The Captive/Large Deductible Debate—A Philosophical Perspective
Donald Riggin | December 1, 2009
I've always maintained that the decision methodology used to determine whether a captive or a large deductible is the better option, regardless of the line of insurance, is infused (or should be) with a philosophical imperative.
For those of you unacquainted with the primary argument associated with the captive versus large deductible, let's review the basics. A large deductible, defined as a deductible or self-insured retention of $100,000 and up, usually represents a passive risk financing strategy. The vast majority of your losses are contained within the deductible, and every now and then you have to dip into your excess insurance limits. You might post an accrual on your financial statements, but you don't maintain a loss reserve; losses are paid from cash flow or retained earnings.
Conversely, captives convert large deductibles into insurance premiums. You and your trusted adviser set an appropriate retention level, perhaps the existing deductible amount, and then have an actuary determine your expected losses within the retention. This figure, plus some expenses, is your captive premium. The analysis then moves onto the tax discussion—whether the captive premium is deductible from your U.S. federal income taxes and whether your captive can deduct its loss reserves. These are but two of the considerations that you'll face when comparing a captive to a large deductible, and they are economic in nature.
The Tangibles and Intangibles
For those of you who are quantitatively inclined, which describes most of us who are in the business of analyzing captives and their alternatives, the numbers tell the tale. The economic argument is, of course, the first order of business, but once we get past that, we're left with what? We're left with the intangibles. These include such things as risk tolerance/appetite and the company's ability to quickly recognize potential opportunities and make the necessary adjustments.
However, the intangibles also include an almost indefinable component—a set of variables based not on the numbers, but based on the company's perception of itself. Put another way, based on the company's philosophy of life. At this point you may be thinking to yourself that Riggin has finally gone "'round the bend" as the Brits say, but stay with me. You might be surprised, or you might be annoyed, but at this point, if you have nothing better to do, you might as well read on.
Captives as a Philosophical Choice
Philosophy is something we little discuss in our business (or any business, for that matter). It is buried within the qualitative nature of our expectations, and whether you know or admit it, it informs and colors our attitudes toward everything we do (and everything we don't do). In business, the closest we come to addressing our philosophical nature is when we discuss a company's culture.
How would you describe your company's culture relative to risk? Most people would say that they're cautious about assuming too much risk (whatever too much means), but they understand that they have to live with a certain amount of risk in order to survive and grow. A few companies, however, embrace risk in much the same way that they embrace change. While many companies pay lip service to the notion that "change is good," their actions betray their true natures.
Tactical Thinking
So, let's have another look at the large deductible versus captive argument, but this time from a philosophical standpoint. You make widgets. You've been making widgets for 50 years. How do you feel about also owning an insurance company? Leaving alone the economic argument for the moment, would your CEO consider this to be a potentially interesting and innovative way to manage risk or would she be horrified at the very idea of owning an insurance company? Do you think strategically or tactically? Most everyone would say that they think strategically, but in reality, many risk management strategies are usually just a series of reactive tactics based on which way the wind is blowing. Sticking to a strategic plan means accepting the bad with the good, because you believe that ultimately, the good exceeds the bad.
The Control Factor
Let's talk about the concept of control. Most C-suite denizens tell us that they want all the control they can get because control equals power. But when presented with an opportunity to assume a greater degree of control over their risk financing expenditures, if it costs a little more (at the beginning) than the status quo, they often demur. The philosophical question here is "What is the value of control?" It's relatively easy to calculate the cost effects of a given approach, but how do we place an economic value on such a thing as control? The answer, of course, is that we can't. The value of control is intrinsic; it reveals itself in ways that enhance our ability to manage costs, deploy resources as efficiently as possible, and, of course, make money.
Consider these words of wisdom: that which we do not control controls us. (This reminds me of a saying in theoretical (quantum) physics—that which is not prohibited is compulsory. But I digress.) In reality, we control very little in our personal or business lives. When we board an airplane, we're relinquishing total control of our wellbeing to the pilots and crew. But we don't think anything of it because we have no choice. The difficulty comes when we find that we do have a choice. And surprisingly, we sometimes assume that the options are illusory; there's no real choice here, just a false choice designed to trick us into changing our behavior. Maybe, maybe not. The point is that control is a slippery concept; when we achieve control, we sometimes don't know what to do with it.
Conclusion
This, in my humble opinion, is how you should approach the large deductible versus captive decision. Yes, by all means, work through the economic comparisons. Crunch the numbers and model all sorts of potential outcomes, but at the end of it all, think about the larger issues. Think about value creation. Think about the tradeoffs between short-term pain (or gain) versus long-term outcomes. Think about the role risk plays in your company's grand plan for the future, and how it affects decision-making.
But most importantly, be true to yourself and your company's core values. Don't embrace a concept because you think you should, but at the same time keep an open mind regarding new ideas. However, remember this—being open minded is great, as long as your brains don't fall out.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.
