3013-001_ed02E Let s talk trucking insurance captives TM
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About Northbridge s let s talk series of publications Northbridge Insurance Let s Talk series of publications has been produced to provide accessible, accurate and unbiased information about important topics facing Canada s trucking industry today. To order additional copies of this or any other publication in our Let s Talk series, please visit our website at www.nbfc.com or call us toll-free at 1.855.620.6262.come your comments.. Lately, there s been a lot of talk about trucking captives and the benefits that they can offer. While all the promotion can sound impressive, it usually only tells part of the captive story. We believe you owe it to yourself to get the full story on captives: how they are structured; how they work; who really benefits; and what their true costs can be to your trucking operation. The goal of this publication, Let s Talk Trucking Insurance Captives, is to provide you with information you should know and questions you should ask when considering whether joining a captive is right for your business. At Northbridge Insurance*, we think you deserve to know all the facts when making important decisions regarding the security and protection of your trucking business. We hope this publication helps you with that goal. Entering a captive poses many challenges. Do captives make sense for trucking operators? 3 Let s talk trucking insurance captives
Table of Contents 1.0 Captives: a definition 5 Mouths to feed 2.0 Can captives work in trucking? 7 The 3-point test But haven t captives worked in other industries? 3.0 Why are we hearing about trucking captives now? 8 But will captive insurance really help your bottom line? 4.0 Joining a captive can cost you more than you think 9 Cash calls Paying the middlemen Captives can spend more of each premium dollar on overhead Captives pay higher prices for reinsurance Loss of privacy No easy way out 5.0 Behind the captive sales pitch 13 6.0 Important considerations about joining a trucking captive 16 7.0 Are your best interests being served by a trucking captive 17 4 Let s talk trucking insurance captives
1.0 Captives: a definition A group captive (or captive ) is a handful of businesses that operates in the same industry and tries to self-insure its collective risks amongst its members. Thus, a few competitors come together and pool their funds to pay for claims in essence, becoming their own insurance company. Captives are commonly formed by companies whose main business is not insurance, and therefore do not typically have the expertise to manage the many functions of a traditional insurance company, such as underwriting and claims management. To overcome this limitation, captives must acquire these skills elsewhere, usually by buying these services on the open market from a number of third-party providers. A partial list of service providers and intermediaries at many captives: A captive manager A wholesale insurance broker An insurance broker A fronting insurance company Actuarial consultants Claims managers Various offshore administrators Safety engineers Litigation case managers Legal experts Captives can involve a long list of third-party service providers and middlemen and each one comes at a cost. How will that affect the ultimate price you pay for insurance in a captive? 5 Let s talk trucking insurance captives Go Back to Table of Contents
Many mouths to feed Captive: Involves many individuals and companies, including you, your captive partners and layers of middlemen and third-party service providers. Traditional insurance: Involves only you, your insurance broker and your insurance company. 6 Let s talk trucking insurance captives Go Back to Table of Contents
2.0 Can captives work in trucking? Captive insurance works in some industries. The 3-point test Within any given industry, at least one of three conditions should be met before a captive can be considered a viable alternative to traditional insurance. How does trucking compare? 1. No company currently offers insurance coverage for your industry. XMany insurers readily provide trucking insurance. 2. The industry does not typically experience large, volatile losses. XTrucking especially long-haul trucking is a highly volatile industry that suffers multimillion dollar losses on a regular basis. 3. The industry s loss experience remains consistently low and profitable over a long period of time. XThe long-haul trucking industry s loss ratios have consistently made trucking one of North America s most unprofitable lines of insurance. Long-haul trucking fails all three tests. But haven t captives worked in other industries? Captives have, at times, succeeded in industries that pass the three-point test. However, even in these circumstances, captives often fail to survive long enough to deliver the original value promised to their owners. In fact, an independent study 1 found that, over a recent five-year period, 65 of every 100 captives ceased operations. As the three-point test shows, captives can provide an effective solution for industries in which the losses are relatively small and highly predictable. However, this is not the case in longhaul trucking. Long-haul trucking is a notoriously difficult line of insurance to survive in, even for established insurance companies. The risk is even higher for alternative providers, such as captives, with little or no trucking insurance expertise. 1 AM Best, Tillinghast-Towers Perrin. 7 Let s talk trucking insurance captives Go Back to Table of Contents
