Conventional insurance coverage at non-prohibitive premium costs has over the past three years gone by the wayside for numerous businesses, professionals and other entities. Poor financial investments, insufficient settings of reserves, incompetent and/or often times shorthanded claims adjusting staffs, and the misappropriation, misuse and/or abuse by insurance carrier officers and directors of an insurer’s funds and/or assets, had in the late 1990’s and early 2000’s placed a number of insurance carriers on the brink of their financial demise. These factors, coupled with the 9/11 World Trade Center terrorist incident, have resulted in a number of large insurers and reinsurers being placed in rehabilitation and/or liquidation. Within the past three years, the world’s largest reinsurer, Reliance Insurance Company, has been placed in liquidation. Other primary insurance companies have also been placed in liquidation (e.g., Legion Insurance Company; United Capitol Insurance Company; Phico Insurance Company) and/or rehabilitation (e.g., Frontier Insurance Company). Other carriers have eliminated the availability of coverage for certain businesses and professionals or otherwise severely restricted the coverage that is still offered while charging exorbitant premiums for such coverage.
Because of the very serious constriction in the availability of conventional insurance, numerous businesses and professionals are turning to “Alternative Risks Financing Techniques” (ARFT). Such ARFT include captive insurance companies and risk retention groups. For material handling equipment dealers and other high risk businesses, these non-conventional programs are sometimes the only means of insuring against losses inherent in their operations. Others have chosen to participate in these programs due to the cost savings, tax and other financial benefits afforded by their use. Each of these programs offer advantages, disadvantages and critical characteristics that need to be considered in the adoption of a potential ARFT.
Captive Insurance Companies
The two primary forms of ARFT used to provide funding for general liability claims are captive insurance companies and risk retention groups. A captive insurance company is an insurance company that has been formed to insure or reinsure risks arising out of the operation of companies that are owned by the shareholders of the captive insurance company. A captive insurer can either be a stock company or a mutual company. Such companies may be formed outside the United States (Bermuda and the Cayman Islands are the primary countries of choice for captives owned by United States based entities) or within the United States in a limited number of states. The formation of such companies depend upon meeting the requirements of highly specialized statutes that require substantially less capitalization than that required for traditional insurance companies. Captive insurers can take any of the following forms:
- A single parent captive that insures only the risks of the parent corporation’s subsidiaries;
- Association or industry captives that are established and owned by several companies in the same line of business (often through an industry or trade association);
- Mutual captives that insure the collective risks of the members through a mutual insurance company whose shareholders are its policy holders; and
- Partial or open market captives that insure not only the risks of entities owned by the owners of the captive, but also insure unrelated third-party risks.
Risk Retention Groups
Risk retention groups are primarily entities that are formed by corporations engaged in the manufacturing of goods or equipment. As a general rule, risk retention groups provide general liability insurance coverage in the field of product liability.
Captive insurance companies and risk retention groups are viable alternatives to traditional or conventional insurance when the cost of traditional insurance is excessive in comparison to the actual claims experience of the insureds. That is, if the total amount of dollars paid for insurance is substantially in excess of the total of amount paid out on claims (including defense costs) by the traditional insurance carrier on behalf of the insured, then participation in a captive insurance company or a risk retention group is a viable alternative to traditional insurance. Captives provide companies with good loss run experience, an alternative insurance format to that of traditional or conventional insurance and are often explored when the traditional market becomes constricted.
Payments made to a properly structured captive or risk retention group are tax deductible by the insured. In addition, funds not used to pay claims and related expenses go back to the insured (rather than being kept by an insurance company or eaten up in agent commissions).
Utilization of an ARFT, such as a captive insurance company or a risk retention group, should only be pursued if:
- There is a long-term commitment to the program (at least five years);
- There is adequate capitalization of the program;
- There are selective participation standards for participation in the alternative insurance program (i.e., companies with bad loss experience are not permitted to participate in the program);
- There is true risk sharing amongst the participants in the program (this assures the existence of deductibility of payments made into the program);
- There is a clear understanding of the methodology of profit sharing (i.e., return of premium dollars not used to pay claims and expenses); and
- The participants in the program establish up front a mechanism for withdrawal from the program.
In order for an alternative insurance program format to be successful, it is imperative that the insureds develop and implement a comprehensive risk management program utilizing knowledgeable specialists and competent defense counsel selected by managers of the program. When these commitments are present and vigorously adhered to, and the program participants have good loss experience that is maintained while participating in the program, the captive insurance companies and risk retention groups enable their participants to implement substantial cost savings over the long term. This equates to more dollars going to the insured’s bottom line, rather than to the bottom line of the insured’s traditional insurance company and its insurance brokers.