As a key emerging market tapped by captives, how does the cannabis industry address risk and insurance in the face of misconceptions and a challenging federal mandate in the US?
The US cannabis industry can certainly be described as a booming emerging industry, reaching an estimated US$250 million in premiums in 2021 — with Rocco Petrilli, chairman of the National Cannabis Risk Management Association (NCRMA) arguing that, if insured properly and with sufficient capacity, this figure could reach close to $1 billion, presenting a huge opportunity for the captive industry.
A HUB International report providing a 2022 industry outlook notes: “The cannabis industry is poised for another year of huge growth in 2022, and the enterprises that will benefit the most are those best-positioned to manage risk.”
Despite this anticipated prosperity, risks in the cannabis industry consistently exceed the availability of insurance, owing to its status as a federally outlawed substance, as well as the inherent dangers in extraction and production. In addition to these specific hazards, the cannabis industry also shares the same risks as other more conventional industries, such as catastrophic crop damage, cyber risk, and skilled worker shortage.
In the traditional insurance market, few carriers underwrite cannabis insurance — and coverage that does exist is expensive and often restrictive. Such competitive rates arise when carrier appetite and client risk profile align, as carriers only want to insure cannabis companies with robust risk control practices.
As Eric Rahn, managing director at Alternative Risk Strategies, explains: “The sheer fact is that when an industry shoots out of a rocket, mistakes are made along the way. We see that it is going to take a while for this industry to mature and stabilise.
“We do not currently have the actuarial data or claims data, or even the rating data for what carriers should be charging for premiums. They effectively just throw something against the wall and see if there is a buyer.”
With this in mind, a separate US insurance market and rate report for cannabis by HUB International identifies that, going into 2022, the cannabis insurance industry is likely to see the continuation of an extensive underwriting process, for example, applications will request projected annual revenues, which will then be used to develop premiums.
Rahn adds: “While some market participants have done well in the directors’ and officers’ (D&O) market niche, others have paid out large claims in 2019 and 2020. The current premiums for D&O insurance have raised the cost of entry into the cannabis industry. That is what happens in a hard market, and that is when people turn to captives.”
High stakes? Use a captive
There exists, therefore, significant interest in cannabis companies looking for alternative approaches to address their insurance needs. Captives present a promising way to solve these challenges as an innovative industry that is willing to take on risks where traditional commercial cover is reluctant, or simply refuses to do so. The majority of cannabis businesses initially set up captives for D&O liability coverage owing to practicalities in the market. This is observed by Patrick Ferguson, Canadian captive and global life reinsurance sales leader at Marsh Canada. He identifies: “Initially, a lot of the work that we did here in Canada was around cannabis companies looking for D&O coverage.
“The marketplace just did not have any capacity, and premium rates were so high, that these companies were looking for alternatives. We were able to set up captives for them in jurisdictions like Bermuda, which allows cannabis captives, provided the insurance is federally legal in the jurisdictions where the insurance is being offered.”
This initial trend is affirmed by Kim Willey, partner at ASW Law. She adds: “A Bermuda captive offers a fully-contained corporate vehicle, which may be set up quickly to mitigate enterprise risk and manage insurance costs in a jurisdiction that is well-versed in captive insurance programmes.”
Now, the cannabis captive market is seeing the expanded use of captives for a greater variety of risks, such as property, general commercial liability, product liability, environmental liability, crop and workers’ compensation.
Willey explains: “As the industry matures and cannabis companies become more familiar with the captive structure, we see captives being used for a broader range of risks, including general liability, property and product risk — such as vaping, which is difficult to insure in the commercial market.”
This evolution is facilitated because captives offer advantages when insuring the cannabis industry compared to other self-insurance structures, according to Petrilli. He highlights the inherent control, transparency and accessibility offered by captives, while organisations such as NCRMA and Trichome (the association’s captive-based model that administers risk protection and insurance products) provide enforcement, control and risk management at the captive core.
Examining the advantages of captives, Ferguson adds: “When you think of self-insurance, the first stopping point is the idea that, a lot of times, self-insuring just means not buying insurance and keeping the risk on your corporate balance sheet.
“Where a captive can provide value in addition to that is in providing an overall governance structure around insuring those risks. So instead of just having the risk on your balance sheet and not buying insurance, you set up a captive insurance company, pay a premium to that captive, and fund accordingly relative to the risk that it is taking.”
Regulation
The interest in Bermuda captives for cannabis companies is primarily attributable to the Bermuda Monetary Authority’s (BMA) notice in November 2019 that it would not object to BMA-supervised entities conducting business with licensed cannabis cultivators, processors or sellers — providing the operations are not contrary to any offences provided for in the laws of a foreign jurisdiction.
This means that cannabis businesses that are federally legal in the jurisdiction in which they operate (for example, Canada) are eligible to set up a captive insurer licensed by the BMA.
In addition, Willey explains that since Bermuda captives are classed as non-commercial insurers, they are not subject to the full Solvency II-equivalent regulation. This means that setting up a Bermuda captive is an efficient option for self-insurance.
Willey adds: “Regulation is very important when considering a self-insurance structure. The BMA was at the forefront globally in confirming that cannabis companies with federally legal operations may set up Bermuda insurance vehicles.”
However, this is considerably more challenging for US-based businesses looking to operate on a national or international basis.
Rahn notes that the restrictions from a federal standpoint mean insurance brokers have a multitude of concerns, beginning with identifying the states that will accept cannabis risk.
“We also have to look at various departments of insurance, the Internal Revenue Service and the Drug Enforcement Administration to determine their stance on cannabis companies. Our clients are mostly Canadian public companies with US operations, which then presents cross-border issues,” he adds.