3.0 Why are we hearing about trucking captives now? For Canadian carriers, revenues have remained flat for years while costs, such as diesel fuel, drivers and insurance, have increased. Not surprisingly, many trucking carriers are seeking solutions to help their bottom line. Captives will seldom, if ever, result in immediate savings. I m always suspect when somebody suggests that it s going to provide immediate savings. Generally speaking, there are no savings up front. And, really, there is no magic wand. A trucking captive spokesperson presenting at the Ontario Trucking Association Conference (November 12, 2004) But will captive insurance really help your bottom line? Insurance is a sizeable operating expense for any trucking company. When insurance rates go up, alternatives can start to sound good, at least on the surface. The sales pitches can include promises, such as: Your insurance will cost you less You ll have less volatility in your insurance program You ll receive dividends You ll have more control over your financial destiny Captive sales pitches want to make you believe that they can offer you the perfect alternative. Unfortunately, these promises are just not realistic in a high-risk industry like long-haul trucking. Alternatives can get your attention in difficult times, but at what cost to your bottom line? 8 Let s talk trucking insurance captives Go Back to Table of Contents
4.0 Joining a captive can cost you more than you think When you become a member of a captive, you become an owner in another business. That means, not only must you provide the captive an up-front capital payment and your annual insurance premium, you re also ultimately responsible for ongoing and future capital to fund cash flow. In addition, your startup capital is typically locked in for a minimum period, usually three years. Cash calls What happens when the captive gets its insurance pricing wrong or suffers more losses than expected something that s happened to almost all experienced trucking insurance companies? Laws prevent traditional insurance companies from increasing the price of your policy mid-term. However, no similar legislation exists to protect members of a captive. In such short fall situations, captive members can be subject to unexpected and substantial cash calls to replenish funds at a moment s notice. Cash calls can put tremendous stress on a trucking company s cash flow. To deal with this major uncertainty, carriers in a trucking captive may each need access to large lines of credit to address volatile cash call situations. Paying the middlemen When you buy traditional trucking insurance, there is only one intermediary between you and your insurance provider: the independent insurance broker, who is an invaluable part of the process. Within a captive, however, many layers of outsourced middle men are required to replace the expertise of an insurance company. This can include a claims management company, an actuarial pricing firm, a regulatory fronting insurance company and safety engineers. Captive members may be subject to sudden, large cash calls to replenish their funds. 9 Let s talk trucking insurance captives Go Back to Table of Contents
Then, there can be levels of intermediaries and salespeople involved,including an insurance broker, a wholesale insurance broker, a captive intermediary and an offshore captive manager. Unlike a traditional insurance company, all of these middlemen take a cut of your premiums every year, each with a guaranteed profit margin. And, none of them assume any risk, nor do they contribute to the ongoing costs or cash calls of the captive. As a member of the captive, those are your responsibilities and you now assume all of that risk. In addition, since the capital you ve paid to join the captive is locked in contractually for a period of time (often three years or more), the commissions and fees these service providers and middlemen collect from you are effectively guaranteed to them for years. Is there a conflict of interest if the salesperson selling you a captive is effectively getting their commission guaranteed for years, regardless of your results in the captive? Captives can spend more of each premium dollar on overhead This leaves less for paying your claims One Canadian trucking captive states that 40 percent of every premium dollar is allocated to cover costs such as its various middlemen and outsourced service providers leaving only 60 percent of a captive member s premium dollars to pay for claims. 2 Contrast this with traditional trucking insurance companies that typically incur lower operating costs. As little as 20 percent is needed to cover costs, leaving more money to pay your claims, which ultimately means lower insurance prices for you than in a captive. With substantially higher operating costs and fewer dollars left to cover claims, truckers in a captive often face two equally unappealing options: Large increases in insurance premiums; or Mid-year cash calls to re-finance capital shortfalls and replenish loss reserves. Either way, joining a captive can get very expensive. Captives can be highly inefficient and spend a lot more money on costs than traditional trucking insurers. 2 Today s Trucking, July - August, 2004. 10 Let s talk trucking insurance captives Go Back to Table of Contents
Captives can spend much more on costs such as its middlemen and outsourced service providers leaving considerably less money to pay your claims. Traditional trucking insurers tend to maintain much lower operating costs as a percentage of your premium dollars, leaving more money to pay your claims, which ultimately means lower insurance prices for you. 11 Let s talk trucking insurance captives Go Back to Table of Contents
