Alternative Markets Reach New Levels

“Client, insure thyself!”

Well it hasn’t quite reached that point yet, but the hard market has caused insurance buyers to commence an unprecedented search for affordable risk management solutions. Pushed to the wall by carriers’ demands for stricter underwriting standards and higher premiums, the buyers and their agents are increasingly exploring the alternative market.

There are a lot of choices: Self-insurance, captives, rent-a-captives, sponsored captives, insurance pools, associations and groups, risk retention groups (RRGs) and purchasing groups (PGs) to name the most popular. Over a year ago A.M. Best’s Review, predicted that “nearly half of the risks of the U.S. commercial market will be placed in the alternative market by 2003.” Given the accelerating trend, that point may have already been surpassed.

“The rate of formation [of RRGs] has tripled this year,” said Karen Cutts, publisher and managing editor of the Risk Retention Reporter. “So far this year 32 have been formed, an all time high.” There were 21 formations in 2002, bringing the total to 90. The August issue of the Risk Retention Reporter covers 117 RRGs, and Cutts said there are at least three more on track for September.

“So far this year there have been 44 new captives formed, and I know there are 12 to 15 currently in the pipeline,” said Ken Horseman, the communications director of Vermont’s Department of Economic Development. “I think we’ll beat the 70 that were formed last year.”

Bermuda hasn’t experienced an upsurge per se in 2003; however, according to Rory Gorman, head of office at Marsh Management Services in Bermuda and president of the Bermuda Insurance Market Association, the island has been forming close to a hundred new captives annually since the late ’90s. He said, “there were 47 new insurance vehicles as of July 31, of which 40 were brand new captives.” He also indicated that the fourth quarter is usually the busiest period for new company formations, and there would probably be around 100 by year-end. Ninety-six were formed in 2002, which makes the growth in 2003 even more remarkable.

Last year witnessed such a rapid acceleration in the alternative market, that Cutts told the Insurance Journal (IJ West Jan. 27) that it had been “a historical period of growth.” A year ago Andrew Barile, who heads a consulting service in Rancho Santa Fe, Calif., specializing in advising companies, associations and other groups concerning alternative market solutions, noted that he had been “doing a lot more captive feasibility studies lately.” (IJ West Aug. 5, 2002).

While Vermont remains the most important U.S domicile for captives and RRGs, the growing demand has induced other states to go into the business. South Carolina has become another leading center. Last June Moody’s Investors Service became the third company to organize a captive insurer in New York. Arkansas landed its first captive insurer last February. Hawaii welcomed its ninth in June, less than a year after it enacted a captive formation law. In August the Kentucky Hospital Association established “a Kentucky-based captive insurer/risk retention group in the Commonwealth.” A group of long term care facilities in Pennsylvania and Ohio just established an RRG in Montana. As Jimmy Durante used to say, “Everybody wants ta get inta de act.”

The newcomers still have a way to go, however, if they are to equal Vermont. Last year the state licensed a record 70 captives with gross written premium volume growing from $5.1 billion in 2001 to $7.2 billion in 2002. “2003 is on a pace to eclipse that total,” said a recent press release.

“We have more than 20 years of experience in the formation and regulation of captives,” said Horseman. “Plus we just passed some very important legislation to update our statutes.” The legislature elevated the former captive “section” to “division” status in the state government. Sections of applicable captive insurance laws were amended to bring them up to date, and the state enacted a “tax cap of $200,000 that goes into effect this year and a 5 percent premium tax reduction going into effect in 2004,” said an official bulletin. Daniel Towle, Vermont’s director of Financial Services, stated, “We will continue to make sure that we keep pace with the changing needs of the industry and will do whatever it takes to retain our leadership position.” Governor Jim Douglas commented, “These changes are an important way for us to thank an industry that continues to support Vermont. We owe our leadership position to those companies that chose Vermont as a domicile and to the management companies and brokers that work so hard on our behalf.”

The state’s reputation, that it caters only to large companies and is mainly interested in pure captives, may also be undeserved. “We have a diverse portfolio, and we don’t want only pure captives,” said Horseman. According to a bulletin issued July 17, while most of the 37 new licensees at that time were pure captives, there were “eight risk retention groups, three industrial insured and one sponsored.”

“Our primary concern is the best interest of the applicant,” Horseman continued. Vermont’s captive insurance division employs more than 20 full time staffers, whose job is to closely examine all aspects of a license application after the brokers, accountants and other organizers have put together a feasibility study. “And we’ll tell them if it doesn’t make sense [to form a captive],” he added.

The healthcare industry is one of the main engines spurring growth in the alternative markets. Horseman noted that of the 44 captives licensed in Vermont this year “eight or nine are in the healthcare field.” Cutts said that so far this year 17 [of the newly formed RRGs] provide a range of liability coverages to hospital health systems and their affiliated physicians, five insure physicians or groups of physicians, and five are insuring nursing homes. “The remaining five cover risks in a variety of business areas, including software developers, roofing manufacturers, contractors, propane dealers, and homebuilders.”

As Barile observed activity in alternative markets tends to coincide with periods of “capacity crisis.” He also noted, “Every time we go through this [a capacity crisis], one sector gets picked on.” Right now there are three. The healthcare industry is trying to cope with steadily increasing med-mal premiums, while nursing homes and long-term care facilities are being flatly refused coverage. Workers’ comp is in almost the same situation, and D&O and E&O coverage is increasingly expensive and hard to obtain. Companies and groups must pay the higher premiums, go uninsured, cease risky operations entirely, or seek a solution in the alternative market.

