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Risk Management

Squeezing More Benefits from a Captive Insurer

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April 02, 2019

Risk Management

A company with an insurance problem turned to a captive and now seeks ways to optimize it.

A tech company suffered a major recall a few years ago and risked being unable to buy product recall insurance—a contractual obligation with customers—if it had a second, similar event. So it turned to a solution that more than 6,500 companies have used to transfer risk beyond traditional insurers: a captive insurance company. The treasurer, meeting recently in New York with other members of NeuGroup’s Treasurers’ Group of Thirty, described the captive and sought suggestions about how to get more benefit from it—perhaps by earning more on the cash it holds or fattening it up with other risks.

FACTS AND FIGURES: Under the arrangement with the captive, the company retains $10 million and self-insures the first $15 million, farming out the rest of its coverage to other insurers. But that $25 million total doesn't look so bad when the company considers that prior to the captive it had a $10 million retention and only recovered about $8 million from the recall, about 50% of the claimed amount. "They covered the cost to ship, the cost to make the units, but not the overhead costs or the cost of actually installing the units," the treasurer said.

THE BENEFITS: Eliminating the previous annual premium of $1 million for external insurance, and considering the captive's rating and other annual expenses, has saved $700,000 a year. The $15 million in cash the company puts in the captive can be replaced by a letter of credit and quickly withdrawn if the need arises, and it contributes to the upwards of $100 million of liquid cash that the board agreed must be available. The treasurer said that hiring outside managers to invest the cash could add further value. And the captive structure retains the tax deductibility of the premium cost, with potentially $2 million in additional tax benefits over 10 years.

HOW TO OPTIMIZE? The company aims to insure high severity, low frequency risks that include product recall, errors and omissions (E&O) and earthquake. To optimize the captive, the treasurer is considering adding certain cyber and medical risk and asked for more ideas. Peers at the meeting said other risks held by their captives include financial and workers compensation. One member noted that medical does not appear to meet the high severity/low frequency criteria. The presenter said it would only kick in when those expenses exceed a certain level—for example, if five corporate executives are hospitalized for life following an accident.

MITIGATING DEDUCTIBLES RISK: The company farms out the E&O and earthquake deductibles, as well as 7% of the product-recall deductible, to a pool joined by 60 or so corporate captives to share risk. "The risk is capped—a worst-case loss is $670,000, and that would be an outlier; normally it's around $30,000 or $40,000 annually," the treasurer said.

THE ESSENTIAL CHINESE WALL: To reap the benefits of a captive you've got to stay at arm's length from it. "We put $15 million of cash in the captive and its investment policy and the parent company's are separate," the session leader said, adding, "We have to be very careful; it needs to be [a separate] insurance company, or we'll lose all the tax advantages." One member asked what happens if a dispute arises between the company and the captive? Should losses rise above the $15 million in self-insurance, putting the next insurer on the hook, then brokerage Marsh & McLennan, which sits on the captive's board, would step in to arbitrate.

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