Specialty Podcast: Exploring Captives in Managed Care - Structure, Strategy and Success

Intro (00:00):
You are listening to the Alliant Specialty Podcast, dedicated to insurance and risk management solutions and trends shaping the market today.

Kenny White (00:09):
Thank you for joining us on another Alliant Specialty podcast. I'm Kenny White. I'm the managed care industry group leader here at Alliant. I'm a healthcare lawyer, been one for almost 40 years. I practiced law for 30 of that and spent the last 11 years as a risk consultant working on managed care primarily with all types of structures, strategies, shapes, sizes, and working on identification, quantification, mitigation and finance of risk in the managed care industry. I've worked on a significant number of captives over the last 40 years, and that's a good thing because today we wanted to talk about captive insurance and the managed care and ancillary healthcare industry. The markets are few. Capacity is limited. Limits and coverage are limited, and restrictive retentions and rates are high. As a result, a lot of managed care and ancillary industries have turned to alternative risk financing. One of those opportunities is by creating or joining a captive. I wanted to draw on the expertise and experience that we have here at Alliant in the captives industry, so I have asked Fred Driscoll and Seth Madnick to join us today. Fred is a consultant with the managed care industry group and has 30 years experience as a senior risk management person at multiple organizations.

He's been part of seven captives over his course of his career, including one at Blue Cross Blue Shield of Michigan, Woodward Straits, where he led the launch of that captive, was named Outstanding Captive Risk Manager of the Year, and the captive itself was named outstanding Captive of the Year while he was there. Seth Madnick, on the other hand, is the director of the Alliant Captives Group. He has over 30 years experience with captives and alternative risk financing. He began his career as an insurance regulatory and corporate attorney and made the move over to the business side of insurance. He refers to it as being a reformed lawyer. Seth and his team design, implement and help clients operate single parent group and sell captives, including in the managed care and in the healthcare industry. With that, wanted to turn over the discussion to Fred and to Seth, but my first question is to Fred. Fred, why would a managed care entity wish to consider the creation of a captive?

Fred Driscoll (02:33):
Kenny, for the Michigan Blue Cross Plan, one of the driving factors that brought captive's opportunities to the forefront was coverage exclusions in the Arizona mission space for the managed care companies. There are very few markets, as Kenny mentioned, and very restrictive coverages. It could be for other lines of business like workers' comp, medical malpractice, professional liability, those generally are one of the categories in terms of quality of coverage. For others it's control, being able to write your own policies, your own terms and conditions and taking things that the market would typically exclude and adding that coverage into the captive policy. Lastly, and one of the most common things you hear, regardless of industry, is access to the reinsurance market.

Kenny White (03:22):
Would it be safe to say that one of the reasons or some of the driving reasons for entities in this space desiring to investigate whether or not they want to have a captive would be rates and retentions or flexibility of utilization for the industry or for their own entity strategy and then certainly control over their own destiny when it comes to coverage?

Fred Driscoll (03:47):
That's a very nice synopsis. Thank you for that, Kenny.

Kenny White (03:50):
Seth, if I was going to look into creating a captive, I'm assuming most people would want to do what's called a feasibility study to determine whether or not it's a right sized thing for them. What are the basic component parts of a captive feasibility study?

Seth Madnick (04:10):
It's interesting because the purpose of the feasibility study is to determine whether the captive is viable for a particular organization or business healthcare group. The feasibility study really serves two purposes. It helps with the viability that go, no-go decision, and it's also required to submit with any domicile you enter for an application. It really serves two purposes. It helps you with that, and then it's a requirement for filing with that. Some of the typical areas that a feasibility study addresses is the domicile evaluation. We look at the captive risk retention levels, what's the right amount to go into the captive, the actuarial analysis on the insurance risk, the frictional costs associated with running a captive because you're really running a small insurance company. We'll do financial pro forma models, typically a five-year pro forma, and the potential for long-term profitability of the captive. Most importantly, we look at the capital and surplus requirements. How much it's going to cost to start the captive in addition to the premium? That will vary of course by domicile.

Kenny White (05:14):
I assume it also varies based upon how you want to utilize the captive.

Seth Madnick (05:20):
Yes, the amount of risk going in, the premium, and the financial strength of the parent company also will have an impact on that.

Kenny White (05:27):
So on domiciles and domicile is nothing more than where the captive insurance company is legally headquartered or the situs of the insurance company, correct?

