WEIGHING THE OPTIONS BECOMING AN INSURER

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2 By Avery Vise Editor s note: This is the second article in CCJ s The Cost of Risk series. Next month s installment will address the role driver selection plays in loss prevention. Several years ago, Dean Sexton abandoned his traditional insurance policy to join a group captive. It has been a good move, says Sexton, president of Carthage, Mo.-based refrigerated carrier D & D Sexton Inc., which operates approximately 140 tractors. A group captive is an arrangement in which the companies receiving the insurance coverage collectively create a business entity to act as the insurance company and share in one another s insurance risks. And if losses are low, companies that own the captive can realize a return on their investment. D&D Sexton s captive one of two transportation captives organized through insurance broker Cottingham & Butler has been around since 1993, although the carrier joined more recently. Interest in non-traditional insurance options usually grows when the market hardens

3 and premiums rise, but that wasn t the case for Sexton. I got in when the market was soft, he says. Why did D & D Sexton trade an affordable premium for an arrangement that required a significant amount of capital and exposed his company to more risk? Primarily, it was because a captive offered the company upside potential. Sexton was frustrated that he received limited insurance payback for his excellent loss control and safety record. Now, rather than a conventional insurance company profiting from its customers better-than-expected loss control, D & D Sexton and other members of the captive reap the rewards when losses come in below the actuarial forecast. And the captive members can earn investment income on the money they put up to cover those unrealized losses. There is a catch, of course. In alternative insurance programs, there s one important guiding principle: The insured bears a greater risk of loss than with other options certainly more than with first-dollar, says Gregory Feary, managing partner of law firm Scopelitis, Garvin, Light & Hanson. Feary has helped carriers set up group and single-parent captives those owned by a single company. Participating in a group captive requires more than just comfort in your own loss control. You must also accept the fact that a catastrophic loss by another motor carrier could hurt you. BECOMING AN INSURER A fundamental change occurs when you go from first-dollar through deductible policies to captives, risk retention groups and qualified self-insurance. The perspective that one has as a trucking executive differs from being an insurance buyer on one end of the continuum to being an insurer on the other end, Feary says. Loss control really means something as you get into these alternative programs. WEIGHING THE OPTIONS Considering your insurance options requires more than determining the premium and deductible. You should consider, among other things, your sensitivity to loss, desire for control over claims, capacity to handle administrative burdens and even your ability to understand and analyze how the program operates. Gtd. Retro Small Large Qualified Risk Retention/ Captive cost policy deductible deductible self-insured risk purchasing group Budget certainty High Med Med Low Low Low Low Loss sensitivity None Low Med High High High High Flexibility Low Low Low Med High High Highest Tax deduction Premium Just Just Just Just High High if premium premium premium premium structured & paid losses & paid losses & paid losses & paid losses properly Ins. co. profit & High High Medium Low Low Low Low admin. expenses Safety incentive Low Low Med/High High High High High Control of claims Low Low Med/High Med/High High High High Security None Low Med High Low Depends Depends Analytics Low Low/Med Medium Medium High High Highest required Coverage Low Low/Med Medium High High High Highest customization Admin. burden Low Low Low Medium High High High Source: Wachovia Insurance Services Commercial Carrier Journal May

