Using Captive Insurance to Reinsure Surety Bonds: A Growing Opportunity

Captive insurance companies have traditionally been used by businesses to self-insure their risks. They offer numerous benefits—the key ones being improved risk control and reduced premiums for their parent companies. 

While captives have long participated in reinsurance, particularly for their own risks and through fronting arrangements, there is growing interest in applying captive reinsurance to surety bonds, especially among US and EU domiciles. 

One of the most innovative applications for captives today is reinsuring surety bonds. A surety bond is a contract among three parties: the principal (the party requiring financial backing, in this case, the captive's owner or parent company), the obligee (the party requiring that a bond be in place), and the surety (the party guaranteeing that the principal will meet its obligations to the obligee). 

Surety is typically used as a guarantee for large commercial financial obligations, primarily in the construction industry. One of its key advantages is that surety bonds are not listed as debt on a company's balance sheet, freeing up capital and credit for other uses. 

Surety Bond Solution 

In this structure, the surety company acts as a fronting company, obtaining indemnity from the principal (the captive owner) and then issuing the bond before entering into a reinsurance agreement with the captive. 

The surety then cedes a percentage of the risk and premium back to the captive, which acts as a reinsurance layer above the surety bonds. If a claim is made, the surety company would first look to the captive for resolution. If the captive does not respond or declines to pay, the surety would pay the claim itself and then seek reimbursement from the captive. 

This risk-financing method is reported to have been developed by Jeffrey Leadley, senior vice president at Alliant Insurance Services, who claims to have implemented the concept on a large scale. In his account, his client—a Fortune 20 national retailer—previously used an indemnity agreement to reinsure its surety bonds but sought to use its captive insurer, which already managed most of its risks. 

Mr. Leadley's client uses surety bonds as a financial guarantee against the reserving and loss activity of its self-insured workers compensation programs to meet the requirements of the 40 states in which it operates. The benefit of reinsuring the surety bonds this way is that captive owners can deploy their capital more efficiently by adding a new line of business, while gaining greater risk control and reducing premiums, he said. 

"Surety bonds were the only line of business not participating in the captive, so they wanted a solution that would remedy that," said Mr. Leadley.

He continued, "By utilizing their captive in this way, they were able to achieve a range of benefits not readily available through traditional treaty reinsurance." 

Overcoming Structural Challenges 

Mr. Leadley said he first had to overcome several challenges, most notably the way surety bonds are structured and underwritten. Because surety is a form of indemnified credit rather than risk transfer, it is rare for a captive insurer or fronting structure to be used to reinsure it, he said. 

He also had to integrate the captive's reinsurance agreement provisions with the corporate indemnity required by the surety company. The new structure demanded a more rigorous level of administration to manage premium flow, risk cession, and financial reporting, he added. 

As a result of successfully utilizing the captive to reinsure its entire surety bond program—worth more than $750 million—Mr. Leadley said his client halved its net annual premium, saving approximately $1.5 million. The savings were reallocated to support other captive activities. 

"This solution has the potential for a much wider application across a range of different industries," said Mr. Leadley. "I'm already talking to companies in the oil and gas, entertainment, and retail spaces, so the potential is huge."

Growing Market Interest 

Mr. Leadley's project is just the beginning. Other captives are now being used as a reinsurance layer for surety bonds. 

In 2017, National Surety Underwriters, a Philadelphia-based underwriting agency, raised $11.5 million to capitalize a special purpose surety reinsurance captive, the National Fidelity Reinsurance Company (NFRC). The funding supported the merger of McCabe and Independent Corporate Underwriters, both managing general underwriters specializing in surety bonds. 

The combined entity allows NFRC to underwrite and reinsure surety bonds of up to $2 million per bond and $4 million in aggregate per principal, insured through its licensed carrier partner, Clear Blue Insurance Company. 

Alex Gedge, senior captive consultant, Global Captive Solutions at Hylant, said demand for such solutions is being driven by companies seeking greater cost effectiveness and better use of available capital. A hard insurance market is also prompting companies to look for alternative solutions, she said. 

