Captive With a Twist: Reinsuring Surety Bonds for Greater Risk Control

One client saved $1.5 million by using captives as a reinsurance layer. Numerous industries could use this application.
By: | March 14, 2019

Captives have traditionally been used by businesses to self-insure themselves and their risks. They offer a multitude of benefits, the key ones of which are enabling their parent companies to have better risk control and to reduce their premiums.

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But lately there has been an increasing uptake in the use of captives to provide reinsurance.

Among the newest and most innovative applications for captives is reinsuring surety bonds. A surety bond is a contract between three parties — the principal (the party that needs the financial support of the bond, in this case the captive’s owner or parent company), the obligee (the party requiring that there be a bond) and the surety (the party that guarantees the principal will be able to meet its obligations to the obligee).

Surety is typically used as a guarantee for large commercial financial obligations, mainly in construction. One of the main advantages of surety bonds is that they aren’t listed as debt on a company’s balance sheet and they free up capital and credit for other uses.

Surety Bond Solution

The new concept functions with the surety company, acting as a fronting company, obtaining the indemnity of the principal, in this case the captive owner, and then issuing the bond before entering into a reinsurance agreement with the captive.

Jeffrey Leadley, regional commercial director, Aon

The surety then cedes a percentage of the risk and the 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 go to the captive to resolve it.  In the event it doesn’t, the surety would pay the claim itself and then seek reimbursement from the captive.

This new risk financing method was pioneered by Jeffrey Leadley, regional commercial director at Aon, who claims to be the first to have come up with the concept on this scale. His client, a Fortune 20 national retailer, was previously using an indemnity agreement to reinsure its surety bonds but was keen to utilize its captive, which already manages most of its risks.

Leadley’s client uses its 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 that it operates in. The benefit of reinsuring the surety bonds this way is that captive owners can utilize their capital more effectively by adding a new line of business, as well as having greater risk control and reducing their premiums, he said.

“Its surety bonds were the only line of business not participating in the captive, so they wanted a solution that would remedy that,” said Leadley.

“By utilizing their captive in this way they were able to achieve a range of benefits not readily available through traditional treaty reinsurance.”  — Jeffrey Leadley, regional commercial director, Aon

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

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

Added to that, Leadley said he had to find a way of integrating the captive’s reinsurance agreement provisions with the corporate indemnity required by the surety company. And the new structure needed a more rigorous level of administration to manage premium flow, ceding of risk and financial reporting requirements, he added.

As a result of successfully utilizing the captive to reinsure its entire surety bond program worth more than $750 million, Leadley said his client managed to halve its net annual premium, a saving of $1.5M. With the money it saved, he said his client was able to reallocate capital to support other activities in the captive.

“This solution has the potential for a much wider application across a range of different industries,” said Leadley.

“I’m already talking to companies in the oil and gas, entertainment and retail spaces, so the potential is huge.”

Tip of the Iceberg

But Leadley’s captive is just the tip of the iceberg, with other captives now being used as a reinsurance layer for surety bonds.

In 2017, National Surety Underwriters, a Philadelphia-based underwriting agency, raised $11.5M for the capitalization of a special purpose surety reinsurance captive, the National Fidelity Reinsurance Company (NFRC).

The funding, in part, went towards the merger of McCabe and Independent Corporate Underwriters, a managing general underwriter 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, which are insured through its licensed carrier partner Clear Blue Insurance Company.

Chad Rosenberg, principal of Rosenberg & Parker, a surety broker, said that in the past, surety bond companies have been reluctant to front for captives, because they already have the indemnity from the captive owner.

But, he added, with the influx of new entrants into the surety bond market, many were looking for new opportunities and ways to differentiate themselves, of which captive reinsurance is just 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 Rosenberg.

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

New Opportunities

Brendan Roche, senior vice president at GC Securities, said companies using captives to access reinsurance have an opportunity to broaden the scope of risks covered and increase their capacity, which may not necessarily be available in the primary market.  Among the biggest growth areas, he said, were employee benefits and cyber.

Chad Rosenberg, principal, Rosenberg & Parker

“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 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,” said Roche.

Jim Swanke, senior director at Willis Towers Watson, said there has been a shift in the way captives have been designed in the last 30 years The shift is a move away from buying excess reinsurance for the captive in the retail market, towards using it to secure reinsurance for higher severity risks.

In addition, he has seen an increasing use of integrated risk programs for multiple years and lines of business, and in order to achieve this, captives have been used to access the reinsurance market.

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“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 Swanke.

