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For decades, captive insurance entities have been used as risk bearing entities, but the motivation for their formation and utilisation has evolved.
For decades, captive insurance entities have been used as risk bearing entities, but the motivation for their formation and utilisation has evolved. What was once an alternative to the commercial insurance market has now evolved into strategic financial vehicles applied in many different settings, such as manufacturing, healthcare systems and life and health insurance companies.
Once formed to address commercial insurance market gaps or failures, captives now facilitate corporate financial and operational strategies. We have arrived at a new and enhanced place where the captive insurance company provides a significant part of the risk financing needs for its owner(s), and is an integral part of their strategic risk management programs and activities.
The financial capital of the captive entity should be effectively managed through prudent management, maintaining appropriate assets to back contractual commitments, balanced investment strategies, redeployment of assets for increased risk assumption, potential reinvestment in the owner/parent or related entities, or the return of accumulated cash in the form of dividends to owners. The captive vehicle has arrived as not only an effective and efficient capital vehicle for its owners, but also as a strategic vehicle.
We see this as both a linkage and leverage opportunity. Companies with a defined and understood business strategy always outperform others. Linking the captive’s operational and financial management to a defined business strategy of its corporate ownership creates alignment and significantly increases the value (or leverage) that the captive entity will deliver to its owners. This alignment is a fundamental aspect of strategic risk management, leading to the key question: how does the captive, or alternative risk management programme, support the owner companies’ or members’ broader business strategies, including revenue growth, expense reduction, cost containment and market opportunities?
Our work at the captive division of the Connecticut Insurance Department has revealed several examples of this linkage and leverage. This in turn has enlightened our understanding and improved our responsiveness to captive owners and service providers in Connecticut.
Operational risk management: patient safety and quality of care
Embedding the strategic risk management process throughout the enterprise and using it as the basis for informing and directing decisions is illustrated by the following example:
A healthcare system learned this lesson the hard way. A patient, suffering from stomach pain, was taken to a healthcare system’s emergency department, where he received X-rays of the chest and stomach areas. Upon review, the attending doctor observed no stomach abnormalities, and after a few hours of observation and dissipating pain, the patient was discharged. Fast-forward two years and this same patient dies of lung cancer. The healthcare system is successfully sued because it was proven that the patient’s X-ray, from two years prior, clearly revealed a lung mass.
This demonstrates how risk management, when limited in scope, may not fully address and support operational or strategic risk management initiatives. In this example, there was a missed opportunity for early diagnosis of a patient’s adverse medical condition.
Alternatively, when entrenched throughout the enterprise, operational risk management facilitates its business strategies. This enhanced operational scenario could be described as follows:
The healthcare system now embeds operational and strategic risk management processes throughout the enterprise. The use of the strategic risk management process as a basis for informing and directing decisions now calls for the attending physician to review the entire X-ray, and all other aspects of the patient’s health. If this comprehensive review of the patient indicates any abnormalities, such a lung mass, it now automatically generates letters recommending follow-ups to the patient’s physician and to the patient’s home address. Extending risk management, along with corresponding accountability, to the organisation’s furthermost tentacles should mitigate losses, thereby improving its profitability and capitalisation.
An optimal approach to embed the operational and strategic risk management process throughout an organisation such as a healthcare system is the formation/utilisation of a captive insurer as a facilitator or ‘transformer’. A captive insurance entity can create a specialised and focused risk entity that can provide functional capabilities that strategically support the organisation as it navigates a rapidly changing operating environment such as healthcare reform. Functional capabilities could include:
The above components should provide enhanced operational outcomes and efficiencies. They could lead to improved onsite risk assessment, risk mitigation and loss control corrective actions, which in turn, lead to improved contribution margins, ultimately strengthening the balance sheet and increasing capitalisation.
Enterprise risk management: embedding risk/reward and cost/benefit analysis
Strategic risk management decisions should follow an integrated model that embraces cost/benefit and risk/reward analysis and assessment. A contemporary example of the adverse outcomes associated with ignoring this process can be observed in General Motors’s ignition switch cost cutting decision, which led to the following:
Cost savings or cost avoidance decision: The cost of each replacement switch for the 2.6 million cars was 57 cents. This would translate into an estimated cost benefit of approximately $1.5 million.
Adverse impact of a sub-optimal business decision:
In this case, the cost savings decision led to personal tragedy for some customers and ultimately, unanticipated financial consequences for the enterprise. Successful companies can expand the cost/benefit or risk/reward system to all of their operations by establishing sound financial metrics for strategically managing their solvency, financial ratings and earnings. Comprehensive corporate governance and strategic risk management programmes can lessen the probability of adverse losses, the corresponding capital strains and reputational risk.
As with most risk bearing entities, the formation and utilisation of a captive in facilitating strategic risk management could prove beneficial. Rather than commercially or self-insuring such risks, a dedicated captive can facilitate the performance of both cost/benefit and risk/ reward analyses. The captive can also establish risk tolerance levels that are clearly understood and articulated throughout the enterprise, consistent with its goals, resources and board of directors’ expectations. Using a captive, for the purpose of elevating the enterprises’ strategic risk management, can lead to enhanced financial sustainability.
Human capital management: retiree medical benefits funding
According to benefit advisor Towers Watson & Co, Fortune 1000 companies reported $285 billion in retiree medical plan liabilities at the end of 2013. Many of those companies do not fund those obligations as pre-funding for post retirement medical benefits is not mandatory.
These obligations stem from employer promises made to employees—both union and non-union employees over time. Companies that now have accrued significant, underfunded liabilities may experience adverse financial impacts as their employees retire.
On 18 May 2014, an Internal Revenue Service ruling stated that an employer’s wholly owned captive insurance subsidiary could reinsure the employer’s retiree medical benefit risks and may be entitled to favourable tax treatment.
Prefunding retiree medical benefit risks in the captive arrangement may provide a number of potential advantages for the employer.
These include a reduction of the volatility of the captive’s financial results, reducing the enterprise’s long-term benefit costs, potential savings on insurance premiums for the employer, and better alignment of employee benefit risks with the employer’s overall strategic risk management strategies. In addition, the captive funding may have certain taxation advantages.
Control your destiny
The value of a captive insurance company extends beyond its original intent or design. The captive owners should measure the value of the captive by how well it meets or supports the operation goals and strategic objectives of its owners. Obviously in this situation, the ultimate return on the captive’s capital and its contributions corporate success will greatly exceed the traditional financial measures.
The organisation that manages its various forms of capital controls its destiny.
Captives are a powerful tool for enterprises of all sizes and orientations, to shape the future of their owners. Captives not only help manage costs, but can also optimise operating returns and improve decision making processes. Even more importantly, captives are a vehicle for leading transformational change.
Properly managed, there is no better set of eyes watching out for you, your employees and your bottom line than those of your own captive insurer.
