by 34% in the second quarter of 2021, according to a Marsh report. For medical stop loss, the rising costs of prescription drugs, the Affordable Care Act’s ban on lifetime limits and the rising costs of medical care in general have caused commercial insurance prices to rise, Julie Robertson, chair of Honigman LLP‘s insurance department who represents businesses in forming captives, told Law360.
As commercial insurance increased in price, captives became comparatively more attractive as they offered several options for lowering costs. Companies with more specialized risk profiles could lower premium costs when using a captive because captives could engage in more granular underwriting and a deeper understanding of the company’s risks. Additionally, as commercial insurers increased retentions, companies could put those amounts into their captives, Robertson said.
“If the claim hits this year, at least I’ve got money set aside for it, and if it doesn’t, good for me, I’ve got money set aside for next year for other things,” Robertson said.
Another benefit of captives that came to the forefront during the pandemic was companies’ increased control of capital. Because those parent companies paid their premiums to their captive subsidiaries instead of outside carriers, they were able to tap into their captives’ capital during the early days of the pandemic, Serricchio said.
“In that pandemic year you found that a lot of companies were needing to access cash — manufacturing, auto industry, retail — and what they did is they used some of their cash in their captive to do intercompany loans,” Serricchio said. “It was amazing because six, eight months down the road, when they were sort of back in business, they repaid that loan, and it showed that the captive really helped the organization.”
Beyond the pandemic’s effect on commercial lines making captives more attractive, there have been developments within the captive space that have made them a more advantageous and accessible option. Over the last decade, the professional services firms that are involved in creating and running a captive, including actuaries, accountants, attorneys and captive managers, have become more efficient at providing such services, Morgan Tilleman, a partner with Foley & Lardner LLP who represents insurers and reinsurers and also advises businesses on captive usage, told Law360. This has helped lower the barrier to entry for many businesses that otherwise might have been put off by the costs of starting up and maintaining a captive.
“It has become an increasingly commoditized service,” Tilleman said. “At one point, this was a bit of a bespoke process. It honestly no longer is.” As a result, most of the day-to-day compliance costs, which are the “hard” costs of running a captive, have become less expensive, Tilleman said.
Additionally, a new form of captive, known as a cell captive, has further brought down costs and allowed smaller businesses, which may previously have been priced out of captive creation, to enter the space. Sometimes known as a series captive, a cell captive is a single legal entity in which different companies looking to set up a captive can purchase a “cell,” or a ready-made captive structure, without having to invest as much time or resources as would be required in setting up a captive on their own.
“It used to be you have to be a big business, come in and capitalize your own captive, hire an actuary, hire a lawyer. And there’s a cost to running a captive insurance company every year,” Robertson of Honigman said.
“It was a strategy that only really large businesses could use 20 years ago. It’s now a strategy that mid-market and even smaller businesses can use as well,” Foley & Lardner’s Tilleman said.
While captives have experienced unprecedented rates of formation and use in the past few years, it is not a certainty that they will enjoy continued popularity. Captives’ use has traditionally risen when insurance markets are “hard,” where premiums rise and capacity falls, and fallen when markets soften, Robertson said.
At the same time, however, the reduced costs of creating and maintaining a captive could convince some businesses to maintain their captive even if the commercial market softens, especially if those businesses value the other benefits of captives like capital control.
“If the commercial market’s cheaper, because they think losses have gone down generally, why wouldn’t I take advantage of that too by just keeping paying my captive what my actuary says?” Robertson said, referring to a situation in which the premium for insurance from a commercial insurer may be lower than that of a company’s captive. “[The premium] maybe is a little more than what the commercial insurance market is telling me, but I’m at least paying myself, and I’m getting the investment income on that. And I’m also making the bet on myself that I’ll do better than what the actuary is projecting.”
Serricchio said that as the markets soften, “you’ll of course always see people being in it for the short term, but I think you’ll see the majority being in it for the long term.”
Another factor that could lead to captives’ continued popularity is there is now increased certainty regarding the regulation of captives, according to Robertson.
“In the beginning, there weren’t many [captives]. So if you were one of the four or five, you were kind of out there on your own,” Robertson said. “But now we’ve come 40 years down the road, so even if the laws haven’t changed, we have a better understanding of how they have historically been applied in practice.”
As captives become more accepted, they are likely to continue to coexist with traditional insurance, rather than ever replacing it, Tilleman said, noting that “there’s a real value to the risk pooling and risk management that only professional insurers can do, that can’t be replaced by an army of captives.” As such, companies can take advantage of both kinds of insurance by knowing which risks are better placed with a captive or with commercial insurance.
“There’s always going to be a coexistence of your capital versus the insurers’ capital, and making those smart decisions” as to when to take on some risk and when to transfer some risk, Serricchio said.
