Case Study: Workers Compensation
Instituting a captive insurance strategy for risk management need not be an all-or-nothing decision; in fact, one benefit of creating a captive is the flexibility it provides to its owners.
In the following example, a medium-sized heavy trucking company operated over 1,000 power units from more than 30 terminals. The company traditionally purchased their Workers’ Compensation coverage with a high deductible from a commercial insurer through their broker.
While their high deductible produced some premium savings, it also created issues that the company wanted to resolve. The uncertain timing of the deductible payments resulted in irregular cash flows which produced difficult liquidity timing issues. In addition, the deductibles of $250,000 per claim required the insured to provide significant collateral to the insurer each year. Over time, this collateral fund had grown to a significant size. While seeking to stabilize cash flows and reduce collateral requirements, the company also wanted greater transparency and more control over the total cost of risk.
The company had a strong risk management culture. This was reflected in a five-year historical loss ratio which was well below its industry peers. The existing high deductibles indicated that management was comfortable taking a certain level of risk. As a result, a captive insurance program was proposed to resolve their cash flow and collateral issues while providing increased transparency of costs as well as the potential for underwriting profits due to superior performance.
A two-step process was proposed. The first step was to form a captive to write deductible reimbursement coverage for their Workers’ Compensation program. While retaining their current insurance with their commercial carrier, the owners funded their captive to reimburse the company for any claim payments made in respect of their commercial Workers’ Compensation policy deductible. This step achieved the first goal of smoothing cash flows while also providing tax efficiencies, as the captive premium was tax-deductible. This transition allowed the owners to witness the effectiveness of captive insurance while continuing to enjoy the familiarity of their commercial program in the short-term.
After the first two successful years of operation, the company switched to a fully fronted program to reinsure the primary $250,000 layer of risk. The front was the same insurance carrier from which they were previously purchasing their commercial Workers’ Compensation policy. A large A-rated insurance company. The captive’s obligations to the front were secured by the establishment of a Section 114 Regulation Trust, which proved preferable to the previous collateral arrangement. This is partly because the trust funds can be used to settle claims rather than simply being held as collateral.
Three years later, the captive insurance company showed a profit of approximately $400,000 on premium totaling over $3.4m. The captive results included steadier cash flows and reduced collateral requirements, while providing the transparency needed to enable the owners to make more effective management decisions.