"As there are complex transactions and capital requirements, companies are looking for bespoke coverage solutions that more closely align with their needs," said Ms. Gedge. "Captives can be used for this instead of a standard market solution." 

Chad Rosenberg, principal at Rosenberg & Parker, said that historically, surety bond companies have been reluctant to front for captives because they already hold indemnity from the captive owner. However, he added, with an influx of new entrants into the surety bond market, many are seeking differentiation and new opportunities—of which captive reinsurance is one. 

"Captive owners, for their part, are increasingly looking for new ways to utilize their captives, put their capital to good use, and reduce their premiums," said Mr. Rosenberg. 

"But it's not for everyone—you need to have a large surety bond program worth around $100 million in bonded liability, and the captive has to be well capitalized." 

Catherine Dorrien, captive consulting leader at Marsh Captive Solutions, said the key challenges in writing surety bond risks are regulatory and contractual coverage requirements. These include the captive's licensing restrictions (it is considered admitted only in its domicile state), the cost and collateral needed for an AM Best rating, and potential T-listing requirements for government bonds. 

Expanding Applications 

Brendan Roche, head of distribution at Lockton Re, said companies using captives to access reinsurance have an opportunity to broaden risk coverage and increase capacity that might not be available in the primary market. Among the biggest growth areas, he noted, are employee benefits and cyber. 

"By pooling your employees' benefits risk in one place, you have a larger piece of business that is easier to place in the reinsurance market," said Mr. Roche. "Using a captive also helps you to better understand, manage, and price your reinsurance risks accordingly. 

"Another area is premium arbitrage, where you place some of the risk with your lead carrier and then put the rest of it in your captive and cede it back to the reinsurance market. Where reliance can be placed on the lead market, the net effect is that you could save premium by using the captive in this way." 

Austin Griffith, senior vice president—captive management at Risk Management Advisors, said captives are an attractive option for reinsuring surety bonds due to their relatively low risk. However, he noted that the main challenge lies in maintaining sufficient capital or surplus to support larger bonds. 

TJ Scherer, vice president at Spring Consulting Group, added, "There are some challenges with placing a surety bond in a captive due to limited market appetite and the fact that it's more of a financial product than an insurance product. Still, there's growth potential for larger clients purchasing significant surety backed by a balance sheet that supports the bond both at the front end and within the captive." 

Collaboration and Integration 

To create an effective solution, Ms. Gedge emphasized that partnership is key—particularly in complex transactions requiring specialized expertise. By working closely with their insurer or broker, regulator, and the right service providers, companies can ensure compliance with all legislative and regulatory requirements. 

"Captives and alternative finance complement well," said Ms. Gedge. "Both can respond quickly to changes for business risks, with a bespoke solution, and can move quickly." 

Karl Choltus, national surety practice leader for Brown & Brown, added, "There are two main ways captives can be used with respect to surety bonds. The first is when you have a large, financially strong entity with a sizable captive that needs to use surety bonds to meet its obligations. In that case, the captive can participate as a reinsurer to recoup some of the premiums paid for the surety program. 

"Secondly, captives often have their own deductible security requirements, which may call for some form of financial assurance to be provided to another insurer. When a captive purchases insurance with a large deductible, it must post that assurance—and that's where surety bonds come in." 

Jim Swanke, lecturer at the University of Wisconsin–Madison and former senior director at Willis Towers Watson, said there has been a shift in captive design over the last 30 years—from purchasing excess reinsurance in the retail market to using captives to secure reinsurance for higher-severity risks. 

He has also observed an increasing use of integrated risk programs spanning multiple years and lines of business, with captives serving as the access point to the reinsurance market. 

"We have seen a transition from setting up captives on a net line basis to a gross line model as captive owners have become more comfortable with using captives as a platform to secure reinsurance for more catastrophic losses," said Mr. Swanke.

"The use of reinsurance has also been perpetuated by this move towards integrated risk programs within captives," he added.