The lure of captives

As healthcare risk managers ponder the challenges they face as a result of healthcare reforms, it is predicted more will turn to the use of captives and risk pooling schemes. HRMR explores the pros and cons of this and finds 10 reasons the captive solution can work for organizations.

The changing healthcare landscape in the US will mean many new challenges for risk managers and a greater array of risks that they must look to mitigate—through both their own risk management systems and the insurance they put in place.

Many will turn to the commercial insurance market for solutions and insurers are responding by establishing bespoke products suited to the needs of healthcare organizations. Brokers are also working particularly hard to understand these new risks and respond.

But a proportion of healthcare bodies will turn instead to captives. Some will already have such structures in place but others will be contemplating using one for the first time. Organizations may explore the use of a captive in their own right or ponder pooling their risks with others.

There are many good reasons to form a captive, and they are documented below. But a captive should not be entered into lightly. Thorough analysis should be done first and the various legal structures, domiciles and reinsurance arrangements considered carefully.

“Captives remain an effective way for healthcare entities to manage their risk. But for those not currently utilizing such a structure, we generally recommend that they conduct a feasibility study to help properly determine the premium funding and what level of risk will be retained in the captive,” says Monique MacDonald, senior vice president at Global Captive Management, a Cayman Islands-based business that provides management and consulting services to alternative risk programs.

“Other items to be considered include choosing the right domicile, implementation of a good claims management system, appointment of service providers, whether fronting or excess coverage is needed and whether there will be any tax implications.”

Shelby Weldon, director, licensing & authorisation, at the Bermuda Monetary Authority (BMA), agrees, adding that it is also important to consider carefully the expertise available to the companies forming and using the captive.

“Parties looking to the captive sector to manage their healthcare risk should conduct feasibility studies with a proper actuarial evaluation, surround themselves with the best possible service team, and look where the experience is. Never underestimate the importance of a knowledgeable board of directors,” Weldon says.
He adds that companies should also be prepared to capitalize their captive correctly from the very start, and warns that, especially for organizations considering pooling arrangements, such schemes are not foolproof—if they are not structured correctly they can fail.

“There are potential pitfalls to such pooling arrangements,” Weldon says. “Many simply do not succeed and firms should be very careful about whose pool they plunge into. Firms should first make sure the fit is correct, and that their partner has a robust corporate governance structure, a balanced service team and a sufficient level of long-term commitment, discipline and understanding.”

He also notes that a new and specific risk will increasingly emerge as hospitals form closer relationships with physician groups. “Hospitals have historically been very selective about the doctors they employ and cover in their programs. With entire groups of doctors now coming under their coverage, hospitals will be exposing themselves to a greater hazard risk. Hospitals will need to vet all doctors joining their facilities very thoroughly.”

TOP 10 REASONS TO FORM A HEALTHCARE CAPTIVE
1 Greater power to negotiate

This mainly applies to schemes whereby a number of entities pool their risks in some way—coming together to share the advantages of transferring their risks in this way. It gives the smaller partners, in particular, much greater power to negotiate than they would have enjoyed before.

“By forming pooling arrangements, smaller ‘partners’ in the group will have greater negotiating power (or indeed have some negotiating power when before there was none) with fronting carriers, reinsurers, banks and service providers,” says Weldon.

2 Better risk management

A key component of any captive or pooling scheme is that it forces the  owner—or owners—to look harder at their risks, claims processes and risk management in a much more detailed way than when coverage is bought through a commercial carrier, or if their exposures are funded through a self-insurance trust. 

MacDonald says she has seen some healthcare bodies change their risk management strategies after forming a captive.

“We have often seen hospital captive boards go through the claims review process at board meetings and realize that the largest portion of claims are from a particular specialty or risk segment,” she says. “This, in turn, leads to the enhancement of the risk management programs in that area. In time, this helps to reduce indemnity costs and increase retained earnings.”

3 Rewards for being good!

Although commercial insurers will reflect the individual loss history of clients when setting premiums, the price charged is also inevitably influenced by many other factors: the performance of the rest of that insurer’s portfolio, availability of capacity in the wider market and the overall risk of the sector as a whole—regardless of how good a client’s individual loss history might be.

