Claims Handling in Captives
Lynn C. Sheils | May 22, 2017
Captive insurance company owners cite the "desire to control one's destiny" as a significant factor in deciding to create a captive. The issue of control is perhaps most visible in the claims management process. Claims are usually the most significant cost of any risk transfer mechanism. Under a traditional casualty insurance policy, the insured has little input in the claims process. Standard insurance clauses give the insurance company control of the most important and expensive aspects of claims. Insuring agreements typically state the following.
We [the insurer] will have the right and duty to defend the insured against any suit....
We [the insurer] may, at our discretion ... settle any claim or suit ...
Given this situation, insureds, at best, have minimal control in the claims handling process. This is often a source of frustration. Commonly voiced complaints include the following.
- Small claims are allowed to linger because the overworked insurance company claims handler does not have the time, or does not take the initiative, to try and resolve a small claim early on.
- Insurance companies will settle a frivolous claim to save defense costs, while the insured foresees that the payment of the frivolous claim is going to encourage more such frivolous claims.
- With the insurance company retaining the right to hire the attorney for the insured, the insured is not getting loyal or qualified defense counsel. A lawyer or law firm may be dependent on a particular insurance company as its main source of revenue. This leads to questions of loyalty. And, while an insurance company rarely hires the cheapest law firm when it comes to protecting itself in a bad-faith or extra-contractual claim, when it comes to the defense of insureds, being the cheapest may be defense counsel's primary qualification to handle the claim.
By contrast, captive owners have much more control of these problem-causing activities. Captives can be set up to administer claims on terms that take into consideration the nature of its parent company's business and claims handling preferences. Captives can choose to resolve claims quickly before they develop into something much larger and more expensive. Claims generally get more expensive the longer they are open. Captives can choose to not settle frivolous claims and force plaintiff's attorneys to incur time and expense litigating claims to deter future lawsuits. Captives also select the defense counsel of their choosing. All of these can be cost-saving benefits to a captive.
But before going down the road of taking control of claims through a captive, a number of decisions need to be made, regarding the lines of coverage that will go into the captive, for which of these coverages will the captive handle the claims, whether to implement internal claims management or use outside resources, and what claims handling procedures will govern the captive.
Lines of Coverage
Critical questions to determine up front are what lines of coverage are going into the captive and how many claims should the captive anticipate for each line. If the parent company wants to place all lines—property, liability, auto, workers compensation, management liability, etc.—the parent needs to be prepared to staff the captive with a robust claims department and with claims handlers that possess specialized skill sets. Claims adjusting is a skill; while risk managers or internal legal personnel can be retooled to be a part of the claims adjusting team, this will require an investment in training. Regulatory requirements for the different lines of coverage also need to be considered and whether the captive team has the skills and resources to meet the regulatory requirements, especially for those lines with considerable regulation, such as workers compensation.
Internal or External Claims Handling
Once the parent has a grasp on the anticipated size and skill set of the captive's claims department, a decision must be made as to whether it would be best to implement an internal claims program or to contract with an outside third-party administrator (TPA) to manage the claims. The parent company should be realistic as to the claims handling capabilities of the captive to avoid the worst-case result of poorly handled claims and increased costs. Oftentimes, a combination of the two approaches is used. The parent may elect to have a TPA manage the high-frequency claims while it self-administers the high-severity claims, or the parent may elect to have a TPA manage claims in highly specialized lines of coverage while it self-administers more routine lines of coverage, or some other combination may be used. If a TPA plays a role in the claims handling, the captive or someone within the parent with claims handling experience should routinely audit the TPA in order to ensure claims are being handled effectively and in line with the parent company's expectations.
Implementing Claims Handling Procedures
When the decision is made to manage claims within a captive, it should be recognized that the captive is now in the hot seat for proper claims handling, just as is any insurance company. A captive is expected to behave as any traditional insurance company. Failure to properly handle claims can result in a number of major issues. The captive should expect problems from the domicile regulators, state insurance departments, reinsurers, excess insurers, claimants, and its parent company. One must also consider the public relations nightmare and reputational bruises the parent may suffer from the captive's failure to properly handle a significant or well-publicized claim. Claims handling needs to be well thought out and consistent. Consistency can be achieved through a properly designed and managed claims handling procedure. The claims handling procedure should set forth the captive's oversight protocol, reserving philosophy, and claims and litigation management philosophy. The claims handling procedure should be part of training for the captive's employees, and the captive should self-audit to ensure it is being followed. The claims handling procedure should be reviewed and updated as needed to reflect changes in philosophy.
Some of the activities that should be considered in creating the claims handling procedure include the following.
Noticing of claims. It is imperative that a captive that buys excess cover or reinsurance give proper notice to its reinsurers and any excess insurers promptly and in accordance with the notification clauses in its reinsurance contract or excess policy. Failure to give prompt notice can result in a denial of coverage. While most jurisdictions impose a prejudice requirement before late notice will bar coverage, this is a dispute that can easily be avoided by making it the captive's practice to err on the side of caution and always provide notice of any potential claim. This may also take some training of personnel at the parent company to make sure they understand the importance of timely noticing a claim to the captive. Oftentimes, employees will want to see if they can make the claim go away or think of it as frivolous and not immediately notice it to the captive. However, this mind-set can lead to late notice issues for the captive, and the mind-set should be overcome through a training and communications program.