Seth Madnick (05:40):
Correct. You can have a captive in over 30 states in the United States, have captive legislation allow you to have captives, plus the usual offshore jurisdictions were fairly common, the early adopters of captives, Bermuda and Cayman. After the 2017 tax bill, a lot of the advantages of offshore have really not been as prevalent, and we're seeing much more growth in US-based domiciles. The issue on domicile selection is the domiciles compete on capital and surplus requirements, licensing taxes and fees. Part of our analysis and the feasibility study will typically narrow it down to three domiciles with the client and look at the pros and cons of each domicile with that. We'll find sometimes in healthcare organizations, they want to be domiciled in their home state if that's an opportunity, if that state has enabling legislation with that. It's another factor to look at.

Kenny White (06:30):
We see that a lot in the managed care industry because the managed care companies are already heavily regulated both at the federal and at the state level. If you're regulated in that way, oftentimes it may not be the same regulators representing the captive insurance companies as the health plans, but they probably are down the hall from one another in the building. A lot of them like to use the political capital that they've got and the regulatory knowledge that they've got of staying in the same state. You see that often?

Seth Madnick (07:02):
Yes, that is a very true statement. Along with that, we found that on the insurance regulatory side, the regulators are much more, they like having businesses with an economic or strong presence in their state to be approved. It's a friendlier reception on the application process.

Kenny White (07:19):
Once you've collected the data, you've done the financial review and the actuarial analysis and everything else with regard to the feasibility study, and the data suggests that this could be an effective or an efficient tool and risk management or risk financing for the industry or the entity, what steps are required in order to form a captive?

Seth Madnick (07:43):
The next phase is after the feasibility study is usually that go, no-go decision where the clients look at what is the economics, the cost of capitalization, who's going to be operating the captive. You're running a small insurance company so, really that selection of who's going to be the directors and the officers, where's the ultimate control going to be? Then there's an application process, and that data gathering process and biographical affidavits and all the background information on the captive ownership and control team really takes a little bit of time, anywhere from three weeks to two to three months. It depends how fast the client moves. Once you have that data, then it's a process of selecting the key service providers. You're forming a new legal entity in the domicile state. You're forming an insurance company. It’s figuring out the legal counsel, it's figuring out the application, the banking relationship, whether their insurance company partner is involved or not, then preparing the application for filing. Once the application is filed, in most states it's a 30-day approval process. That's typically the, you get down to the serious component of building out the operational side with the client and how we're going to run and manage the captive and what are the initial lines of coverage going in. Understanding that the heavy lift is starting the captive. Once it's up and running, the lines of coverage can be expanded or changed. It's a mix and match scenario, but the heavy lift is the starting process.

Kenny White (09:17):
So, Fred, you've been involved in a number of captives both on the captive owner side and on the consultant side. Who are the titles of the people at any given entity that need to be part of this process that Seth was just describing?

Fred Driscoll (09:36):
Yes, generally the interest in creating a captive comes from finance. Obviously finance would be involved, and it can be influenced by where risk management reports, but clearly finance, most certainly legal, general counsel, tax because there are tax implications from these types of businesses. Regulatory compliance, which you've already mentioned, a heavily regulated industry, then another regulated entity within that family. So regulatory compliance, and then close the loop on it, audit, so that they know what they're auditing. You can educate them on processes and procedures and information, so that when it's time to do the audit, you're not teaching them. You may have to refresh some things, but you don't have to teach them from the beginning. But getting them involved early is always helpful.

Kenny White (10:22):
If it's a true managed care entity as opposed to a pharmacy benefit management company or a medical services organization or a TPA or one of those, you'd have a chief actuary. I'm assuming that a chief actuary or a chief risk officer should be one of the people that would be included as well?

Fred Driscoll (10:40):
Yes, absolutely. Even if you don't use your internal actuaries to provide service to the captive, it's really important that they understand what the captive can do and does and how it impacts their performance on the health side.

Seth Madnick (10:54):
That's a really good point because when you look at who are potential directors and officers of the captive, you want a board who understands or somebody on the board who understands the operational risks going in the captive, so they can help make good decisions on the risk levels and the operation side of the captive. We want them to pay attention to the captive and have an understanding of what's going into the captive.

Kenny White (11:17):
It is an insurance company, it's not a bank account.

Seth Madnick (11:19):
Correct.

Kenny White (11:20):
It needs to be run like an insurance company, and that normally requires the chief risk officer or actuaries to be involved so that you don't get out over your skis. From a regulatory perspective, what goes into the captive if I'm going to decide to use it for a particular purpose? The policies and other documents inside the captive have to go through regulatory review, correct?

