Living benefit riders to life insurance policies: Pricing considerations and strategy
Adding benefit riders to policies provides meaningful coverage for those who need it, and carriers usually can do so at a relatively low cost.
Captive insurance is a narrow niche within the insurance industry that is often not all that well understood, even by insurance professionals. Sometimes it seems like the insurance industry, including the captive insurance segment, has a language all its own. As insurance professionals, we are used to using this language and jargon in our day-to-day jobs.
Examples and analogies can go a long way toward bridging the knowledge gap between insurance professionals and the general public for captives. Here, we will use health insurance provided by a company to its employees to illustrate a captive insurance program. Even though most captive insurance is for other types of risk, health insurance provides a great window into understanding how captives work. First, we consider it from the perspective of an employee; second, we consider it from the perspective of the employer; and finally, we extend the example to other types of insurance.
For our example, we start with a group health insurance policy purchased by an employer or company from a commercial, for-profit health insurer. The policy has two annual deductible options for covered employees and their families—a low deductible ($1,000 in annual out-of-pocket expenses) and a high deductible ($5,000 in annual out-of-pocket expenses). For this article, we assume that the employee’s policy covers the employee and their family. For every covered medical expense, the employee or the employee’s doctor/provider submits a claim. Depending on the annual deductible chosen, the employee is out of pocket for the first $1,000 or $5,000 of covered costs during the year.
The employer pays for most of the premiums, which average $20,000 per employee per year at the $1,000 deductible level. Employees choosing the $1,000 deductible are charged 10% of the premium, or $2,000, in the form of pretax contributions from their salaries. In exchange for choosing the high deductible option and taking on the risk of having to pay extra out-of-pocket expenses, the company reduces the pretax contributions made by the employee by $1,000. Relative to the employee at the $1,000 deductible level, this has the effect of paying the high deductible employee an additional $1,000 in salary, representing some portion of the reduction in the employer’s cost of the health insurance policy.
The company also offers a health savings account (HSA) option if the employee chooses the high deductible plan. The employer contributes $1,000 annually to the HSA, and the employee can contribute up to an additional $4,000 per year. Contributions to the HSA are on a pretax basis with respect to federal income taxes, so there is a tax benefit available to participating employees. Also, employees can direct how the funds in their HSAs are invested.
Starting with the employee, there is a minimum risk of $1,000 of out-of-pocket expenses each year. We describe risks not covered because of a deductible provision in an insurance policy as “retained risk” (other types of retained risk are discussed below). If the employee chooses the higher deductible option, there is an additional retained risk of up to $4,000 of out-of-pocket expenses. In exchange for taking this risk, the employee receives $2,000 ($1,000 in the HSA and $1,000 in extra pretax income), as well as the potential federal tax benefits afforded by the HSA. Under the high deductible, the employee now has up to $5,000 of retained risk.
Focusing on the high deductible scenario, the HSA can be viewed as a small insurance company, wholly owned by the employee solely for the purpose of covering the risk of incurring medical expenses for that employee/family. In the corporate world, wholly owned subsidiary insurance companies that cover risks of the owner are called “captive insurance companies.” The owner of a captive insurance company is usually called “the parent.”
In this insurance company analogy, premiums equal the contributions to the HSA, and the employee chooses how much retained risk to put into the HSA in terms of pretax contributions. That is, if the employee contributes $1,000, on top of the $1,000 contributed by the employer, $2,000 of the $5,000 of retained risk is “insured” in the HSA. The $2,000 could be considered as the policy limit. The remaining $3,000 is still retained risk, but it is not prefunded into a segregated account. Just like an insurance company, the employee, as the owner, manages the affairs of the HSA, including directing how the funds in the HSA will be invested.
HSAs are regulated at the federal level and certain rules apply. But the key rule is that contributions to an HSA are allowed on a pretax basis. For example, if an employee is in the 25% federal tax bracket, contributing $1,000 of pretax salary to an HSA allows an equal amount of health expenditures. However, if an employee does not contribute to the HSA, that $1,000 is treated as taxable income and after federal taxes leaves only $750—to pay for those same health-related expenses, or anything else because the funds are outside of the HSA.
If funds remain in the HSA at the end of the year, they are retained and available for future covered health expenses. Insurers use the term “surplus” to describe such amounts left over after all claim and other obligations have been recognized.
