Enterprise risk captives insure risks that are highly volatile and severe – events that happen infrequently, but when they do happen, they are very big. Over the course of a few years, a captive can go from very low liability to a total limit loss. That’s why captives need to be structured correctly, so that they’re ready to absorb these losses when they do happen.
Captive loss ratio
There is a misconception that captive loss ratio pools are at 5 percent, and that underwriters are overwriting the risks a captive covers. It’s true that a captive can operate for 5 – 7 years on average with no loss at all, and then suddenly experience a 100 percent loss, accounting for a more realistic 50 percent loss ratio.
Comparing this loss ratio rate to the commercial market won’t work in this case. The loss ratio for a captive is going to be much lower in profitable years, and extremely high in a given year. A commercial policy might insure nuisance flooding and pay out on small claims throughout the year – a captive, on the other hand would cover a catastrophic flooding event and may pay only one huge claim in ten years. Additionally, captives cover catastrophic events that aren’t even priced on the commercial market.
An A.M. Best Special Report on captive performance outlines how any why captives differ from commercial rates and is well worth a read for additional information on the topic.
Pricing risk appropriately is a key function of any insurance company. A really big player in the insurance industry can be brought down quickly if they haven’t structured their pricing appropriately.
As captive managers, we’re looking at the severity and volatility of risks, along with the cost of the claims and the breadth of the coverage. These are the four key areas of captives that influence pricing. Because captives are “boutique” in what they offer as well as in how claims are paid, some of the pricing is higher. Captives don’t see the type of day-to-day volume in claims that commercial providers do, so captive managers don’t enjoy contract pricing with law firms or big accounting firms. These costs are perhaps less frequent, but more expensive to the captive manager when they arise.
Captives also specialize in deductive buydowns. As the nature of the commercial market changes, so do captives. Consider employment practices and liability coverages. Most companies that carry an HR policy typically have HR procedures well in place. The sophistication of HR in general has caused underwriters to raise deductibles so that only the most severe claims are covered. But when a problem does arise, the companies are now faced with paying out-of-pocket claims of up to $25,000 to almost $75,000 in some cases. Captives are there to alleviate those instances where the unexpected occurs.
Accuracy in pricing
In Part I of our enterprise risk captive series, we talked about how important it is that a captive works with a reputable actuarial firm. Accuracy in pricing is critical to captives. When you’re talking with a potential captive manager, ask these questions:
- Can you break down your expense ratio for me?
- Can you show me your past performance for loss ratios?
- How do you calculate future loss ratios
- Can you talk about the experience your underwriting team has and how their experience relates to my industry?
The relationship that you have with your captive manager will be a close one. Be sure the company you work with can speak with integrity about their approach to the business, their expenses and losses, and that they’ll patiently take the time to help you understand their business as well as you want them to understand yours.
If we can help you work through some of these questions, contact us.