How retailers can benefit from forming a captive insurance company Featured

8:01pm EDT September 30, 2011
How retailers can benefit from forming a captive insurance company

As retailers consider ways to control cost and increase revenue, many are achieving those goals by creating a captive insurance company.

Captives exist to underwrite the risk of their parent and affiliated companies, and can provide many benefits to retailers, says Adrian Richardson, managing director of Aon Risk Solutions, Global Risk Consulting.

“The concept is not new,” Richardson says. “Companies have had their own insurance companies financing their risks since the early 1900s. The idea was considered alternative then but has become a mainstream part of how insurance programs are put together.”

Smart Business spoke with Richardson and Kevin J. Pastoor, CPCU, managing director of Aon Risk Solutions, about how captive insurance companies can help retailers, as well as those in other industries, control costs and increase revenue.

Why should businesses consider joining or creating a captive insurance company?

Businesses should consider joining or creating a captive because captives can be an efficient methodology to finance their retained loss costs. The first step for a company that is considering moving from a guaranteed cost program is to determine whether it makes sense to retain risk.

Do you have a frequency of losses that is reasonably predictable? If so, it’s unlikely to  make sense for you to dollar swap with the insurance market. Paying $1 in premium and getting, say, 60 cents back from an insurer in paid losses might not be the most efficient way of insuring your risk.

Once you have a captive structure in place, you can build from an initial platform and consider what else to do with that insurance structure. How can you expand the use of the captive to not just simply finance retained loss costs in an efficient manner? How can you start creating some kind of revenue growth?

What are some ways retailers are expanding the use of their captives?

Many companies provide warranties or guarantees to their products. These  might be part of a program in which both administration and risk is assumed by a third party.  The opportunity could exist where these programs can be restructured so your captive insurance company accepts the risks associated with the warranty or guarantee.

If a retailer is using a third-party  warranty company to administer and underwrite the entire program, then there is no risk to the retailer. However, if there is a cost to the customer for the warranty, the retailer may have less control on customer experience and the whole revenue stream. In addition, the risks associated with the revenue stream are transferred to a third-party provider. It could make sense for your captive insurance company to take on that risk, control the program and customer experience more tightly and capture some of the profits being made by the third party.

Another way retailers are expanding the use of their captive insurance company is through the provision of supply chain insurance. Most retailers have several suppliers providing them with materials and goods, and as part of that cost of supply, suppliers have their own insurance programs. In many instances, the programs are smaller than the retailer’s. Retailers are therefore putting together suppliers’ risks programs and financing them through their captive. That method can remove some of the insurance costs to the supplier.

How can you tell if using a captive is the right choice for your company?

There are trigger points. How comfortable are you managing retained loss costs? Are your business’s retained loss costs at a level where you can absorb some of the frictional costs associated with a formal structure?

A captive structure is a formal mechanism to finance these risks. You are creating an entity or becoming part of a legal entity that is financing these risks, so there will be frictional costs associated with it. Understanding frictional costs and whether your retained loss costs are of the size that makes one of these options worth pursuing is a key aspect to this decision.

How can a risk consultant help companies make that decision?

A risk consultant will look at your program design and try to optimize it based on risk transfer costs and analyzing your loss costs. The consultant will do this to find the optimal level between risk transfer and risk retention.

You also should determine the best way to warehouse those retained loss costs. Can the company pay it from revenue? Do you want to set up a formal vehicle to finance those loss costs? Do you have subsidiaries or legal entities that all pay different premiums? Can you consolidate these costs through a single captive structure? These are some of the issues to examine with a risk consultant.

Review your options and the realistic costs. There might be collateral requirements, such as fronting costs. I recommend working with your consultant on a comparative exercise to determine whether a captive insurance company would help you derive the most efficiency in costs.

How can a company determine which type of captive insurance company to use?

There are a spectrum of captive structures, ranging from the wholly owned, single-parent captive in which a single entity owns 100 percent of the risk, through group-owned captives with multiple owners pooling their risk.

The single-parent captive is likely to be for those businesses that have taken the step of risk retention and are already retaining significant loss costs. Their costs are the size that it makes sense for them to create a full, wholly owned captive.

As a baseline, for a single-parent captive, annual operational costs are likely to be in the region of $75,000 to $100,000. You will want to absorb that cost within the financing of your retained loss costs. If your company is not large enough to take frictional costs on board of a single-parent captive, it might be opportune to consider a group captive scenario or perhaps other related structures, such as a cell company.

Adrian Richardson is managing director of Aon Risk Solutions’ Global Risk Consulting. Reach him at adrian. richardson@aon.com or (212) 441-2020. Kevin J. Pastoor, CPCU, is managing director of Aon Risk Solutions. Reach him at kevin.pastoor@aon.com or (248) 936-5346.