Note the steps involved by the employee, which are to a) first choose how much risk to retain, and b) then choose how to finance that risk. On the latter point, the employee can choose not to put any additional funds into the HSA, and simply operate on a “pay as you go” basis. Here, the retained risk (other than the $1,000 contributed by the employer) is the obligation of the employee. We can think of the employee’s wealth in terms of assets and liabilities (in corporate terms, a “balance sheet”). At any point in time, to the extent there are health expenses that have been incurred but not yet paid (i.e., the employee went to the doctor and the claim has been submitted to insurance and is pending), the employee carries that obligation (“liability”) on their balance sheet.
The employee could contribute up to $4,000 into the HSA, and prefund the risk by setting aside money into this wholly owned, segregated account. Alternatively, the employee could also set up a separate bank account and deposit money that is dedicated to paying retained health expenses instead of using the HSA. While that would assist in tracking health-related expenses, it wouldn’t be as tax-efficient because it would not be regulated as an HSA. However, the funds could be used for other purposes if the employee needed those funds, which is not the case with an HSA. As such, a dedicated, segregated bank account has some similarities to an insurance company, but there are some material differences.
With respect to the HSA scenario, the employee is often given an HSA debit card that can be used to cover healthcare expenses. Or the employee can pay healthcare expenses separately (maybe with a credit card to get points), and then seek reimbursement from the HSA. The reimbursement would take place by the employee writing a check to themselves against the HSA to him/herself. Here, the owner of this small notional insurance company (i.e., the HSA) writes a check to themselves from the checking account of the insurance company. In the captive insurance world, these arrangements are often referred to as “reimbursement policies.” The owner has chosen to retain a certain manageable level of risk and has set aside funds in a segregated account to pay for these risks/expenses as they arise. Note that for large, catastrophic, unpredictable risks, such an arrangement would likely not make financial sense.
What drives the behavior and corresponding decisions of our notional employee? If the employee is young and healthy and has had minimal health-related expenses in the recent past, that employee is likely selecting the high deductible option, on the premise that out-of-pocket expenses will likely be $1,000 or less. Also, the employee would receive the $1,000 in additional pretax compensation and would be able to use any unused portion of the $1,000 in the HSA in the future.
Alternatively, if the employee has a preexisting condition and/or knows in advance that medical expenses will exceed $5,000 in the upcoming year, that points to the $1,000 deductible. Here, it would be most cost-effective to transfer the risk between $1,000 and $5,000 to the health insurer. Under the $1,000 deductible, the employee would need to use $1,333 of salary, which, when taxed at 25%, would leave $1,000 to pay the deductible. For the $5,000 deductible, and assuming full use of the HSA (i.e., making the full $5,000 contribution), the employee would need to use $3,000 of salary (the other $2,000 coming from the employer in the form of $1,000 for selecting the higher deductible, and $1,000 as a direct contribution to the HSA).
For the employee with expected annual health expenses in the range of $1,000 to $5,000, some risk management comes into play. Doing the math, the breakeven point is $3,333 of health expenses. At that level, the employee with the $1,000 deductible uses $1,333 of salary, which when taxed at the 25% marginal rate, pays off the $1,000 deductible. Moving to the $5,000 deductible, the $3,333 of claims would be covered by the $2,000 from the employer, and an additional $1,333 of salary, contributed to the HSA on a pretax basis. This type of analysis is often referred to as a “cost-benefit analysis,” and in the context of contemplating setting up an insurance company, it would be part of a “feasibility study,” where the long-term viability of the venture would be analyzed.
In the cost-benefit analysis, the employee would likely look at past healthcare expenditures and anticipated expenses in the upcoming year and make a decision on how much to contribute to their HSA. Some employees will simply choose the maximum amount, even if it exceeds annual expected retained risk in the near term. The HSA then builds up “surplus” that can be used in the future.
Note that the main function of most types of insurance, including health insurance, is to protect against large, unexpected losses. Absent the health insurance, in the event of a large medical expense, the employee faces a series of financial hardships, and in extreme cases eviction and/or bankruptcy. Health insurance achieves that main function—to protect the assets of the employee.
The fully funded HSA can also be viewed, on a much smaller scale, as protecting the employee’s assets. Prefunding these expenditures in a segregated and regulated account reduces the risk of not having enough money to cover these expenses. But the main purpose of using the HSA is to pay for retained risks in a cost-efficient and tax-efficient manner. Asset protection is a secondary consideration.
Individuals have many options to retain risk. With a robust set of insurance policies, the most common retained risks are deductibles under auto and homeowner's policies. But there are other potential retained risks such as flood (not covered under standard homeowner's policies), disability (if the employer doesn’t provide it), or losses over and above policy limits on purchased insurance policies, to name a few. These uninsured risks are also a subset of retained risk (although not eligible to be financed through an HSA).