Seth Madnick (11:45):
Correct. There's two ways that typically risk is transferred into the captive. One is what we call reinsurance, where you have an admitted or not an insurance carrier issuing the policy or either compliance or rating purposes, and then the risk is transferred into the captive. That's a reinsurance arrangement. In that situation, there'll be a reinsurance agreement. The other method is what we call direct placement, where the captive is issuing the policy directly from the insurance captive to the healthcare organization. That's where you have to draft the policy and have that form approved, but there are advantages and disadvantages with everything in insurance. That would be obviously in form and style and coverage and manuscripting coverage as you want, but the captive has the ability to manuscript and issue those policies.

Kenny White (12:35):
There's another way that the captive could be used as well, and that's as part of our fronting arrangement, correct?

Seth Madnick (12:41):
Right. That's what I was describing where the carrier is issuing the policy and then the captive is reinsuring or standing behind that A-rated carrier who's issuing the policy known as fronted arrangement.

Kenny White (12:52):
In that scenario, if we take for instance in the managed care industry, stop loss, which is an administrative services-only style TPA arrangement whereby the managed care company is issuing an insurance policy to self-funded insurance programs through employers to cover outlier claims. Now that policy could be issued directly by the parent company to the employer, and then could be seated in a reinsurance agreement back to the captive. Correct?

Seth Madnick (13:26):
Correct.

Kenny White (13:28):
Or it could be completely held by the parent company, and then the captive could partially participate in that so that there's no actual reinsurance agreement. There's just an agreement on the quota share with regard to the actual risk. Correct?

Seth Madnick (13:45):
Yes, and you can basically create a reimbursement structure with the captive or risk transfer from the captive side of it. You're not affecting the primary placement or the main coverage placement, but rather developing a risk transfer arrangement between the captive and the parent.

Kenny White (13:59):
Fred, when we started Woodward Straits, it wasn't being used for much originally. That was the plan to walk before we ran, but in the next 10 years it went from one policy to 50 and a whole bunch of other things that were added in. What were some of the uses that you and your entity at the time created or used the captive to cover?

Fred Driscoll (14:26):
We did a few things that were unique. One was we operated in a state that required a very impossible to purchase from the marketplace TPA bond. When we couldn't find what the state required, we drafted our own policy and issued it in the captive. It was like a hundred-thousand-dollar limit with no deductible, which no carrier writes. We were able to do that and be in regulatory compliance in that state. We made a quasi-acquisition. I think in most other industries or most other types of companies, that would be a straight up acquisition. As most people who listen to this will understand, some of your policies terminate upon change of control automatically. So, you purchase tail or extended discovery, and the policies that the entity that we were acquiring had predetermined premiums in them of a million-and-a-half dollars roughly. We looked at that number, we talked to the actuaries and we said, look, is there a way without forcing it, that we could have the captive issue these runoff policies and charge them a more reasonable premium? The actuaries put pencil to paper, and when they were finished, it was a significant savings, roughly half of that premium. Those are two examples. One of the other things, what I didn't mention when I said finance earlier, involve your risk-based capital experts within the organization because there are opportunities with certain transactions to improve risk-based capital numbers. The devil's in the details of course, but there's opportunities there beyond the value of just the straight risk transfer, so other financial benefits from it. Those are two or three things that we did.

Kenny White (16:00):
You could put directors and officers liability coverage in the captive. You can put errors and omissions coverage in the captive. If you wanted to put property coverage or specialty coverage like aviation or auto or boiler or pollution, whatever might come up in the captive, cyber insurance, you could run through the captive. One of the things that I thought that we've used captives in the past for, one was what's called a differences in conditions or a DIC policy in the captive that would drop down and pick up where the commercial markets were excluding coverage. You wouldn't have the entire panoply of what might be covered by an E&O or a D&O policy in the captive, but you would have this DIC policy that would drop down if the commercial carriers wouldn't cover something and it was excluded from their policy, then the captive picked up that liability and not the rest of it.

The other thing I think that we saw a lot, well other than the stop-loss piece, was the flexibility that you get not only with the M&A transactional risk insurance that you were talking about before, but if you acquire another company that requires some significant regulatory approval with regard to a risk transfer program, that you can recreate that within the inside of another captive insurance company to where to the outside world it looks exactly like it had before. But hopefully the entity is saving a lot of money by doing it that way and gaining a lot of control over the coverage. Watching our time here, I wanted to get both of your thoughts on some cautionary tales. Captives, particularly single-parent captives, are not panaceas and just because we all happen to be hammers, not everything is a nail. The possibility the feasibility study could come back and say, look, this is not a good idea for you or what you want to use it for is not going to be particularly helpful for you. But I wanted to get both of you to tell me some, what are some cons, some no-go concepts that come into play when you're looking at this as to what might make you tell a client, this is not a good idea. Seth?