Making a coverage determination. A captive has a duty to independently review coverage. The captive should undertake this duty with a view toward being independent and fair, because the relationship of the captive with its reinsurers and excess insurers is paramount to the success of the captive. If the captive is viewed as not honoring its duty of utmost good faith and as just "going through the motions" in its coverage determinations and claims decisions, disputes are likely to arise.
Thus, the captive should follow the traditional steps of determining coverage, as follows.
- Identify the insureds.
- Identify the policy effective date.
- Identify the location of the claim.
- Review the insuring agreements.
- Check for exclusions.
- Confirm conditions have been met.
If a claim moves into litigation, the captive should again undertake a coverage review following the "eight corners" approach of determining whether the allegations made within the four corners of the lawsuit fall under the coverage set forth within the four corners of the insurance policy.
Coverage decisions should be made in writing, particularly when there is any question about the applicability of the coverage terms to the claim. When there are facts that may cause the claim to fall outside of the coverage terms, a reservation of rights letter should be issued. If the facts provide a good-faith reason for coverage not to apply, a coverage denial should be issued. In a situation where the parent company does not agree with a captive's denial of a claim, it may be necessary to retain an independent external resource, such as a coverage attorney, to review the facts and weigh in on the matter.
Responsibly investigate claims. Claims should be adjusted in a proper and business-like manner with the claims handler conducting as thorough an investigation as would be expected in a noncaptive setting. Reinsurance contracts generally have a claims cooperation clause affording reinsurers an opportunity to be associated with the captive in the defense of a claim with the captive's cooperation, as well as an access to records clause affording reinsurers the right to inspect all books, records, and papers of the captive in connection with the reinsurance. When excess insurance is used in lieu of or in addition to reinsurance in most states, the excess insurer may sue the primary insurer, the captive in this case, for mishandling claims under the theory of equitable subrogation.
The important point here is to recognize there is a very real possibility that reinsurers and excess insurers can gain access to the captive's claim’s file. In such an event, the captive should be able to present a claim file demonstrating a professional and responsible investigation of the claim.
Advance preparation for all types of claims. Claims presented to the captive may require outside resources such as forensic accountants, medical consultants, accident reconstructionist, property appraisers, structural engineers, other types of expert witnesses, and/or outside defense counsel. The captive should not wait until an event happens before considering available resources. The captive should be continually vetting outside vendors and resources and putting business contracts in place for the "just-in-case" scenario. The captive should know who its go-to resource is in any given claim situation in any given geographical region so that when the captive gets a call of a major claim event on a Saturday evening, the captive can deploy resources immediately. Otherwise, the captive will lose considerable time sending e-mails and making calls that will most likely go unanswered until the next business day.
Consider an event such as Hurricane Rita when multiple refineries and factories along the Louisiana coast were heavily damaged in addition to the chaos within the city of New Orleans. If a captive did not have resources lined up in advance, it was an impossible task to obtain property appraisers or structural engineers as all resources were tapped. This would mean the captive's claim to its reinsurers or excess insurers would have been submitted after those of prepared entities, and it would be sitting at the bottom of the reinsurer's or excess insurer's stack of claims. Many captives found themselves in just this position after Hurricane Rita, and it is not uncommon to hear of reinsurance claims not being fully settled until 3 to 4 years after the event. Organization and preparation are paramount to a successful captive.
Investing in a claims system. At a minimum, a captive should be able to log and track open and closed claims in each line of coverage as well as track financial information on claims. The financial data being tracked should include the amounts paid, reserved, and total incurred for each claim. This information will be required to obtain competitive and accurate reinsurance and excess insurance quotes. The captive should also be reviewing this type of data to track metrics on claims, such as loss causes, the average amount of time claims are open, the average cost per claim, and the drivers of cost in order to identify new or changing risk trends specific to its parent. A key feature to reducing claims costs in a captive is to reduce the number of claims. If the captive is not running loss metrics to inform the risk management department on key loss drivers, an opportunity to reduce the number of claims and thereby the costs of claims will be lost.
The unwritten rules. While it may not be written in the captive's claims handling procedures, if the retention is small in comparison to amounts ceded to reinsurers or covered by excess insurance, the captive's claims staff should be trained to always work effectively with all excess insurers and reinsurers. A good working relationship with these parties can help lead to the captive's success. This is best achieved by implementing procedures to ensure there are no surprises for excess insurers and reinsurers nor the captive. The captive should take steps to make sure reinsurers and excess insurers are always aware of what is happening with a claim. The captive should put reinsurers and excess insurers on notice early, give updates before being prompted, and be transparent with its claims' data and evaluations. The captive should avoid being surprised by a coverage position of its reinsurers or excess insurers. The captive should seek the reinsurers' or excess insurers' buy-in early in the claim process and confirm that any lingering coverage reservations of the reinsurers or excess insurers have been addressed. The captive should also seek the reinsurers' and excess insurers' input on the captive's claims handling strategy. Chances are the captive's reinsurers and excess insurers have seen many more claims than the captive has, so the captive should lean on the expertise and experience at its disposal.
A captive can truly provide a means for a parent company to take control of its destiny, particularly with respect to claims. But, the parent and the captive must recognize that this requires forethought as to the types of claims it will handle, resources to make available for handling the claims, and the claims handling process necessary to perform in a proper and businesslike manner. A closing thought that should guide the process: since the captive has a special relationship with its insured, conflicts of interests are going to be presumed by reinsurers and excess insurers. The captive should therefore take the steps necessary to mitigate that perception.
Lynn C. Sheils | May 22, 2017