The commercial insurance market can often be a difficult place for contractors. The insurance industry goes through market cycles; companies that are eager to insure contractors today may have no desire to do so when their losses mount and the market tightens. Because of this uncertainty, larger contractors often consider alternative markets for financing their risks of loss. One alternative is a captive insurance company, which is created and owned by one or more non-insurance companies to insure the owners’ loss exposures. Other options include self-insurance (paying losses out of pocket) and insurance options such as dividend plans, large deductible plans, retrospective rating plans, risk retention groups and purchasing groups.
According to Business Insurance magazine, there were more than 5,200 captive insurance companies operating in 2008, falling into several types. Single parent captives are owned by one company. Group and association captives are owned by multiple entities. For example, groups of contractors could form captives to insure themselves and others. Businesses that cannot afford the capital requirements of a captive can “rent” one from an insurance company or reinsurer, allowing them to share in the risks and the profits. Captives often use what is called a “fronting” mechanism, where an insurance company or reinsurer issues and administers the policies and handles the claims, and the insured businesses pay for the losses. Captives may insure the risks of their major owners only, or they may also insure other organizations.
Large companies may choose to self-insure; groups of companies in particular industries may band together to self-insure the risks of the group. For example, in some states groups of contractors have formed trusts to self-insure for workers’ compensation losses. Companies may also choose to partially self-insure by purchasing a large deductible program (one with a deductible of $100,000 or greater per occurrence) for workers’ compensation. Retrospective rating plans, while still insurance policies, are closer to self-insurance in that the final premium includes the amount of the business’ losses during the policy term, subject to a minimum and maximum. Dividend plans are types of insurance policies that typically offer the business the chance of receiving a portion of the premium back via a dividend should losses fall below a specified level. Risk retention groups are groups of businesses in the same industry that have created an insurance company for liability coverage. Purchasing groups are groups in the same industry who band together to buy liability insurance from one insurance company.
Each alternative has advantages and disadvantages. Captives may offer tax advantages, they cut out the portion of the premium spent on insurance company overhead and profit, and they give the owners control over risk management. However, they must meet large capital requirements to comply with state laws, and fronting arrangements still require insurance company involvement. Self-insurance, large deductible and retrospective plans reduce premium costs, give businesses some control over their loss costs, and provide incentives for safe operations, but they can also be a drain on cash flow and their ultimate costs may be hard to predict. Contractors that can predict their future losses with reasonable accuracy may find these plans advantageous.
Since all of these options require contractors to finance at least some losses themselves, they should have access to significant financial resources before using any of them. Also, the options can be complex; a contractor should consult with a professional insurance agent to investigate each option’s implications for the business. Traditional insurance is no longer the only financial protection option available to contractors, but it would be unwise to jump into an alternative without learning the facts.