Captives for Small and Medium-sized Enterprises By some measures, the Captive Insurance industry has been remarkably unsuccessful. The brokers and consultants that help form Captives can count among their clients many of the largest Companies. However, these make up less than 1% of all firms. They have been far less successful at penetrating the far larger market represented by Small and Medium-sized Enterprises (SME’s). SME’s are the backbone of advanced economies. In the European Union, SME’s are estimated to make up 99% of all firms, and to employ over 65 million people. In many sectors, SME’s drive business innovation and competition. What exactly are SME’s? Such companies are classified by reference to the number of people they employ. In US terminology, Small Enterprises are those that employ up to 100 individuals, while Medium Enterprises employ up to 500. SME as a category excludes both micro-enterprises (with fewer than 10 employees) and large firms that employ more than 500 people. Why would SME’s be interested in Captive Insurance? SME’s that have established Captives have done so for similar reasons as their larger cousins. Risk Management is often as big an issue for smaller firms as it is for larger ones and in some cases arguably even more important. SME’s often occupy distinct market niches, where their reputation is a competitive advantage, and makes a major contribution to their business success. Their ability to manage risk effectively is a key to their continued success. They often do not have the luxury of size to weather problems brought about by poor risk management. Such firms can often demonstrate better loss histories than the Commercial Insurance market is willing to recognize in their premiums. For SME’s, effective cost control can significantly contribute to the bottom line. At the same time, savings on commercial insurance are not easy to achieve. Often SME’s cannot afford to employ dedicated expert risk managers to negotiate with Insurers. This means they are often limited to taking packaged insurance products that may not be well adapted to their business. Further, they are not in a position to negotiate on equal terms against large, possibly multi-national Commercial Insurers, and because of the smaller volume of premium, Insurers’ overheads can often represent a larger element of their Insurance costs than those of larger enterprises. SME’s benefit as much if not more than large companies from the ability to secure ongoing insurance coverage for mission critical risks. Medical Malpractice or Construction Guarantees are non-negotiable if you are a primary medical services provider or a Construction Contractor. Many firms cannot afford the risk posed to the viability of their business by the cycles of interest or disinterest in those lines of business by the Commercial Insurance market, let alone the budget uncertainty this can introduce. As closely controlled Corporations, many SME’s do not have access to Capital Markets to grow their business. As such they recognize the importance of maximizing the return on their assets. Many SME’s that have set up Captives have been attracted by the tax efficiencies a properly set up Captive can offer, and the ability to benefit from the investment returns on retained premiums and reserves. As Wealth Managers, London & Capital has been able to blend over twenty years experience of managing assets on an absolute return basis – producing positive returns regardless of overall market direction – with an expert understanding of Captive insurance and the scope for asset management within regulatory requirements. In our experience, those Captives that have focused on managing assets as well as insurance risk in their Captive, have been those that have succeeded in reducing the long terms cost of risk in their business while generating enough free cash in their Captive to make it self-financing and in some cases even a profit centre. In the light of such benefits, why has there not been a better take up of Captives among SME’s? While these benefits are clear to those SME’s that have established Captives, many other SME’s have not understood the benefits of this approach for their business, including: The ability of a Captive Insurance arrangement to monetize good risk management through the capture of underwriting profits that would otherwise end up with Commercial Insurers, The ability to secure a reliable source of insurance coverage at a known cost over an insurance cycle, allowing the Parent Company to focus on its core business, Access to wholesale Reinsurance markets for difficult to place risks, Closer involvement in the handling of claims, leading to a better understanding of the operational risks in the business, The ability to tailor insurance coverages to their precise requirements, including the ability to include specialist coverages or catastrophic risks not available in the commercial market, and The ability to manage premium timing to match the cash flow of the parent Company and even more importantly over the long term, the ability to capture investment returns for the benefit of the Captive on the premiums and reserves. There are a number of contributing factors that account for the low penetration rate of Captives among SME’s. These include: A lack of awareness of the benefits offered by Captives among SME’s, The inability to generate enough premium volume to justify a program, The perception of high direct and indirect costs of ownership, and SME’s concerns over the retention of insurance risk in-house. It is for the Captive Industry to find ways of reaching decision makers among SME’s with the arguments in favour of Captives. So far the focus has largely been on reaching Companies through their Insurance Brokers. Increasingly, it is being recognized that the attractions of Captives as effective financial vehicles also needs to be communicated to financial decision makers through their CFA’s, Banks, Wealth Managers, Tax Consultants and Legal Advisers. It is true that a minimum volume of premium needs to be available to justify the establishment and operating costs of a Captive. However, the Captive Industry has gone some way to make Captives a viable alternative at lower premium levels. The perception that owning a Captive implies high direct costs has never been less justified. In part the problem of perception arises as a result of the unbundling of the costs of insurance – Insurance Companies’ overheads are rolled into the premium cost and not easily identified. Once a captive is discussed, all the individual expenses become transparent. However, often immediate cost savings can be achieved, even allowing for the amortization of the initial establishment costs. In many instances however, SME’s are just as concerned about indirect as direct costs. How much Management time will be required to run an Insurance subsidiary? What resources are needed to ensure statutory requirements are fully met? What are the risks of non-compliance? It is for these reasons that SME’s often find it more attractive to take part in a Captive that is not directly owned, than in a single-parent Captive. The Captive Industry has been very responsive to these concerns, offering a range of solutions that provide most if not all of the advantages of a single parent Captive, in an easier to operate package. These include Agency Owned Captives, Group and Association Captives, Cell Captives, and Rent-a-Captive arrangements. In addition to more flexible Captive structures, service providers that make up the Captive Industry have developed services better suited to SME captive Owners. For example, Insurance Managers that specialize in alternative Captive structures are available in most jurisdictions. Some Consultants can now offer streamlined feasibility studies that can quickly and more cost effectively identify whether a Captive is a suitable solution. Many SME’s – being smaller Companies – have a closer connection between functions such as Operations, Risk Management and Financial Control. This makes it easier for the Company to learn from its risk management experience, and to implement initiatives designed to reduce operational risk, thereby reducing loss and waste, and improving its products and services. For those Captive service providers that have focused on the needs of SME’s, a number of issues are evident – Captives are well suited to manage the insurance needs of many SME’s, and their requirements, though often smaller, are no less challenging than those of large enterprises. In many instances SME’s rely even more heavily on their advisers than larger Companies do, to bring to bear expertise that may not be available at the Parent Company. However, working with SME’s can be even more rewarding, as reporting lines are shorter, and decision making can often be much quicker. Following the success of the Captive concept among large Corporations, the Captive Industry has demonstrated that it can adapt its offerings to SME’s. As the industry continues to innovate, it will open up a far larger market for its services, among those Companies that are both the backbone of the economy now, and the breeding ground for tomorrow’s corporate giants.
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