Captives pay higher prices for reinsurance In a limited manner, reinsurance can help protect insurance providers traditional and captive from the unforeseen costs of catastrophic claims. Traditional insurers usually enjoy significant advantages in buying reinsurance: buying power that comes from the economies of scale of insuring tens of thousands of trucks, and from demonstrating a long history of expertise within the trucking insurance industry. Captives, on the other hand, are subject to much higher prices for reinsurance because of their small size and limited experience in trucking insurance. With only a handful of members, no long-term trucking insurance expertise, no reinsurance track record and outsourced middlemen who lack a direct vested interest in the captive s claims performance, captives usually do not have anywhere near the buying power of a traditional insurance company. Reinsurers can charge a trucking captive far higher rates for the same reinsurance coverage, reflecting the captive s higher risk potential and lack of trucking insurance experience. In addition, when traditional insurance companies experience a multi-million dollar loss, they may see a reinsurance rate increase the following year that can then be distributed over thousands of policyholders. As a result, the effect of that rate increase on any one policyholder is minor. In contrast, when a captive experiences the inevitable multi-million dollar losses, the distribution of the reinsurance price increase over the captive s few members can lead to dramatic rate increases, cash calls for each member and huge volatility. Loss of privacy Because members of a captive become partners in a business venture, each member may be compelled to share sensitive and confidential information about their business, such as finances, routes and safety practices. This poses obvious risks. After all, at the end of the day, your partners are also your current and future competitors. No easy way out As part owner in a joint venture, you may face significant legal and financial hurdles, should you desire to leave a captive. Likely, you have been compelled contractually to lock in your capital for many years. And, while you may be promised the freedom to give up your membership at any time, all the capital you ve invested will likely not be able to leave with you, effectively locking you in for years. A successful captive... requires a minimum commitment of 5 years from its owners and participants. Even a 10-year commitment is not unrealistic. Disincentives or even penalties should be erected to reduce the potential of early withdrawal. Captive Insurance Company Reports (July 2004). 12 Let s talk trucking insurance captives Go Back to Table of Contents
5.0 Behind the captive sales pitch Insurers don t reward you for those years where you have low losses. Join our captive, and you keep the profit for yourself. This isn t how insurance works, whether at a captive or a traditional insurance company. If it did, no trucker with a few years of low losses would need insurance. Reality: Multi-million dollar losses happen all the time in trucking and are getting more frequent. To manage this risk, insurance companies and captives must ensure that adequate reserves are available to cover these losses when they inevitably occur. Say you pay $100,000 in annual premiums and have had no losses for three years. In your fourth year, however, you experience a $5million loss. A traditional insurer will likely continue to provide you with regular and stable coverage into the future, even though your last 25 years and next 25 years of combined premiums won t cover the cost of that one claim. A captive doesn t have the capital or luxury to wait 50 years to recover the cost of that one large claim from you and your fellow captive members, or to repay reinsurers. We can handle your claims as well as a trucking insurance company. When one of your drivers gets into an accident, especially in the US, chances are you re getting sued. In such cases, it s crucial that the people handling your claim have the skills to successfully defend you and have their interests closely aligned with yours. A traditional trucking insurance company has full-time trucking claims experts on staff and shares the same vested interest as you: They want to see those lawsuits where you re being sued settled quickly for the lowest payout possible. As a result, an insurance company s best interests are perfectly aligned with yours. Contrast this with a captive that outsources the management of your claims to a thirdparty firm. An external claims firm, whose primary source of income is billable hours, has no vested interest in the outcome of your claims. In addition, third-party claims management firms are typically generalists, not trucking experts. This begs the question whether they have the trucking expertise to help you minimize your claims costs. A captive, with no real expertise in managing trucking lawsuits, can put losses on your record at unnecessarily high levels. In other words, if you get hit in a captive with an unnecessarily large lawsuit payout that could have been settled for far less money, it s you who will feel the pain not the thirdparty company managing your claims or any of the other captive middlemen. Remember, when an unnecessarily large loss goes on your record, it will follow you around for years to come. Effective claims management is crucial to your bottom line. Are the interests of a captive s outsourced claims managers truly aligned with yours? The reality of insurance is that both a captive and a traditional insurer need to put away funds in good years to pay for trucking s large and inevitable losses. 13 Let s talk trucking insurance captives Go Back to Table of Contents
In a trucking captive, you ll get a nice big dividend at the end of each year. To receive annual dividends, a captive must be consistently and predictably profitable, year after year. However, long-haul trucking has been one of the most unprofitable lines of insurance in North America. History has shown that trucking has bankrupted even experienced, well-funded insurance companies. A cursory look at insurance companies and their operating ratios (the amount paid out for every premium dollar collected) during the 1990 s brings this fact into clear focus. The overall insurance industry paid out, on average, $1.08 for every $1.00 collected in premiums. Compare this to long-haul trucking insurers, who are estimated to have paid out $1.50 and even $2.00 for every $1.00 they collected in premiums. Being an owner of a captive makes you liable for these kinds of losses. vehicles, such as treasury bills and government bonds. Investment yields are based on interest rates, which are set by central banks and are not in an