Frequently I am asked by larger propane and fuel distributors whether they should consider joining a “captive” insurance program rather than using a standard insurance company to handle the risks they face. My response is always the same: Why? What problems are you currently having that you feel can be fixed by going with a captive?
Many times the answer is to save on the insurance premiums the marketer is paying. Other times it’s the belief they can do a better job than their current insurance company is doing, due to their safety culture. So, let’s compare the options.
The marketer faced with growing overhead might feel that he would be better off financially if he took on some of his own risks. Self-insurance, by definition, is exactly that—the marketer is assuming the risk.
For example, marketers have chosen to self-insure their physical damage on their rolling stock by deleting comprehensive and collision from their vehicles. They are gambling there will be no major losses to their fleet. However, the downside is when a major claim occurs to an expensive bobtail, for instance, and the company’s bottom line is slammed.
Several years ago, I presented a quote to a marketer who had a large fleet of vehicles. He declined comprehensive and collision on all his larger vehicles such as bobtails and transports. Several months later he called and told me to delete a bobtail from his liability schedule. One of his drivers had rolled the vehicle, hit a rock, and broke a valve that allowed propane to escape.
An ensuing fire totally destroyed the tank and chassis. His company had a $50,000 asset fully paid for on his balance sheet. Because of the accident, the marketer had to buy a new bobtail at a cost of $150,000, which was financed. This caused a swing on his balance sheet from a positive $50,000 to a negative of $150,000. The marketer later asked what it would have cost to insure the bobtail for comprehensive and collision. The answer: $279 for the year.
Marketers may choose to self-insure buildings, large LPG storage tanks, comprehensive, and collision, but insurance agents cringe when the marketer may think it prudent to not purchase other equally important coverages such as employment practices liability, cyber liability, and excess or umbrella insurance. “Self-insurance” in those cases means—no insurance. The savings are minimal, and the gamble in the event of a loss could cost a marketer the company.
Let’s consider a current policy trend that is again making its way across the country—captive insurance programs. A program might start when a large company feels it’s paying too much in insurance premiums and it is above average in controlling risk factors faced. The company is looking for an alternative to transfer a portion of its risk to an outside entity partially, or solely, owned by the enterprise.
How Captive Insurance Programs Work
The procedure works like this: fees are paid to a company to come up with an actuarial study. The actuaries determine expected losses for each line of coverage and, based on the findings, may recommend taking the next step, which is to raise the necessary capital to pay for expected losses in advance. When the funds are raised, the member can either join an existing captive program or form a new one for the member(s).
Upon raising the capital of $1,000,000 or more, the search begins for a fronting insurance company that has state insurance licenses in the various locations in which the captive wants to operate. The fronting cost is normally 15 cents out of each dollar.
The fronting company’s licenses are used to satisfy the need to provide certificates of insurance to entities wanting proof of insurance. The insurance company should be an approved carrier in all the various states.
Once the fronting company is found, the search begins for reinsurance. The captive member is required to pay a retention on the first dollar of every claim; normal retention is $250,000 per occurrence before reinsurance responds to pay the remainder.
For example, on an auto policy showing a coverage limit of $1,000,000 combined single limit, the first $250,000 of a large bodily injury or property damage claim would be paid by the member, with the remaining $750,000 paid by the captive’s reinsurance.
Reinsurance is expensive, typically costing 27 cents out of every dollar paid to the captive. The captive is only as good as the reinsurance coverage, and it is normal to see more than one reinsurance company absorb the financial uncertainty of the captive. At this point, the cost of belonging to a captive is costing around 42 cents out of every dollar.
Once the captive is operational, members can transfer their general liability, auto liability, and workers compensation coverages into the captive. However, that leaves the marketer with finding property coverage, physical damage on the vehicles, cyber liability, employment practices liability, and excess coverage, all of which are outside the scope of what the captive can insure.
It can be troublesome to cover the risks not covered by the captive. Most insurance companies that write insurance for propane companies do so in a commercial package, or on a package basis that includes liability and property coverages. Broader coverage is provided and the carrier has the ability to discount the premium if all of the exposures are written by the same company as a package.
Another major concern is, who is going to pay the claim when a captive is involved along with the ancillary insurance companies writing the additional coverages? When the insurance is coming from one source, there is no question which company is going to pay. When there is a disagreement, the captive member is stuck paying the entire claim.
Several other areas need to be investigated, such as claims handling. All claims costs for adjusters, engineers, and lawyers are paid by the member, in addition to the fees assessed by the captive.
If there is more than one member in the captive and there is a shortfall in operating funds, all members can be assessed. The claims by one party can financially affect all members of the captive.
I recently reviewed a general liability policy written by a captive insurance company for a propane/fuel company. The fronting company’s policy excluded all pollution, including pollution from a friendly or hostile fire. Years ago, one of our insureds had a massive fire at its office/warehouse. The warehouse had large bulk lubricant storage tanks. The fire became so hot that the lubricants poured out of the tanks, caught fire, flowed down an alley, across a parking lot, and into a stream.
