The purpose of any alternative risk structure is to achieve the most appropriate balance between risk assumption and risk transfer to optimize savings while supporting the organization’s risk management, financial and business objectives. In many cases, self-insurance is the most efficient alternative risk transfer mechanism. The benefits that can be derived from self-funding can be further amplified through captive participation in an excess coverage like medical stop loss that insures a self-insured plan. It is a way of double-dipping to maximize cost savings on insurance and enhance the profitability of the captive. For smaller employers, participating in a group captive can provide increased access to many of the same captive advantages that are enjoyed by larger organizations, such as increased risk spread, service provider cost leveraging and surplus dividend sharing.
The primary objective of a captive is to reduce the employer’s dependency on traditional insurance by efficiently retaining manageable layers of predictable risk while transferring more volatile and unpredictable layers to a (re)insurer. This enhances the employer’s ability to reduce and stabilize insurance costs by controlling risk rather than simply assuming it, recognizing that a captive should not focus on assuming risk but rather on how retained risk is utilized and proactively managed.
In addition, the captive should not be viewed simply as a way to reduce the cost of medical stop loss coverage itself but rather as a component of a much larger strategy for reducing the costs associated with delivering health insurance to employees, hopefully on a long-term basis.
A medical stop loss captive can help achieve a number of key objectives:
1. Reduce the total cost of healthcare benefits. As opposed to simply paying claims within the same layers from general assets, funding layers or medical stop loss coverage through a captive allows the employer to more easily recognize and deploy surplus from underwriting profit and investment returns attributable to the funding of these layers. For example, a medical stop loss captive enables an employer to:
- Capture underwriting profit when losses are less than projected
- Accrue investment income on premium reserves
- Stabilize rates and the cost of risk over time
Surplus derived from the captive’s underwriting and investment return can be returned to the employer more efficiently in the form of dividend distributions or strategically deployed to offset future costs or expand benefits to employees, or retained within the captive to smooth financial volatility associated with other lines of coverage.
2. Smooth cash flow impact. The disciplined funding and loss-reserving of a captive structure can help smooth the impact of loss-sensitive programs on cash flow and budgeted results. Rather than paying for claims out of operating funds or expensing them as they arise, the insured instead funds a fixed annual amount to the captive, and the captive accrues for the expected claims costs.
A frequently cited objective for captives, especially for risks with low frequency but potentially high severity, or large medical claims, is to build a loss fund over time to offset large claims that could be lasered by a stop loss carrier when they occur. (Lasering is the practice of setting a higher deductible for individuals whose health status makes them more likely to file large claims.) The captive loss fund may be used to absorb large claim lasers rather than paying them out of operating cash flows. The captive can effectively be used to convert a large, ongoing medical claim into a budgeted expense.
3. Increase control and flexibility. Accruing surplus through participation in a captive allows an employer to more comfortably increase retentions in the future and enhance the pliability of the program’s response to market conditions. The employer can provide more options for program design and customize coverage to better fit the demographics of the employee population.
4. Increase focus on medical risk management. Medical stop loss captives can be used as a tool for the employer to track the financial performance of its decisions through data analytics. The increased ability to identify specific cost drivers can help the employer to more effectively control the cost of risk and more appropriately adjust risk management, claims and funding.
5. Augment enterprise risk management. Related to the focus on risk, incorporating non-traditional risks within a captive can help enterprise risk management initiatives. By quantifying the probability and financial outcome of other unrelated risks, it can determine how or whether to hedge those risks.
The same standard that is used to determine the appetite for financial risks should be applied to the conventional insurance program. By incorporating it into the captive, the periodic financial review will provide another tool to track results and measure decisions. Adding stop loss to a captive that primarily writes “long-tail” coverage, such as workers compensation or liability, can provide a protective “short-tail” stability hedge by diversifying the captive’s risk portfolio.
6. Reduce dependency on the traditional commercial insurance market. The flexibility afforded by accumulated captive surplus can help the employer manage its future insurance costs. Annual medical losses can be unpredictable. A bad loss year may be followed by premium increases dictated by the insurance carrier. As the captive loss fund builds, the employer can leverage surplus and more readily adjust how much risk it opts to retain in the future. This ability to adapt based on changing market conditions will enable the employer to further decrease its dependence upon the commercial insurance market. A captive can also facilitate access to more efficient capacity by purchasing necessary coverage as reinsurance rather than insurance that may have higher policy costs and more restrictive coverage terms.
Prospects for Continued Growth
Growth within the single-parent captive segment has not been in the actual number of self-funded employers, but rather in the number of self-funded employers now purchasing medical stop loss coverage to protect against the Affordable Care Act’s mandate for unlimited lifetime benefit maximums. Many larger employers are now formalizing their retained health care benefit risk by converting it into medical stop loss coverage within their existing captive and then purchasing reinsurance for the higher layers of risk that must be transferred.
Most of the growth in new self-funded employers is coming from employers with less than 500 employees. As a result, the number of group captives catering to smaller and mid-sized employers will expand. Group captives allow smaller to mid-size employers to replicate the risk profile of a much larger entity to take advantage of risk financing structures more typically available to larger enterprises. It is expected that there will be continuous growth in this segment.
Interest in self-funding and stop loss captives will continue to grow as medical costs continue to rise, and uncertainties related to health care reform threaten the amount of control employers can maintain within more conventional insurance structures. For many employers, properly structured captives can stabilize—and even lower—the cost of medical stop loss coverage, and they can facilitate enhanced benefit delivery over more traditional self-insurance.