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Idea Exchange Agency Captives

Captives Fuel Growth and Income for
Agency Owners
Now is the Time for a Captive: Don’t Wait for the Next Hard Market

By Chris Kramer Kramer

I
n times likes these, where the insurance low and what can be a the biggest motivation bear in mind that carriers rely heavily upon
industry is now in its fifth year of a soft of all, under certain captive structures, under- agencies and brokers to distribute their prod-
market, the use of an agency captive writing profits will be tax exempt if premi- ucts in time of gaining market share, but
insurance company can spark both rev- ums to the captive are no more than $1.2 mil- retreat or pare down sales efforts – and com-
enue and profits to improve an agency’s over- lion annually (more on that later). missions – during hard markets. If there is a
all financial performance. The agency captive Waiting for the next hard market will only profit sharing agreement, an agency owner
may also provide the owners a reduce the agency owners’ should take into account the volatile nature of
better return than a profit opportunities to forge new part- carrier profit sharing agreements, which can
sharing agreement. The current nerships and profit strategies as increase under soft markets conditions, but
Insurance captives, as they soft market is most carriers will increase costs significantly reduced in hard markets. As stat-
are used today, were the brain- and reduce capacity. ed before, the time to start creating an agency
child of an Ohio insurance perhaps the Under the profit center strat- captive strategy is before the hard market.
agent, Fred Reiss, over 50 best time to egy, the agency captive will usu-
years ago. Originally designed ally require a fronting carrier Typical Comparison
to insure the property risk of create a cap- (holds the licenses required to Under a typical agency captive comparison,
its non-insurance owner, captive strategy. conduct insurance business) let’s consider that an agency has a $5 million
tives have evolved to finance and perhaps a reinsurer, which book of homogeneous business with a loss
risk across almost every indus- will share in the risk with the ratio of 35 percent. Commission payable is 15
try and can be owned by a variety of interests, agency captive of insuring the policyholder. In percent. Total revenue to the agency is
including agencies, associations and groups. exchange for the captive assuming some level $750,000.
Premiums in captives now reach $50 billion of risk, it can be rewarded with a share of the Under an agency captive structure, a new
annually and the captive itself can be domi- underwriting profits as well as retaining any carrier has offered 18 percent commission and
ciled in close to 30 states in the United States investment income made by the captive. will share risk with the agency captive. The
as well as offshore. The book of business the agency and carrier captive will receive $1 million in reinsurance
Agency captives are primarily created to will consider can be homogeneous, like a pro- premium. After captive expenses and losses
reinsure the risk of their clients, however, in a gram book of business, or heterogeneous, incurred an underwriting profit is declared of
risk class where there is a demand for cover- where several classes of business are included over $200,000. This is in addition to the
age but no insurance carrier – as what can but only one to two lines are underwritten, increase in commission ($150,000) as part of
happen during a hard market – agency cap- such as workers’ compensation, for example. the agency’s agreement with the carrier and
tives can be excellent platforms from which In both cases, the book will possess a histori- before investment income. However, the
to create new products or replace coverage cally low loss ratio. In addition, the carrier results of this scenario can be made even bet-
from carriers who have abandoned the risk partner will insist that the agency possesses a ter.
class. Both have the potential to create profits high level of underwriting expertise in the Since 1921 (and updated in 2004) small non-
and spur top line growth. risk class and competent information technol- life insurance companies in the U.S. may elect
ogy under which the book can be audited and to be exempt from paying federal taxes on
Why Best Time Is Now a database created. Perhaps most importantly, their underwriting income and taxed only on
The goods news for agency owners who are the agency must have the claims management their investment income. This election com-
considering an agency captive is that the cur- expertise (or the access to it) as well as the monly referred to as an “831(b),” means that a
rent soft market is perhaps the best time to operational efficiency to reduce claims costs. non-life insurance company that is a U.S. tax-
create a captive strategy. In this current mar- While the benefits that are produced under payer, including a captive, may make an elec-
ket, there are more carriers willing to provide an agency captive can include underwriting tion under section 831(b) to be taxed on its
fronting and reinsurance to agency captives profits and investment income, a key advan- investment income only so long as its annual
and with less premium volume requirements. tage for the agency owner comes from the premiums do not exceed $1.2 million. This
Carriers are looking for new business (like increase in the control aspect of the carrier- election has become so important to the insur-
everybody else), rates have stabilized, costs are agency partnership. Agency owners should ance industry, particularly to smaller insur-

