The Benefits of Traditional Workers’ Comp vs. Captive Programs

Risk sharing has existed for millennia. The idea is to divide the risks among two or more parties who agree to cooperate and share the outcomes, whether positive or negative. The Code of Hammurabi, produced in 1750-1755 B.C., is considered the first published insurance risk management documentation. Later, in medieval Europe, members of guild systems would put their money into a pool used to provide mutual aid and cover losses, such as crop failures, theft, fire, and death.²

In a way, we can consider the rising popularity of captives to be a modernized return to the origins of insurance, at least regarding pooling money.

Workers’ comp captives can look attractive at first, especially when promoted by insurance agents who are proponents of the model. On the surface, it makes sense: smart businesses want to spend less and make more. But take a deeper look and you’ll notice numerous complexities that can influence whether a captive is the right call.

The primary reason a business considers joining a captive is cost reduction. The Insurance Information Institute reported significant reductions in premium rates and experience modification factors. In one example, “an electrical contractor achieved a 38 percent reduction in its experience modification index and a 52 percent reduction in its workers compensation premium rate over ten years.”³

There is the added benefit of improved claim control. In traditional insurance, the insurer determines its proprietary claims process. Within the captive structure, group members can choose specific claims and processing procedures through third parties, potentially cutting unnecessary charges. Captives also provide specialized coverages for risks that are more difficult to insure, such as “pollution liability, asbestos liability, terrorism, cybersecurity, credit risk, and employee benefits.”⁴ Cyberattack insurance can be a massive, unexpected risk that few traditional providers include in standard policies.

Impact of potential regulatory changes
The majority of captives exist in offshore domiciles, such as the Cayman Islands and Bermuda. However, U.S. domestic domiciles are becoming more common in states such as Vermont, Delaware and Mississippi. Offshore domiciles offer the advantages of lower capitalization requirements, favorable local tax treatment, and a higher potential premium to surplus ratio, while domestic domiciles offer less expensive formation costs and a “familiar” regulatory structure. One of the primary concerns ahead for captives is government regulation, whether resulting from the nuances of U.S. state-by-state tax laws or potential foreign regulations.

“When you participate in a captive, you are responsible for your results. And if your results are bad, the rest of the captive may have to be responsible for the remaining liability.”

– SVP Mike Arnold

Joint and several liability
Fear of government regulation is not the only drawback for group captives. There is joint and several liability, meaning all parties share rights and responsibilities, but you are specifically held accountable for your contributions. 

SVP Mike Arnold notes, “when you participate in a captive, you are responsible for your results. And if your results are really bad, the rest of the captive may have to be responsible for the remaining liability.” Member voting is a double-edged sword, as it protects the financial performance of the group, but can also work as a detriment against members with high claims losses. 

Transferring authority
A general rule of thumb is a minimum four-year commitment in a captive membership to see returns. This commitment implies a transference of risks to the group which leads to transferring authority to the group. A company can then become vulnerable to mistakes, misguidance, or its own poor performance (higher claims) leading to removal from the group. 

Reduction in service quality
In some cases, captives have a lower standard of service quality due to poor choices in third-party vendors. Cost-cutting can reduce quality, and individual captive members are usually not in a direct administrative position to influence decision-making.

Fragmentation 
A consequence of risk sharing is fragmentation. This occurs when a risk sharing pool becomes too large, and the distribution of risks becomes unequal and diluted, leading to inefficiency, inequity, and adverse selection.⁵ If you don’t have a full grasp on who is managing your business’s risks, then the potential money saved is outweighed by the potential greater risks that are unaccounted for. 

Unexpected expenses
Along with the capital requirements involved with joining a captive, your business will be required to expend considerable time and resources. This could lead to hiring more employees and/or reconfiguring departments to accommodate the changes. It’s very possible for a business to underestimate this commitment.

To be considered for a captive, a company is typically privately owned, mid-sized (50-250 employees) or larger and has revenue of $10 million to $1 billion. Approximately 200,000 companies qualified to join the nearly 6,000 global captives recorded in 2021,⁶ and the number of captives has only grown since.

Generally, captives operate like self-insurance in that they must contract with a licensed insurer to issue policies. Captives then can comply with state financial responsibility laws (i.e., certain states requiring evidence of coverage for workers’ compensation).

Conventionally, companies must be able to thrive in a captive to survive in a captive. While there are potential savings through joining a group captive, conversely, there is exposure to greater financial burden. One challenge is short-term cash flow. Initial costs are high, which is a poor fit for many companies exiting traditional insurance or expecting major operational changes in the near future. It is especially unadvisable for the risk adverse. A business needs to have high cash-flow and patience when considering the captive path.

While data from actuarial studies shows that captive members lower their rate of claims, or accidents, and halve the chance of fatalities over the long term, it’s crucial to understand that these studies often compare data from group captives against the entire insurance industry—the good and the bad. The data from captives appears more positive because they are typically comprised of large, low-risk wealthy businesses with effective loss prevention plans.

We recently had a discussion with an existing policyholder who had expressed interest in a captive through its insurance agent. The policyholder wanted to better understand the financial benefits of choosing Summit, so we reviewed the existing paid-loss plan and illustrated how they were on track to reduce costs.

We showed the policyholder how much their experience modification factor (mod) had improved from being higher than average to lower than average since starting with us. A mod is an industry rating that is used to set a company’s workers’ compensation premium and is reflective of the policyholder’s actual loss history. In this company’s case, a primary point against joining a captive was their improving mod trend in collaboration with Summit. It’s important to note that swapping your workers’ comp risk management strategy could halt the financial progress of an improving mod.

Before any major decision about switching to or from a group captive, the first step is research. When assessing whether a captive is the right choice, business directors and commercial insurance agents can rely on Summit specialists to provide professional guidance on coverage that best meets your needs.