Although regulation is generally considered to be a hindrance in this federal respect, with the lack of harmonisation between state and federal law presents practical and legal challenges, Ferguson adds that regulation can be helpful.
He explains: “A captive being a regulated insurance entity provides a lot of braces and various rules around how it operates. It gives a sphere of regulation around how the captive is run, which clients find beneficial relative to how they are insuring risk versus simply keeping it on the corporate balance sheet.”
Time to be blunt
Legal restrictions at a federal level remain a significant challenge in providing insurance coverage for the US cannabis industry. It is expected that even the provisions of the SAFE Act will not fully address the problem of high commercial insurance prices owing to the limited loss history of the emerging cannabis market.
At present, banks are a significant problem for the cannabis industry as a whole, because few banks will openly handle cannabis money. Petrilli of NCRMA explains that this is a result of misconceptions around the reputation of the cannabis industry, as well as an outdated federal mandate.
“We must find ways to get around this statute and form a solution to the banking problem to open up a larger floor. This external non-operational risk arising from banks and other non-operational sources affects capacity, which then makes it difficult to determine the risk management side of cannabis operations, as companies have to mitigate both the internal (cannabis) risk and the external (litigation) risk.”
This challenge is affirmed by Marsh’s Ferguson. He explains: “The federally legal aspect of cannabis is really the biggest challenge for a variety of reasons, as it really closes the door on the captive solution for a lot of clients.”
He adds that another significant challenge facing the cannabis industry is reduced capacity, as only certain markets will write to cannabis companies that have insurance in a non-federally legal jurisdiction.
“The hope from our perspective with this challenge is that the US in particular will choose to federally legalise recreational cannabis, because that would provide a new window of opportunity for getting coverage for these companies, not just in captives, but in general.”
Outside of regulation, the cannabis industry faces specific challenges as outdoor cultivators are especially vulnerable to weather risk, particularly in the context of climate change-related natural disasters and extreme weather events. Securing crop insurance has traditionally been difficult for growers, on top of which persistent severe weather creates catastrophe risk.
On the other hand, indoor growers that rely on an IT infrastructure are susceptible to cybercrime as a top manufacturing risk during the extraction process. For example, a ransomware attack could target air conditioning controls or a carbon dioxide feed that must be set at exact levels for optimal crop growth.
There is also a significant liability concern if a cyberattack affects product labelling — the issues here go beyond business interruption and loss of revenue. Overall, cannabis businesses are particularly vulnerable to so-called ‘bad actors’ owing to their cash reserves and often weak IT infrastructures. In addition, the extraction process involves hazardous and explosive chemicals that cause high insurance premiums.
The industry as a whole is attempting to reduce the use of dangerous chemicals, but lacks the technology to eliminate the use of solvents (such as butane, propane, ethanol and carbon dioxide), which pose a significant health risk for both workers and consumers.
As the smoke clears
In order for the cannabis industry to overcome these underlying challenges it must address the barriers to business growth in innovative ways.
For example, parametric insurance presents a possible solution for outdoor growers and crop risk as the model would pay out in full when a weather element reaches a certain threshold, regardless of actual damage.
Looking to the next 12 months, Alternative Risk Strategies’ Rahn anticipates little change in the landscape of cannabis captives outside of further increasing premiums and restricted capacity. He notes that most D&O capacity in cannabis is gone by June, leaving market participants essentially “fighting over the same scraps”.
He adds: “I do not think we will see anything drastic until the SAFE Act, or until cannabis is no longer federally illegal. This will allow banks, insurance companies and institutional investors to come into the industry to provide the much-needed capital, both on the reinsurance side and on the primary side.
“It has been and continues to be an interesting ride — you must take the long view here. In the short-term, I think cannabis will continue to be state-regulated and free from any federal restrictions. It is going to be interesting to see how states react to open market pricing to compete for the supply and demand of cannabis.”
With the current market conditions set to continue for the foreseeable future, Willey expects a continued interest in the Bermuda captive model, while Petrilli anticipates increased risk-bearing capacity through captives, as well as a greater need for custom coverages to meet state and municipal regulations, and a growing sustainability agenda driven by insurance with risk management at its core.
Ferguson concludes: “??The whole idea of captives in the cannabis industry is evolving. There is a lot of depth and range for additional solutions to the cannabis industry with captives, and we are really at the beginning of this evolution with cannabis companies looking at captives. I think we are going to see a lot of interesting things happening in the next few years.” Joint control
The US currently has two key proposed pieces of legislation which, if passed, have the potential to make traditional financial resources more accessible to cannabis operations:
The Safe and Fair Enforcement Banking Act (SAFE Act) aims to protect banks and financial institutions that service cannabis-related businesses in states where use is legalised for medical or recreational purposes. As a Schedule I controlled substance by the US Drug Enforcement Agency, banks face penalties from federal regulators for serving legitimate businesses in states where cannabis use is legalised owing to the lack of harmonisation between federal and state law. Therefore, many of these businesses are forced to use a cash-only model which makes them highly vulnerable to theft, fraud and violent crime.
Under the SAFE Act, federal regulators would be explicitly prohibited from distributing these penalties, which means that legitimate cannabis businesses could operate under a safer, more trustworthy model.
The Clarifying Law Around Insurance of Marijuana Act (CLAIM Act) aims to open the insurance market to more competition, as well as offer greater capacity, assist lower premiums, and encourage new markets for hard-to-place risks. It will also protect ancillary businesses to the cannabis industry, such as landlords, technology vendors, legal, accounting and design professionals, who will be able to continue providing products and services without the fear of losing their insurance.
The CLAIM Act would prohibit penalties for insurers that provide coverage to a state-sanctioned and regulated cannabis business, as well as the termination or limitation of an insurer’s policies on the basis they have engaged with a cannabis-related business.