“The use of reinsurance has also been perpetuated by this move towards integrated risk programs within captives.”

David Provost, deputy commissioner for the State of Vermont’s captive insurance division, said captives will always have the need to reinsure certain lines of business they can’t insure directly. These include workers’ compensation and consumer lines, he said.

“Certain lines such as workers’ comp can’t be written directly by the captive — the captive must either reinsure through an admitted carrier or an approved self-insurer,” said Provost.

“Captives are also barred from writing consumer lines such as warranties or cell phones; reinsuring a front for such lines can be a profit center for the parent,” Provost said. &

Alex Wright is a U.K.-based business journalist, who previously was deputy business editor at The Royal Gazette in Bermuda. You can reach him at [email protected]

More from Risk & Insurance

More from Risk & Insurance

4 Companies That Rocked It by Treating Injured Workers as Equals; Not Adversaries

The 2018 Teddy Award winners built their programs around people, not claims, and offer proof that a worker-centric approach is a smarter way to operate.
By: | October 30, 2018 • 3 min read

Across the workers’ compensation industry, the concept of a worker advocacy model has been around for a while, but has only seen notable adoption in recent years.

Even among those not adopting a formal advocacy approach, mindsets are shifting. Formerly claims-centric programs are becoming worker-centric and it’s a win all around: better outcomes; greater productivity; safer, healthier employees and a stronger bottom line.

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That’s what you’ll see in this month’s issue of Risk & Insurance® when you read the profiles of the four recipients of the 2018 Theodore Roosevelt Workers’ Compensation and Disability Management Award, sponsored by PMA Companies. These four programs put workers front and center in everything they do.

“We were focused on building up a program with an eye on our partner experience. Cost was at the bottom of the list. Doing a better job by our partners was at the top,” said Steve Legg, director of risk management for Starbucks.

Starbucks put claims reporting in the hands of its partners, an exemplary act of trust. The coffee company also put itself in workers’ shoes to identify and remove points of friction.

That led to a call center run by Starbucks’ TPA and a dedicated telephonic case management team so that partners can speak to a live person without the frustration of ‘phone tag’ and unanswered questions.

“We were focused on building up a program with an eye on our partner experience. Cost was at the bottom of the list. Doing a better job by our partners was at the top.” — Steve Legg, director of risk management, Starbucks

Starbucks also implemented direct deposit for lost-time pay, eliminating stressful wait times for injured partners, and allowing them to focus on healing.

For Starbucks, as for all of the 2018 Teddy Award winners, the approach is netting measurable results. With higher partner satisfaction, it has seen a 50 percent decrease in litigation.

Teddy winner Main Line Health (MLH) adopted worker advocacy in a way that goes far beyond claims.

Employees who identify and report safety hazards can take credit for their actions by sending out a formal “Employee Safety Message” to nearly 11,000 mailboxes across the organization.

“The recognition is pretty cool,” said Steve Besack, system director, claims management and workers’ compensation for the health system.

MLH also takes a non-adversarial approach to workers with repeat injuries, seeing them as a resource for identifying areas of improvement.

“When you look at ‘repeat offenders’ in an unconventional way, they’re a great asset to the program, not a liability,” said Mike Miller, manager, workers’ compensation and employee safety for MLH.

Teddy winner Monmouth County, N.J. utilizes high-tech motion capture technology to reduce the chance of placing new hires in jobs that are likely to hurt them.

Monmouth County also adopted numerous wellness initiatives that help workers manage their weight and improve their wellbeing overall.

“You should see the looks on their faces when their cholesterol is down, they’ve lost weight and their blood sugar is better. We’ve had people lose 30 and 40 pounds,” said William McGuane, the county’s manager of benefits and workers’ compensation.

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Do these sound like minor program elements? The math says otherwise: Claims severity has plunged from $5.5 million in 2009 to $1.3 million in 2017.

At the University of Pennsylvania, putting workers first means getting out from behind the desk and finding out what each one of them is tasked with, day in, day out — and looking for ways to make each of those tasks safer.

Regular observations across the sprawling campus have resulted in a phenomenal number of process and equipment changes that seem simple on their own, but in combination have created a substantially safer, healthier campus and improved employee morale.

UPenn’s workers’ comp costs, in the seven-digit figures in 2009, have been virtually cut in half.

Risk & Insurance® is proud to honor the work of these four organizations. We hope their stories inspire other organizations to be true partners with the employees they depend on. &

Michelle Kerr is associate editor of Risk & Insurance. She can be reached at [email protected]