Seth Madnick (18:17):
There's certain areas that you look at. First is the capitalization requirement, whether the client is able or willing to fund capital into the captive and have sufficient capitalization as the captive would grow. There are safe harbors on formulas on funding capitalization in addition to your premium to start. But that floats from a three to one to five to one, let's just say four to one premium to surplus. So, for a million dollars a premium, a minimum of 250,000 in capital, and you can just do the math up from there. Do they have the ability to properly fund and should there be an adverse scenario in the client's willingness to fund capital? The other is the right online discussion of what are the limits the captive can validate the premium that a client is paying for the limits that they're receiving, but what is the amount of risk that would be funded for the exposure in the captive, and is it reasonable in the case of a severity loss? Could their client absorb that in their captive? It's also that surplus strain or growth with the captive, just maintaining proper capitalization as the captive is growing over time, as Fred's described some of the additional lines you can bring on.

Kenny White (19:24):
In addition to that, you've also got to pay premiums

Seth Madnick (19:28):
You got to pay your premium. A captive premium is really driven by the projected loss cost plus operating expenses of the captive. You also have to pay premium taxes. That's the only thing, the tax to run your captive. If you're running direct placement policies, there are different tax rates about those policies. The states all want to get their premium tax. Taxes do not go away when you have a captive.

Kenny White (19:50):
Sometimes because it's an insurance company, not everything is covered. You have to say no.

Seth Madnick (19:56):
Correct. Yes.

Kenny White (19:57):
Fred, you have experience with that?

Fred Driscoll (20:00):
Yes, unfortunately. There were a couple things that occurred early on. One was our first claim was a professional liability claim, and the entity that had the claim didn't want to present it because it was like taking from one pocket and putting it in another. We reassured those folks that this is a real insurance company, the regulators want to see payments, the IRS wants to see payments. You should submit your claim, and we'll process it accordingly. The other thing that happened early on was we had a claim that wasn't, notice of that circumstance wasn't provided on a timely basis internally. When the claim was presented, we had to deny it for late notice. That wasn't very popular, but it was agreed upon by all the subject matter experts both internally and externally that it was the proper thing to do.

Kenny White (20:47):
I know nobody was happy with me.

Fred Driscoll (20:49):
No, they weren't. Or me.

Kenny White (20:51):
Since I was the one that told them they couldn't pay it.

Fred Driscoll (20:55):
Right.

Kenny White (20:56):
Seth, do you have anything else that you might want to add? Direct benefits that you see from the use of a captive that might cause someone to go through the process of a feasibility study, the formation of a captive, the administrative and regulatory approvals and putting the money into the captive and then using it?

Seth Madnick (21:17):
Thinking about a captive as one of the levels of risk financing, if you're looking at a client's risk financing portfolio, the captive is one of the tools in the toolbox. The clients really need a long-term perspective on risk financing. If you're taking a long-term view of owning and managing risk and just buying capacity in the insurance marketplace for what the clients cannot absorb on their own, balancing their ability to absorb risk, that's really the discussion. For clients, it gives them an opportunity to own and manage that risk and unbundle and select the service providers. Manuscript coverage, it gives a lot of flexibility on structuring insurance risk, and it also provides leverage in the marketplace for the buying of insurance that if they cannot get the coverage or limits they want, the client can take that risk into their captive. That becomes a negotiation tool with the market in addition to validating premium. I think Kenny and Fred, from my side of the table, it really benefits clients who have a long-term risk financing perspective.

Fred Driscoll (22:15):
The only thing I would say, and it goes back to your question earlier about drawbacks. Sometimes management can get complacent with performance. In difficult times for the parent company can sometimes mean difficult times for the captive. If the parent company has become reliant upon dividends or other benefits from owning the captive, and there's a downturn in the performance of the captive at the same time there's a downturn at the parent company, that can be problematic. It’s like anything else, that shouldn't keep you from engaging, but you just be mindful of the fact that that dividend, it could go up dramatically depending on performance, or it might go down or eliminated altogether for a period of time if performance is low.

Kenny White (22:58):
I hope this discussion has given the listener at least a hundred-thousand-foot view of captives in the managed care space, the reasons, feasibility, formation, involvement, utilization, pros and cons, within a 25-minute timeframe rather than a week long or semester long course on alternative risk financing. If you have any additional questions, please reach out to myself, to Fred, to Seth, managed care industry group, the captive group at Alliant. We would be happy to answer whatever questions that you might have with regard to single-parent captives, cell captives, group captives in managed care and healthcare and look forward to that discussion. Thanks to Fred and Seth for your time today, your insight and your comments, and that will conclude the podcast.