N12 | INSURANCE JOURNAL-NATIONAL REGION December 7, 2009 www.insurancejournal.com

ance companies, that the National Association
of Mutual Insurance Carriers (NAMIC) has put
several bills in front of Congress and the
Senate to increase the limits to over $2 million.
Looking back at our comparison, if our
agency captive qualifies to take the 831(b) elec-
tion – you will want to work with the cap-
tive’s auditors and your own tax resources to
confirm – it would mean that the $200,000 in
underwriting profit would be exempt from
federal taxes and taxed only on its investment
income. That is a considerable benefit when
designing an agency captive, specifically when
the owners consider a reinsurance agreement
with the carrier.
Agency captives can also be suitably posi-
tioned to replace coverage lost due to hard
markets conditions. When the hard market
returns, a number of carriers will exit certain
lines of business, capacity will diminish, and
agency commissions, including profit sharing,
will be reduced. Under these set of market
forces, we often see the rise of another wave of
captive formations, those that are created not
so much for a profit center strategy, but to pro- agency captive. Clients, too, may also be invit- least $3 million to $5 million in the first year,
vide capacity and coverage to policyholders. ed to participate in the captive as investors to though in this prolonged soft market, some
Insurance agency owners are on the front reward loyalty and to induce good risk man- captives are starting with less than $1 million
lines of a hard market and are often called agement controls to their business. to $2 million. Fronting carriers seem to be
upon to provide solutions when the traditional abundant but that will quickly change when
markets are unable. While temporarily enjoy- Start the Discussion the market turns. If you have a program that
ing the rise in revenue as a direct result of cor- Determining whether an agency captive is a does not require a front, formation may be easi-
responding premiums, owners who have gone good fit for your firm can start with a discus- er and less costly. As mentioned before, finan-
through a hard market (or two) know business sion with a qualified captive manager who has cial resources of the captive will require capi-
can be lost forever to alternative risk transfer experience in agency or brokerage operations. tal, and collateral, if the program is fronted.
providers while the insur- At Atlas, we start by conduct- Above all, loss history should be at least three
ance carriers replace lost ing a “pre-feasibility” session years old, preferably five, and it must be verifi-
capital and increase policy- A key advantage where we provide a conceptu- able. Ideally, the loss history will show fre-
holder surplus. An agency for the agency is al risk/benefit analysis before quency but not severity. Lastly, not all domi-
captive, however, can be an the prospective agency cap- cile regulators will allow agency captives to
ideal platform from which the increase in tive owner spends money and be formed under their jurisdiction. Vermont,
owners can provide addi- control of the resources on a feasibility for example, does not permit agency captives
tional capacity and coverage study, which can range from while Washington, D.C., does, as do many off-
to their clients, which can carrier-agency $15,000 to $50,000 and up. shore domiciles, like Cayman.
lead to higher retention partnership. Part of the process is also The prospects for developing an
ratios and increased client looking at what kind of finan- agency captive have never been more
loyalty. cial resources the agency has favorable to owners of agencies, broker-
While agency captives are extremely useful because a significant variable in deciding to ages, managing general agents and pro-
in helping to increase revenues for their own- create a captive will include not only how gram administrators. IJ
ers, they can also be useful in keeping key much capital will be required to support pre-
employees – and good clients – as well. A well mium in the captives, but for many carriers, Kramer is senior vice president with Atlas Insurance
thought out captive ownership structure can collateral will be required as well. Management, a leading independent captive manager with
include key employees who are vitally impor- a presence in multiple domiciles. This article is adapted
tant to the ongoing operations of the agency. Requirements and Commitments from Kramer’s presentation at the recent Target Markets
Employees such as these can be rewarded What does it take to consider an agency cap- Program Administrators Association Annual Summit.
with a share in underwriting profits of the tive? Usually, a premium commitment of at E-mail: ckramer@atlascaptives.com. Phone: 440-892-3314.

www.insurancejournal.com December 7, 2009 INSURANCE JOURNAL-NATIONAL REGION | N13

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