With a captive, as long as it covers only the risks of its parent and affiliated entities, the premium should be partially based on its own loss history, and not just that of the general insured public.

“This leads to less volatility in the premium funding from year to year,” says MacDonald. “It often results in a lower cost of coverage than that available in the conventional insurance market.”

4 Access to the reinsurance markets

When using a commercial insurer, a proportion of that risk will almost always be passed on to the reinsurance markets. For organizations forming captives, they can now do this themselves, but in a way that best suits their risk profile, appetite and needs as a business.

“Another benefit is access to reinsurance for excess layers and the ability to utilize excess retained earnings for future dividends or grants back to the parent,” says MacDonald.

5 Shared resources

Again, this mainly applies where organizations work together to pool their risks. An advantage of such an arrangement is the opportunity to share not just risks but also education, best practices and other areas of expertise. “This will often also lead to positive loss ratio trends and an improving bottom line,” says Weldon.

6 You can domicile it onshore

Domiciles such as Bermuda and the Cayman Islands have traditionally dominated when it comes to where companies have based their captives. Their legal and regulatory infrastructures are robust and very favorable to captives, while the islands also boast decades of expertise in this arena.

But not all companies are comfortable with such an arrangement and a number of US states have adjusted their laws in recent years to capitalize on the demand to locate such vehicles locally. “It was slow to catch on but you’re starting to see more hospitals and health systems using domestic captives,” says Mary Anne Hilliard, the chief risk counsel and vice-president of Safety & Patient Experience at the Children’s National Medical Center in Washington DC. “Vermont is strong and Columbia has laws that allow for captive insurance; I believe the domestic marketplace will improve the quality of captives because there will be more choice. You could have a similar level of captive activity domestically as on Bermuda or Cayman.”

7 You keep the profits

Unlike the premium paid to a commercial insurer, the user of a captive could eventually recoup this cost if it succeeds in keeping claims levels low. This is equally true for groups which opt to pool their risks—it is a good incentive to improve risk management and to keep on top of the claims process.

“Benefits to such pooling—or group—associations are that they are subject to positive underwriting results. Firms that pool their risk with like-minded peers enjoy the same benefits as pure captive owners,” says Weldon. “With sound risk management and claim adjudication practices, underwriting profits and investment income remains within the captive facility.”

8 Coverage can be extended

Traditionally, professional liability and general liability risks have been the major lines of business covered through captives. But, especially in light of the new structures and challenges they face thanks to healthcare reforms, some healthcare providers are adding new areas of coverage.

MacDonald says she has seen risks such as equipment maintenance, cyber risks and employment practices liability added, while some are employing ‘slot programs’ for physician coverage, which allows for the adding and deleting of healthcare professionals in the same specialty without the need to purchase extended reporting period (ERP) coverage—a helpful tool given the widespread integration of physicians into hospitals.

9 They are suitable for all sizes

Although traditionally used by bigger institutions, current regulations mean that the captive option is now feasible and cost-effective for smaller organizations, especially if they are willing to pool their risks in some form with other organizations.

Weldon says that Bermuda’s healthcare captive activity continues at a steady pace but he has noticed an upturn in interest from smaller providers. “In terms of recent trends in healthcare captive licensing applications, we are starting to see increased interest from small- to medium-sized firms in forming captive facilities,” he says. “This may be due to the fact that most large healthcare systems already have some form of alternative risk option, and healthcare commercial market premium increases, on average, are low.”

10 A post-merger solution

There has been a recent trend of strategic merger and acquisition activities taking place between physician groups and medical facilities. This has been driven by both the pursuit of competitive advantage and the implementation of the Patient Protection and Affordable Care Act (PPACA), which is expected to increase overhead costs for smaller practices.

This is expected to drive the use of pooling arrangements and captives as these organizations try to manage the new risk profile and find the best and most cost-effective way of offsetting their liabilities. MacDonald believes it will drive more cash into captives, old and new alike.

“A continuing trend in the healthcare industry is the pooling of risks due to mergers and acquisitions between healthcare systems of varying sizes,” she says. “Such acquisitions will generally result in increased coverage being written by the captive of the parent organization. Such transactions involve much coordination, particularly in terms of what additional coverage will be transferred to the captive, and the risk management systems employed throughout the newly merged system to manage their exposures.”