Is Affordable Pricing an Impediment in Your Captive's Mission Statement?

Captive insurer mission statements are intended to be living, dynamic documents. Too often, they are crafted during the captive's start-up phase and then forgotten. Most captive mission statements contain references to affordable pricing. Given the ongoing market conditions, it may be time to remove this reference and refresh your mission statement.

While captive insurers' mission statements are wide ranging, many include the following or similar verbiage: "We seek to provide stable and competitive insurance pricing for our members." Why shouldn't a captive insurer's members seek to enshrine this ideal into the written declaration of the captive's core purpose and focus? In fact, if you search online for reasons for forming a captive insurer, "stable and affordable" pricing is frequently mentioned.

This isn't surprising given the history of captive insurance. In the "Early Days of Captives" in Captive.com's captive insurance history timeline, the opening paragraph begins, "The early period of captives was dominated by very large single-parent captives and a few large group captives. They were formed in reaction to insurance crises (i.e., a lack of capacity and high prices)." Obviously, the need to provide stable and affordable pricing was a key component in the creation of the modern alternative insurance market and therefore carries over to today.

As times change, captive insurers should work to adapt. In a September 7, 2015, Insurance Journal article titled "The Hard Market That Wasn't," authors Rudy Dimmling and Greg Hoeg wrote the following.

For the U.S., property/casualty industry recent events have mimicked the boxing idiom one, two punch. P/C industry professionals haven't seen a combination of an underwriting cycle and an investment environment quite like this within recent memory. The typical prolonged soft underwriting cycle followed by a much shorter, but very strong hard market has failed to materialize. In fact, the last three soft markets have averaged nine years in length while the last three hard markets have averaged only three years.

It is now 2 years later, and the proverbial "hard market" still has not returned and by some indications may never do so. As shared in a June 12, 2017, Captive.com article titled "Excess Capacity and Strong Competition Drive Down Reinsurance Rates," JLT Re reported that reinsurance rates fell for the sixth consecutive year at the June 1, 2017, renewal. Excess capacity and strong competition among traditional and insurance-linked securities markets, particularly for some of the more sought-after placements, were once again instrumental in driving reinsurance rates down. The result is a reinsurance market awash with capacity as supply continues to exceed demand. Granted, primary commercial insurance is not reinsurance, but the story lines are similar.

Mission statements, and their corollary—vision statements—are frequently crafted during the start-up phase of the captive insurer. More importantly, they are intended to be dynamic, not static, and should be revisited on a regular basis. As the captive insurer undergoes changes both internally, hopefully as the result of growth, and externally, as a result of changing environments, the board and management team should review and update the mission statement. Given current insurance market conditions, captives should take a look at their mission statement and make revisions, especially where it concerns stable/affordable pricing.

This is not a call for captives to abandon trying to produce stable and affordable pricing but rather a reminder that it should not be seen as an overarching goal. With the persistence of soft market conditions, captives can get drawn into the downward pricing spiral. This becomes easier when a stated goal is to provide "affordable" insurance. If your pricing is higher than the markets by 10 percent or more, you open yourself up to the argument that your premiums are no longer affordable. While this is more likely to happen with group captives, it can still occur for single-parent captives.

Captive.com's recent article on risk culture (see "What Makes a Successful Risk Culture") notes that "as captives have matured and continued to flourish they have been called upon to expand the risks that they underwrite. Captive boards and management should work to understand that, as their risk appetite grows, so should their dedication to building a successful risk culture within the captive." Mission statements can be instrumental to this end, assuming they are dynamic, living documents. Well-written mission statements provide the following.

• Guidance to management's thinking on strategic issues, especially during times of significant change
• Definition of performance standards and risk appetites
• Framework for employees that provides focus and common goals and guides decision making
• Structure for ethical behavior

Insuring new risks, however, requires capital. The capital necessary to support the additional risk can be generated internally through the captive or secured externally through reinsurance and/or capital support. Captives wishing to generate the capital internally understand this can occur only if the pricing on their current lines of business is profitable. But profitable underwriting may appear to conflict with stable and affordable pricing. An example can help illustrate this point.

A captive insurer may set its pricing structure so that a dollar of contribution (premium) is used to fully offset the loss and expenses associated with the line of business. Written out, it looks like this:

$1 contribution = loss costs + general and administrative expenses

In this example, a captive would only add to its capital or surplus position from underwriting when the losses and/or the expenses are less than anticipated. Pricing is absolutely affordable in this example. Unless another insurer wishes to write this business as a loss leader, there is no way to undercut the premium amount, unless the captive uses investment income to fill the gap. A captive using these guidelines could only grow its capital at the same rate as the return it generates on its investment portfolio. Affordable pricing, therefore, becomes an impediment to expansion of the risks the captive can underwrite.

Take a look at your captive's mission statement and review the last time it was updated. Does it contain a reference to stable and affordable pricing? Is this statement an accurate representation of the wishes and needs of the members? Do members recognize that having this as an implicit part of the mission statement may create a conflict where the captive is asked to underwrite new risks? Good governance requires that the board and management reassess the captive's mission statement on a periodic basis. If not checked, you may be sending an incorrect message surrounding the captive's goals and aspirations to its employees and insureds.