Rory Gorman noted that, contrary to the ’90s when big companies were primarily focused on creating an additional profit stream with their captives, now they are overwhelmingly dedicated “to controlling the cost of risk.” As an example he cited the average 50 percent increases in the cost of D&O coverage and workers’ comp—singling out California’s 100 percent rise in workers’ comp as a prime example. He also noted the greatly increased demand for property coverage.

The implications of the growing demand for captives and RRGs may go beyond a “hard/soft” market analysis. For one thing the pipeline is clogged. South Carolina reportedly told the Pennsylvania and Ohio long-term care people that “they wouldn’t be able to even look at a new captive submission until after Jan. 1, 2004.” A principal factor, according to Gorman, is the increase in submissions by applicants. Those with the most risk—and the most money—go to the head of the line. As a result, he said, “there’s a lot of pent-up demand for traditional captives.” In fact the alternative market may have achieved a sort of critical mass, which will keep demand high for years to come in spite of general market conditions. Vermont appears to be an exception; “we can issue a license in 30 days or less,” said Horseman—providing all the requirements have been met.

The return of “soft market” conditions may not result in substantial decreases in the number of captives and RRGs. Cutts observed that in the last hard market “insurance companies were abandoning their policyholders,” forcing them into the alternative market. When the market turned, “many of them remained as RRGs.” This time around even more entities are going to opt for that solution. The relationships they build up with the carrier or broker who handles their captive tend to grow over time, said Cutts, and “they tend to remain as RRGs,” and don’t return to the market even when more favorable conditions appear.

The alternative market itself is strengthened as more companies and groups move into it; i.e., the more captives and RRGs there are, the more interest is created in them among others who are in similar situations. This makes it easier to accept self-insurance as a realistic solution to risk management problems, rather than as an exotic vehicle reserved for Fortune 500 companies, and that encourages greater numbers of feasibility studies and more alternative market formations. Eventually the trend becomes self-perpetuating, and largely disconnected from market fluctuations.

Pure captives or RRGs, however, are frequently too costly for smaller or poorer companies or groups to form and maintain; which has led to the development of PGs, sponsored captives, and rent-a-captives, or, as they’re called in Bermuda, “Segregated Account Companies” (SACs). Cutts indicated that although PGs continue to be formed, “the carriers have become very selective. You need a good loss history and minimum annual premiums of around $10 million.” In easier times minimum premiums could be as little as $500,000. “There are also fewer carriers, and thus less choice,” she continued.

A broker, an insurer or an insurance agency may form a sponsored captive. The sponsor retains actual ownership of the insurer, but usually underwrites none of the risks. It provides or “rents” its use to interested groups in exchange for a premium payment. These “are ‘firewalled’ from one another,” Gorman explained. “Each one is in a locked box and only pays claims of that one insured”—hence the term SAC. The insureds are protected from having their funds reached by creditors or liquidators in the event another user of the captive becomes insolvent. An agency can use such a vehicle to offer their clients an additional solution to risk management concerns, while still retaining the clients’ business, and even increasing it, as the captive account grows.

Improved claims management concerns are an unintended, but fortuitous, consequence of the increased use of alternative market solutions. Captives, RRGs, etc. differ markedly from classic insurers. Notably, except for PGs, there’s no primary carrier who has assumed the risk. That stays with the company or group. With your own money at stake, you have a critical interest in the gains and losses of the captive. That’s the best incentive in the world to control costs, and it greatly encourages the insureds to start paying more attention to claims control.

“We’re seeing huge retentions,” said Gorman, “up to $25 million.” As a result companies that are self-insured are indeed becoming more concerned about loss control and safety procedures. He indicated that both risk managers and claims managers need to have more data available, and need to pay more attention to it, along with increasing security precautions and hiring company personnel who are adequately trained to recognize and respond to risks. The situation is analogous to the procedures of companies like AIG and Hiscox, who require would-be buyers of Kidnap, Ransom and Extortion coverage to conduct a thorough analysis of the risks and put in place pre-emptive planning to prevent loss events from happening.

If the trend spills over into the rest of the industry, so much the better. As Katie Robley, publisher and editor of Claims Guides, a division of Wells Publishing, observed, “the claims people are the poor relations of the insurance industry. They’re frequently poorly trained and badly paid.” Gorman said with workers’ comp, “You have to put greater emphasis on claims administrators and examine the claims process.” Better training and higher pay to attract competent people would be a good start. Paying a good claims manager $70 or $80 thousand a year is well worth it, as they can probably save a lot more than that in claims payments.

In theory any market benefits, when it becomes more efficient. Some groups, companies or individuals, unable to get traditional coverage, will also be unable to find a solution in the alternative markets, and will ultimately disappear—Professor Hayek’s “creative destruction” theory at work. Those remaining should be functioning more effectively.

Hard markets in med-mal, workers’ comp and D&O may last quite a while. There are no indications that the runaway claims costs and jury verdicts are going to start shrinking any time soon. Therefore providers of these types of services may have little alternative other than to become self-insured. As the validity and advantages of forming a captive, an RRG, or similar solution, continue to be recognized, it will stimulate more alternative market growth.

Organizations that opt for the alternative markets aren’t totally lost to the insurance industry, as companies beef up their staffs to accommodate all the new captives, and RRGs.

“The first thing we tell them [potential captive licensees] is find a manager,” said Horseman. He mentioned Marsh, Aon and AIG, but there are many other service providers who have specialized captive management units. Seeking the advice of an experienced company remains critical, both in the formation and management of a captive. The transfer to alternative markets then becomes close to a zero sum game, as jobs are cut back on one side—buying and selling insurance—they grow on the other end—managing and providing services for alternative market companies. It’s all part of the insurance industry.

Topics Carriers Agencies Claims Workers' Compensation Market Vermont Risk Management