Recently, there has been an increase in inquiries and formations of so-called agency captives. This is a type of captive in which the insurance agency that handles the clients' business, or the producer of the business, owns the captive and persuades a primary insurer to reinsure to it. The broker/producer is then able to increase its income from the same piece of business.
While there are strong reasons to consider such an arrangement, as always, caution must prevail as this is ground previously plowed, seeded, harvested, and burnt. Let's examine the past for the prologue.
Looking Back
Decades ago, and even a bit today, some promoters convinced many car dealers that an additional revenue stream would be for the dealers to sell coverage, such as extended warranties, through the use of a captive. These structures were sold by the thousands in the 1990s. Many dealers and promoters made considerable rewards with these captives. As they drew attention from regulators and taxing bodies they acquired the unfortunate name of producer-owned reinsurance companies, or PORCS for short. They also came under fire and lost much of their appeal as taxes, penalties, and lawyer fees escalated.
At about the same time, there were some primary insurers who persuaded some of their most loyal agents to form captives in which they could place their best business and thereby receive potentially tidy profits on the back end of the process. These entities quickly became a structure for the primary insurer to reduce one of its fixed costs—commissions—and to "over allocate" other fixed costs, unallocated and allocated loss expenses, to the producers, all while cementing a long-term relationship whether that became the best structure for the ultimate client or not. These were hard to unwind and created a lot of ill will.
The central theme of the problems that grew from these early agency captives are that they were specifically designed to accept premiums from clients who would be unlikely to have any losses, and to call the profits insurance.
Establishing Legitimacy
So, how should these work in order to gain legitimacy? One of the best ways always is disclosure. The buying client should know that their agent owns a reinsurer which will be accepting some premiums on his/her risk. Why would the client find this acceptable? Well, not all will, but many will see that the agent has committed his/her own financial resources and see that act as a strong vote of confidence in the client's risk management program. It must be clear to the client that this does not necessarily increase the agent's income on the account and that, indeed, some of that income is now at risk. The situation may be one in which, without the agent's active financial participation, the client may have more difficulty in obtaining coverage, or find it but not at the most efficient price.
Another important fact is to accept many types of risks. To engage in "cherry picking" to enhance one's own income while putting at risk the income of other insurers in your agency will not end well. While one primary insurer may be particularly pleased with the agent's financial participation in anticipation of receiving only the best risks, the other insurers in the agency will be less pleased to be writing the second string risks.
Both of the foregoing points lead to what is probably the most important feature, which applies universally to all captives, i.e., the captive must be seen by all observers to be an insurance company. That means using one's own capital, using actuarially-based premiums, being regulated in a recognized domicile, using acceptable forms, and most of all, paying claims. If the structure cannot pass this test, then trouble will follow.
To gain acceptance, it would also help to involve the client financially where feasible. Have the client in with you on the captive as an investment partner. This takes some engineering to be done correctly, but it can be done, and may clear many other hurdles quickly.
Taxes will have to be addressed (as always). Each situation's facts and circumstances are different, but qualified counsel can assist. The potential for tax efficiencies is there, but again, caution and prudence are in order.
Conclusion
The key is to prepare a well-thought plan as to why you wish to create this company and to consider the advice of others as to the way to do it efficiently and soundly to avoid unnecessary hassles, time, and money in the process. It can then become a powerful and useful tool in your agencies' arsenal and benefit the agency, its clients, and insurers.
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