4 Participation in a single-parent or group captive truly means owning an insurance company. The captive is a corporation generally formed by one or more companies that are to be insured by that captive. Owners buy into the captive by contributing capital. Over time, the number of owners in a group captive can grow and usually does. The captive s owner or owners pay an insurance premium to the captive and eventually benefit or suffer from the difference between the loss experience and the loss projection just as a regular insurance company would. Usually, the insured participant pays a deductible and posts collateral to ensure payment of losses. A captive typically differs from a conventional insurance company in several respects. First, most captives operate under the laws of another country, such as the Cayman Islands or Bermuda, although Vermont-based captives are also quite common. Overhead is kept to a minimum. Money spent on plush offices or executive perks would only raise the insurance cost of the captive s owners. When you hear of an offshore captive, you think of Learjets running around. It s not that at all, says Jack McSherry, president of Chester Springs, Pa.-based Penn Tank Lines and president of Fleet Solutions, a group captive organized by Marsh Inc. in For legal reasons, an offshore captive must arrange for a domestic insurer to front the coverage. A U.S. insurer agrees to pay the losses with the captive obliged to repay the insurer. For this service, the domestic insurer will assess a fronting fee that typically runs 5 to 10 percent of the premium, Feary says. The structure of captives varies. For example, in some situations known as rent-a-captives the captive membership is essentially leased rather than owned. Or as Feary puts it, A rent-a-captive member is an apartment dweller, and the group captive member is a condo owner. Even among group captives, rules and structures differ. CAPTIVATING ADVANTAGES Beyond the chance to recover some of your investment in loss control, captives offer other advantages. With the group captive s buying power, there is less exposure to market pricing, so the premium doesn t rise dramatically the way it does with conventional insurance when the supply of insurers dwindles. In a group captive, the premium generally will be fully tax deductible. Qualified self-insurance typically allows you to deduct only actual losses and only as they are paid. But what truly tips the scales in many cases is workers compensation, says Mike Lopeman, vice president of Gallagher Captive Services, a subsidiary of Arthur J. Gallagher & Co. That s often the biggest problem for motor carriers today, especially in states like Florida and California, he says. Sexton would agree. This year, he shopped the open market just to test his captive program. He found that he could get a reasonably comparable deal on physical damage and liability, but on workers comp they couldn t touch it. A captive s coverage flexibility doesn t end at auto and general liability, physical damage and workers comp. You can write coverages that might not otherwise be available from conventional programs, says Thomas Captive members must think and act like insurers Tray, senior vice president and head of Marsh Inc. s south region transportation practice. Those coverages might include environmental risk or loss of receivables, Tray says. Another advantage of group captives is their layered structure, which keeps risk sharing under some degree of control. Members are responsible for and pre-fund their own losses up to a certain amount, which varies from captive to captive. Risk sharing starts above that threshold, and if the loss exceeds still another threshold, the reinsurance coverage purchased by the captive kicks in. In the event losses exceed forecast, captive members can spread the financial damage out over time. In a group captive structure, you know what your potential losses are, and you know what the stop losses are, Lopeman says. If there is an assessment, you have three years to pay it off. The trend is toward giving individual members of a group captive even more control over their risk. Changes in the laws of Bermuda and the Cayman Islands over the past three or four years, for example, are allowing for group captives that are less tied to the shared risk model. One of the scarier aspects of group captives in the past is that someone will suffer a major loss, Feary says. But new protected cell public laws provide for a structure in which each owner, or cell, benefits from a firewall, he says. There is very limited risk sharing among members. WHO QUALIFIES? Once a group captive is up and running, it looks to add members so it can build the premium base and spread the 4 May 2003 Commercial Carrier Journal

5 burden of fixed costs and losses. Growth is desirable but only if the circumstances are right. That s the quandary Ray Mahan sees. You need other people paying into the captive to make it solvent, but you don t need the wrong people, says Mahan, vice president-risk management for Florence, Ala.-based USA Motor Express. Mahan considered captives during his company s recent renewal period but ultimately chose a conventional program in part because it was easier to enter and exit. You can t put a defining growth number on a captive because you don t want to lower the bar, Marsh s Tray says. In other words, quality is more important than quantity. To grow a captive, its manager might seek out trucking companies individually or through brokers and agents. Often, existing members recommend companies they know well. Very small carriers generally can t consider captives because they can t raise the upfront capital and because their premium isn t high enough to garner the captive s interest. It has to make economic sense, says Gallagher s Lopeman. A member should have at least $250,000 of premium to go into the captive. GOING IT ALONE Larger carriers can form their own captives The consensus among experts in captives for trucking companies is that once a carrier reaches 1,000 trucks or more, it should consider forming its own single-parent captive. At that point, the company probably has the financial wherewithal to capitalize the startup of a captive and fund its operating costs. And a single-parent offers the same benefits as a group captive, plus full control over risk. Among the advantages over qualified self-insurance is the ability to deduct the full premium, not just losses as they occur. But beware. The premium the captive owner pays to the captive isn t automatically tax deductible, says Gregory Feary, managing partner of law firm Scopelitis, Garvin, Light & Hanson. The Internal Revenue Service may determine that the payment is really just a reserve set aside to pay future losses and that only the losses are deductible as they are paid. To qualify for full deductibility, either the captive must not be a wholly owned subsidiary of its parent or 30 to 50 percent of the total premium dollars received by the captive must go to insure risk unrelated to the parent, Feary says. This approach works well in trucking, he says, because insurance provided to owner-operators can qualify as third-party risk. At 350 power units, Penn Tank Lines falls near the middle of the size range for the owners of Fleet Solutions. The largest carrier in the group is around 900 power units, and the smallest is 75, McSherry says. Feary typically sees carriers in captives as small as 50 power units and as large as 400. Lopeman believes that between 75 and 300 trucks makes the most sense, although a smaller carrier based in California or another tough workers comp state might still be able to justify the investment. But practically everyone agrees that once a carrier reaches 1,000 trucks, it s time to consider a single-parent captive instead of a group captive. (See Going it alone. ) A solid safety program and loss record is a given. But financial stability is almost as important. Strong financials are important because if you have someone whose financials are deteriorating, one of the first things to go is loss control, says Tray. At the end of the day, who am I in bed with? Problems with financial stability, not loss control, often disqualify a prospective group captive member, says Mark Fitzjerrells, director of captives for Cottingham & Butler. In this business environment, there are very few companies that meet that requirement. The concern isn t just collateral but also the ability to pay drivers, service equipment and so on, Fitzjerrells says. Aside from these basic criteria, captive members and managers say that the overriding qualification for joining a captive is company culture. You just have a loss prevention culture that you aren t going to stand for losses. Period, McSherry says. If you seek to join a captive, expect a rigorous process. Fleet Solutions, for example, uses a checklist of about 100 questions regarding safety and operations just to determine whether a carrier is worth subjecting to more rigorous review, McSherry says. After Marsh s transportation group reviews the prospect, the reinsurance company scrutinizes the trucking company s most recent five years of financials. If a carrier survives that, the prospect goes to the captive s underwriting committee for a yea or nay. Only the superior need apply. Each year we have raised the bar on qualifying, McSherry says. We have to be sure that we don t bring in one bad apple. In fact, just as the current owners must approve the addition of new owners, the owners of a group captive generally have the right to ask an owner to give up its stock and leave the captive. That might happen if the member starts to suffer repeated heavy losses. The extended trucking slump also has made it more likely that a car- Commercial Carrier Journal May

