Captives Fuel Growth and Income for Agency Owners

By Chris Kramer | December 30, 2009

In times like these, where the insurance industry is now in its fifth year of a soft market, the use of an agency captive insurance company can spark both revenue and profits to improve an agency’s overall financial performance. The agency captive may also provide the owners a better return than a profit sharing agreement.

Insurance captives, as they are used today, were the brainchild of an Ohio insurance agent, Fred Reiss, over 50 years ago. Originally designed to insure the property risk of its non-insurance owner, captives have evolved to finance risk across almost every industry and can be owned by a variety of interests, including agencies, associations and groups. Premiums in captives now reach $50 billion annually and the captive itself can be domiciled in close to 30 states in the United States as well as offshore.

Agency captives are primarily created to reinsure the risk of their clients, however, in a risk class where there is a demand for coverage but no insurance carrier – as what can happen during a hard market – agency captives can be excellent platforms from which to create new products or replace coverage from carriers who have abandoned the risk class. Both have the potential to create profits and spur top line growth.

Why Best Time Is Now

The good news for agency owners who are considering an agency captive is that the current soft market is perhaps the best time to create a captive strategy. In this current market, there are more carriers willing to provide fronting and reinsurance to agency captives and with less premium volume requirements. Carriers are looking for new business (like everybody else), rates have stabilized, costs are low and what can be a the biggest motivation of all, under certain captive structures, underwriting profits will be tax exempt if premiums to the captive are no more than $1.2 million annually (more on that later).

Waiting for the next hard market will only reduce the agency owners’ opportunities to forge new partnerships and profit strategies as most carriers will increase costs and reduce capacity.

Under the profit center strategy, the agency captive will usually require a fronting carrier (holds the licenses required to conduct insurance business) and perhaps a reinsurer, which will share in the risk with the agency captive of insuring the policyholder. In exchange for the captive assuming some level of risk, it can be rewarded with a share of the underwriting profits as well as retaining any investment income made by the captive.

The book of business the agency and carrier will consider can be homogeneous, like a program book of business, or heterogeneous, where several classes of business are included but only one to two lines are underwritten, such as workers’ compensation, for example. In both cases, the book will possess a historically low loss ratio. In addition, the carrier partner will insist that the agency possesses a high level of underwriting expertise in the risk class and competent information technology under which the book can be audited and a database created. Perhaps most importantly, the agency must have the claims management expertise (or the access to it) as well as the operational efficiency to reduce claims costs.

While the benefits that are produced under an agency captive can include underwriting profits and investment income, a key advantage for the agency owner comes from the increase in the control aspect of the carrier-agency partnership. Agency owners should bear in mind that carriers rely heavily upon agencies and brokers to distribute their products in time of gaining market share, but retreat or pare down sales efforts – and commissions – during hard markets. If there is a profit sharing agreement, an agency owner should take into account the volatile nature of carrier profit sharing agreements, which can increase under soft markets conditions, but significantly reduced in hard markets. As stated before, the time to start creating an agency captive strategy is before the hard market.

Typical Comparison

Under a typical agency captive comparison, let’s consider that an agency has a $5 million book of homogeneous business with a loss ratio of 35 percent. Commission payable is 15 percent. Total revenue to the agency is $750,000.

Under an agency captive structure, a new carrier has offered 18 percent commission and will share risk with the agency captive. The captive will receive $1 million in reinsurance premium. After captive expenses and losses incurred an underwriting profit is declared of over $200,000. This is in addition to the increase in commission ($150,000) as part of the agency’s agreement with the carrier and before investment income. However, the results of this scenario can be made even better.

Since 1921 (and updated in 2004) small non-life insurance companies in the U.S. may elect to be exempt from paying federal taxes on their underwriting income and taxed only on their investment income. This election commonly referred to as an “831(b),” means that a non-life insurance company that is a U.S. taxpayer, including a captive, may make an election under section 831(b) to be taxed on its investment income only so long as its annual premiums do not exceed $1.2 million. This election has become so important to the insurance industry, particularly to smaller insurance companies, that the National Association of Mutual Insurance Carriers (NAMIC) has put several bills in front of Congress and the Senate to increase the limits to over $2 million.

Looking back at our comparison, if our agency captive qualifies to take the 831(b) election – you will want to work with the captive’s auditors and your own tax resources to confirm – it would mean that the $200,000 in underwriting profit would be exempt from federal taxes and taxed only on its investment income. That is a considerable benefit when designing an agency captive, specifically when the owners consider a reinsurance agreement with the carrier.

Agency captives can also be suitably positioned to replace coverage lost due to hard markets conditions. When the hard market returns, a number of carriers will exit certain lines of business, capacity will diminish, and agency commissions, including profit sharing, will be reduced. Under these set of market forces, we often see the rise of another wave of captive formations, those that are created not so much for a profit center strategy, but to provide capacity and coverage to policyholders.

Insurance agency owners are on the front lines of a hard market and are often called upon to provide solutions when the traditional markets are unable. While temporarily enjoying the rise in revenue as a direct result of corresponding premiums, owners who have gone through a hard market (or two) know business can be lost forever to alternative risk transfer providers while the insurance carriers replace lost capital and increase policyholder surplus. An agency captive, however, can be an ideal platform from which owners can provide additional capacity and coverage to their clients, which can lead to higher retention ratios and increased client loyalty.

While agency captives are extremely useful in helping to increase revenues for their owners, they can also be useful in keeping key employees – and good clients – as well. A well thought out captive ownership structure can include key employees who are vitally important to the ongoing operations of the agency. Employees such as these can be rewarded with a share in underwriting profits of the agency captive. Clients, too, may also be invited to participate in the captive as investors to reward loyalty and to induce good risk management controls to their business.

Start the Discussion

Determining whether an agency captive is a good fit for your firm can start with a discussion with a qualified captive manager who has experience in agency or brokerage operations. At Atlas, we start by conducting a “pre-feasibility” session where we provide a conceptual risk/benefit analysis before the prospective agency captive owner spends money and resources on a feasibility study, which can range from $15,000 to $50,000 and up. Part of the process is also looking at what kind of financial resources the agency has because a significant variable in deciding to create a captive will include not only how much capital will be required to support premium in the captives, but for many carriers, collateral will be required as well.

Requirements and Commitments

What does it take to consider an agency captive? Usually, a premium commitment of at least $3 million to $5 million in the first year, though in this prolonged soft market, some captives are starting with less than $1 million to $2 million. Fronting carriers seem to be abundant but that will quickly change when the market turns. If you have a program that does not require a front, formation may be easier and less costly. As mentioned before, financial resources of the captive will require capital, and collateral, if the program is fronted. Above all, loss history should be at least three years old, preferably five, and it must be verifiable. Ideally, the loss history will show frequency but not severity. Lastly, not all domicile regulators will allow agency captives to be formed under their jurisdiction. Vermont, for example, does not permit agency captives while Washington, D.C., does, as do many offshore domiciles, like Cayman.

The prospects for developing an agency captive have never been more favorable to owners of agencies, brokerages, managing general agents and program administrators.

Kramer is senior vice president with Atlas Insurance Management, an independent insurance management firm providing captive insurance company formation and management services in the District of Columbia, the Cayman Islands, Anguilla, the Bahamas, British Virgin Islands and Nevis. This article is adapted from Kramer’s presentation at the recent Target Markets Program Administrators Association Annual Summit. E-mail: ckramer@atlascaptives.com. Phone: 440-892-3314.

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