The oily smoke was so severe that it coated numerous cars and buildings in the direction that the wind was blowing. The pollution cleanup cost was more than $1,000,000. Fortunately, the insured had the proper insurance coverage and the total claim was paid. If this company had been a member of a captive program, it would have had to pay the entire cleanup cost because of the policy exclusion.
The history of captives in the propane industry reveals that they are fairly short-lived. Many propane marketers remember Nobel Insurance, which sold stock in order to raise the capital needed. Of late, there was the Jamestown program, which went out of business in 2012.
Problems for captive programs stem from several areas, such as programs that insure propane and fuel distributors—pollution claims that stem from the overturn of a gasoline or diesel transport can easily be in excess of $1,000,000, which can quickly drain the coffers of the captive. Failure of the captive to properly set adequate loss reserves is also a problem. Workers compensation claims can have long tails and may require several years to resolve. The original loss reserve may have to be increased several times before the claim is settled.
This reminds me of a phrase I use when discussing high-retention programs—they can be “rolling thunder.” The rolling thunder occurs when a captive member has a claim in one policy year that doesn’t settle in the same year. Then the next year, there is another claim that settles immediately. Now there are two claims settling in the same year, which may mean that the member would owe two retentions of $250,000, or $500,000 total. This is why irrevocable banks’ letters of credit may be required.
To join a captive means that the company must have the resources to pay the retention, be willing to spend time learning about the captive, have staff people to handle the follow-up on the claims, and have knowledge of claims procedures. This usually means having a risk-management department.
Questions to consider:
• How long has the captive been in business?
• What financial investment must my company make to join?
• What will my retention be in the event of a loss?
• Who else will be members?
• Are there other energy risks such as fuel distributors in the captive?
• Will my company get loss runs from the captive’s operations?
• How well-capitalized is the captive?
• Will the captive save me money, or cost me more money than going with an established insurance company?
When considering the various options for placing your company’s risks, or assuming them yourself, there are a number of old adages that one should consider:
• There is a fair price for a gallon of propane (or any commodity), and that includes insurance.
• Be careful not to be penny-wise and pound-foolish.
This article started with a question, Why? Why leave an established insurance company program with a provider that knows the risks a propane marketer faces for a captive? Captives were never designed for the small- to mid-size company. They were designed for companies with premiums in excess of $500,000, and they work best when the member is not faced with catastrophic losses. They are the last resort for firms that are faced with catastrophic losses and are forced to invest large sums of capital to stay in business.
Standard Insurance Companies
Insurance is based on the law of large numbers. That is defined as writing a number of diverse accounts with common risks, such as propane marketers. The law of large numbers says that, with affinity accounts, a larger number will not have losses during the course of a policy period, and the combined premiums of the group will pay for the losses of a few of its members.
This being the case, then it stands to reason that, over a period of time the insurance company will develop a price structure that will allow it to pay claims, meet overhead, and continue to underwrite the risks assumed. Or, if it is underpricing the coverage, it will be forced to raise premiums or stop writing insurance.
When an insurance company takes a premium, it puts the money into an investment pool. The money is used to fund investments. When a claim is made, funds are withdrawn and put into a cash account to pay the claim. The idea is to have enough premium dollars coming in to keep the investment pool fully funded. The profit comes from the return on investments rather than a surplus in the premium charged versus claims and expenses paid. Let’s use a dollar of premium to demonstrate what happens when the dollar is paid to an insurance company:
- $0.32-$0.36 is used for general and administrative expenses (G&A). This has to include all costs to operate, such as salaries, expenses, and commission to agents, and also includes charges for claims handling, engineering, defense costs, loss-control services, reinsurance, accounting, marketing, governmental regulations, and taxes. These are all requirements to be a full-service insurance company.
- Approximately $0.60 is left to pay claims, depending on the company.
When marketers go to an established insurance company, they get a written quote that, if accepted, has an annual premium. For that premium, they get a policy that promises to pay for future claims. At the end of the policy term, the marketer has no additional premium due, except possibly an audit to establish actual payroll and sales. The liability is all taken on by the insurance company.
The marketer that uses a knowledgeable insurance agent, and an A.M. Best A-rated insurance company, has a number of safeguards to guarantee that losses will be paid.
Insurance companies must file their annual financial statements with the various state insurance departments, which the states review for solvency and ethical business practices. Insurance companies are required to maintain a surplus equal to 25% of their written premiums. State and federal law dictates how claims are to be handled.
In most states there is a guarantee fund that pays claims in the event of insurance company insolvency. And finally, most agents carry errors and omissions insurance if they fail to insure the risk properly. In the end, the goal is to keep companies in business so they can enjoy the fruits of their labor.
Frank B. Thompson is a chartered property and casualty underwriter based in Phoenix. He is the owner of PT Risk Management, an independent insurance company specializing in writing propane and petroleum risk policies throughout the U.S.