6 rier s deteriorating financials will cost the company its captive. That happened recently in the captive D & D Sexton belongs to. With times being tough, three companies weren t invited back, Sexton says. LONG-TERM APPROACH In any given year, a trucking company participating in a captive might find a better deal in the conventional insurance market. McSherry doesn t believe captive members will face the choice anytime soon between the captive and a soft insurance market, however. I think that will be awhile. You don t see a lot of people scurrying to compete. Still, a soft market will return one day, and captive members will face that decision. Marsh s Tray argues that what should make captives attractive is the fact that they largely free companies from the hard/soft cycle. One of the things they are looking for is stability, he says. They are removing themselves from the ups and downs of the market. People don t want to get into a hard or soft market. They just want to pay what they perceive to be their losses. And that, Tray argues, is one of the big advantages of captives. Ultimately, the trucking company gets back its money minus the losses and fixed costs while potentially earning a significant investment return on the capital it parks in the captive. Trucking companies in a group captive need to adopt a long-term mindset not just about costs but about profits as well, advises Jim Millar, transportation division leader for Wachovia Insurance Services. There s no underwriting profit or investment income right away, Millar says. Losses don t get valued until 18 months and then not really until 30 months. Although there are exit strategies in a soft market, Feary advises trucking companies to consider a captive a long-term strategy that flattens insurance costs over time. A hard market might be the justification for starting the captive, but owners should strongly consider sticking with it even when the market softens. But even if the temptations of a soft market become too strong, there are ways to put your captive on the shelf and keep it alive but dormant until needed again, he says. Although there may be no penalty for exiting a captive, one important issue is collateral, which is usually posted in the form of a letter of credit (LOC) to ensure coverage of losses that might pay out over several years. That financing capacity is tied up until the captive or fronting insurer frees it, and some carriers may have trouble obtaining another LOC to collateralize a new insurance program. OTHER WAYS TO BANK ON RISK A captive isn't the only insurance alternative for trucking companies willing to accept greater risk in exchange for important benefits. For a discussion of other options, see the online version of this article at Feary urges trucking companies to understand the collateral return process clearly. Don t let the captive decide when they are giving back your LOC. The collateral issue is hardly limited to captives. As deductibles have risen in conventional insurance policies, so has collateral. In those situations, the same potential for discouraging an exit strategy exists, limiting a motor carrier s ability to move from that insurance company to another or even to a captive. I have seen some unscrupulous insurance companies use collateral as a wedge, Feary says. Establishing a clear and definitive Captives can vote out poor-performing members process for returning collateral is just as important in a conventional program. Under the best circumstances, existing a captive simply won t make sense. Ultimately, the success of a captive depends less on matching the deals available in the conventional market than on pulling together a group of well-run trucking companies, managing claims well and focusing on loss control. We say that we are the cream of the crop, says McSherry. If we keep getting the cream of the crop, we will be very successful. Claims management and loss control services will dictate the success of any captive, says Fitzjerrells. If you don t have those, you will fail. Sexton s advice is both simple and challenging to implement. The key is to try to not have accidents and to be proactive when you do have an accident. It s your money, so you better be wise. For links to resources on various insurance options, including a glossary of terms, see The Cost of Risk series at 6 May 2003 Commercial Carrier Journal