Alternative Risk and the Small-to-Midsize Business

Editor's Note: In this Thought Leadership article, Jeremy Colombik, managing partner at Management Services International, and Adam Perea, executive vice president of captive programs and services at Elite Risk, explore how small-to-midsize businesses can benefit from alternative risk financing.

In the business world, a "black swan" event refers to a rare and unforeseen occurrence that can significantly impact a business beyond what is typically expected.

For example, the COVID-19 pandemic, which disrupted businesses globally, led to changes that have reshaped many aspects of how companies operate, resulting in shifts that few could have predicted.

Although events like the pandemic have historically driven insurance premiums higher, there is an alternative, particularly for businesses and individuals with capital at risk.

A captive insurance policy involves certain risks for those adopting it. Using one's own resources to establish an insurance entity comes with inherent risk. In a time when risk takes many forms, traditional insurers, wary of excessive or high-stakes claims, may either refuse coverage or charge prohibitively expensive premiums, putting businesses in a difficult position. Reinsurance treaty renewals and losses from catastrophic events, such as named storms, continue to make coverage harder to secure and more costly as the hardened insurance market remains challenging.

Captive Insurance

A captive can help a business or individual manage these alternative risks, offering reduced financial exposure and the potential for significant cost savings, ultimately leading to a lower total cost of risk. Think of it as a "rainy day fund" that, barring a claim, contributes to surplus growth for your insurance company.

Here's how it works: The business uses its capital to create its own insurance company and purchases a policy from it. After undergoing an annual underwriting process to select the risks they want to insure, an actuary provides appropriate pricing based on the company's limits of insurance and chosen policy type. A captive management firm is usually engaged to ensure compliance and manage administrative tasks. Should a qualifying event, whether a black swan or something else, trigger a claim, the payout comes from the captive, just as it would from a traditional insurer.

If no claims are made during the policy term, the captive owner benefits from the underwriting profits, which would otherwise go to large insurance companies profiting from your risk management efforts.

Why form a captive rather than simply self-insuring? Captives offer numerous advantages, particularly in covering risks unavailable in the commercial market or risks that come with coverage exclusions. Captive insurance companies allow access to the reinsurance market and can participate in shared pooling facilities, enabling you to reduce your risk exposure while benefiting from tax-deductible premiums and reserves, as opposed to holding post-tax dollars for potential risks.

Blended Solutions

A blended solution incorporates a captive, but the insured shares the risk and, therefore, doesn't receive all the rewards. In this arrangement, a traditional insurer writes the policy, collects premiums, and assumes part of the overall risk. The captive assumes a portion of the risk, and the insurance company cedes a corresponding portion of the premiums to the captive.

This approach allows businesses to take greater control of their risk management programs while reducing the total cost of risk and sharing in the underwriting profits.

Blended solutions offer flexibility in managing risk. Businesses with favorable loss histories that continue to face rising premiums due to their industry or classification can gain more involvement in their insurance programs, taking on some risk while demonstrating confidence in their risk management practices. Different strategies include reinsuring a specific layer of risk or entering a quota share agreement, in which a portion of the risk is shared with the insurer.

Reinsurance allows a business to target specific risk tranches they are comfortable insuring, while a quota share distributes the risk between the captive and the insurer. The percentage of risk shared is negotiable and agreed upon with the insurer.

Typically, a captive will hold back a portion of the premium to secure the insurer's credit risk and, in many cases, provide collateral for the risk assumed. However, there are programs available for small-to-midsize businesses that allow risk-sharing through reinsurance or quota share agreements without the need for posting collateral, relying instead on premium holdbacks. Collateral requirements can often be a barrier, adding to the total cost of risk even in favorable years.

In summary, while alternative risk financing is not suitable for every business and should be approached with caution, it provides a viable option for those seeking more control over their policies and financial investment. For businesses with unique risks or a desire for more control over their insurance, it can be a sound strategy—not only from a liability perspective but also from a financial one.