investor s control. For several years, interest rates have been at historic lows, with no significant change in sight. In relative terms, investment returns today are virtually non-existent. Good news for borrowers, but bad news for investors. From an investment point of view, this is actually the worst time ever to join a captive. Trucking insurance has been one of the most unprofitable types of insurance in North America. New insurance providers, like captives, face huge challenges. The odds are that you ll be putting more money into the captive, not getting dividends out. Why let the insurance company make all that investment income? Due to the unpredictable timing of claims, insurance premiums must be placed in stable investments until those funds are needed to pay claims. Investments are usually made in safe, interest-bearing 14 Let s talk trucking insurance captives Go Back to Table of Contents
Insurance companies have built-in, guaranteed profit margins. This is simply not true. The very nature of insurance is defined by taking on large levels of risk, which is why investors have always considered insurance a highrisk business. If trucking insurers had guaranteed profit margins, then why have the vast majority of them failed and disappeared over the years? Since the captive buys reinsurance, you and your fellow members don t have to worry about the effects of large losses. In trucking, multi-million dollar losses are both common and frequent and maybe absorbed partially at least initially by reinsurance coverage. However, when reinsurers suffer large losses, they often demand large price increases. These increases can affect the captive s relatively few members far more severely than if the same increase was spread out among the tens of thousands of accounts of a traditional insurer. In addition, trucking captives can pay much more for the same reinsurance, as they neither have the economies of scale nor the long history of experience and relationships that give reinsurers confidence in their operations. In a trucking captive, you ll get cheaper insurance rates. A typical sales tactic in many businesses is to quote a low, first-year price to entice you to join. However, as we ve seen with trucking captives, the total cost from the guaranteed commissions, fees and profit margins of its middlemen and outsourced service providers, to higher reinsurance rates can ultimately be far more expensive than traditional insurance. While your commitment and capital are locked in, your insurance rates are not, which means your premiums and other fees can be increased dramatically in subsequent years. In addition, the middlemen selling you on the virtues of joining a captive may be in a conflict of interest. By convincing you to join a captive for three or more years, they are, in essence, guaranteeing their commission income for years at a time. Large losses in a captive can cost you far more than the same losses with a traditional insurance company. Once you re locked in, a captive can increase your insurance rate dramatically. 15 Let s talk trucking insurance captives Go Back to Table of Contents
6.0 Important considerations about joining a trucking captive 1. Long-haul trucking has historically been one of the most unprofitable lines of insurance in North America and has bankrupted even experienced, well-funded insurance companies. Being an owner of a captive makes you subject to this same situation. 2. Captives work in some industries but, as the three-point test shows, long-haul trucking fails on all counts. 3. Captives often have many layers of middlemen, who take guaranteed commissions and fees out of your premium dollars, which can increase your cost of insurance. 4. Captives can have far higher operating expenses than traditional trucking insurers, leaving less money to pay your claims. 5. Without the economies of scale of a traditional insurance company, a captive will likely pay far more for reinsurance. In addition, reinsurance cost increases can expose captive members to serious financial volatility. 6. In a captive, your capital can be locked in for years, with no easy way out. 7. In shortfall situations, you may be subject to sudden and substantial cash calls that can put considerable stress on your company s cashflow. 8. You may see dramatic insurance rate increases in subsequent years once you re locked into a captive. 9. A captive may compel you to share operational information information that is typically private and confidential with your captive partners, who can be your current or future competitors. 10. Captives guarantee income and fees for its various middlemen and service providers, not for you. 16 Let s talk trucking insurance captives Go Back to Table of Contents
7.0 Are your best interests being served by a trucking captive? Insurance is supposed to provide you with peace of mind. But in a captive, you re taking on all the insurance risk yourself. And, as history has shown,most well-funded, professional insurance companies have been extremely unprofitable in trucking insurance. In a captive, you not only take on the risk of an inherently volatile and unprofitable business, you may also be placing your trucking company s well-being in the hands of an inexperienced trucking insurance provider. And, the risks don t stop there. In a captive, third-party service providers and layers of middlemen provide the claims and insurance functions that the captive s members lack. However, when the compensation of these various services are essentially locked in for years at a time and is not tied to the success or failure of the captive, it begs the question: Whose best interests does the captive really serve? Is this really peace of mind? Are your best interests really being served by joining a captive? Ask questions. Get all the information you can before deciding whether to join a captive. You have a right to all of the information you need to make the best decisions for your business. 17 Let s talk trucking insurance captives Go Back to Table of Contents