Turning to the employer or company, it has the option of purchasing the health insurance plan described above from a commercial health insurer. The health insurer would charge premiums based on the expected cost to cover the insured employees, with lower premiums (relative to the low deductible option) for employees choosing the high deductible option.
Insurance premiums are made up of three basic building blocks: expected claim costs, expenses to operate the company, and a profit margin. The largest component for most types of insurance, including health insurance, is for claims—actual claim costs, and the corresponding claim handling and administration expenses. The other expenses are those related to operating the health insurance company and are often referred to as “frictional costs.”
Just as the employee weighed their deductible options based on expectation of claim costs, the employer can also consider retaining risk. Given enough employees, a cost-benefit analysis of the employer’s historical health insurance claims often shows that the number of claims, and the corresponding costs of these claims, is fairly predictable. In some years, the historical claims data will have occasional large, unusual claims, but the timing and annual costs of these claims is more random. In our example, we assume that the employer’s historical claim costs are predictable up to $300,000 per insured person per year. Above that level, the cost of claims varies significantly year over year—sometimes zero, and sometimes millions of dollars.
The employer would then seek a quote from its health insurer whereby the employer pays (retains) the first $300,000 per insured person per year (“specific stop-loss limit” for health insurance; “per occurrence limit” for most other types of insurance), usually subject to a maximum annual amount (“aggregate stop-loss limit” for health insurance; “aggregate limit” for most other types of insurance). The aggregate limit, similar to the employee situation, is the maximum out-of-pocket risk for all retained claims for an individual insured, above which the insurer is back on risk.
The health insurer would reduce the premium to reflect its estimate of the claims that will no longer be covered by the policy. If the new premium quote, when added to the employer’s own estimate of the claims up to $300,000, is less than the original quote, it suggests a cost savings to the employer. This is often the case, because some of the expenses embedded in the insurer’s premiums are expressed as a percentage of premium, such as “commissions,” “premium taxes,” and profit margins. Commissions compensate insurance agents or brokers for putting the deals together between the policyholder (employer) and the insurance company. Premium taxes are levied at the state level and compensate the state for regulating insurers and/or for general budget items.
As an example, assume the original quote was $2 million, with 10% commission, 2% premium tax, and 8% profit and overhead/administration, for a total of 20% of frictional expenses. The employer estimates that the cost of the claims limited to $300,000 per person per year (the specific limit) will be $1.0 million (including claim administration expenses). This suggests a reduction in premiums of $1.0 million / 0.8, or $1.25 million. That is, there are $250,000 of “frictional costs” embedded in the portion of the premium associated with claims up to $300,000; multiplying premium of $1.25 million by 20% yields the $250,000.
While the employer might expect the premium quote to drop by $1.25 million to $750,000, the health insurer is now faced with a policy that only covers large and unusual events (i.e., over $300,000 per person per year), and will likely increase the profit margin embedded in the new policy to compensate for this new and more variable risk profile. In our example, the quote comes back at $900,000. The employer’s total cost is now $1.9 million—the retained estimated claims of $1 million plus the new premium of $900,000—which is $100,000 below simply buying the fully insured plan at $2.0 million.
The estimate of claims is just that—an estimate based on long-term averages. Actual claim costs limited to $300,000 per person per year could come in higher or lower than the average. But if, on average, the $1 million estimate is representative, while actual costs will be higher or lower year over year, in the long run the employer will have saved $100,000 per year.
At this point, the employer now has retained risk related to its employee healthcare expenses. But the risk was measured and deemed to be a cost-effective way of providing benefits to employees, while not exposing the employer’s balance sheet to unusual or catastrophic events. In this case, the retained risk by the employer is not called a deductible; instead, it is called “self-insurance.” The distinction is subtle and is not material to this discussion, but it's useful to note that it is still retained risk.
The employer is then faced with the decision as how to finance this newly retained risk—either on a pay-as-you-go basis and carrying any corresponding amounts on its balance sheet, or prefunding some or all of it into a segregated account. If the latter is chosen, much like the employee, a separate bank account can be established, with no special regulatory or tax treatment.
Or the employer could establish a wholly owned, subsidiary captive insurance company. A feasibility study would normally be conducted, which would include a cost-benefit analysis, including a review of potential tax benefits. If management decides to proceed, a full business plan would be submitted as part of an application for a license in the state in which the captive will be headquartered—this state is called the “domicile” or the “domiciliary state.” The captive will normally have no employees and will retain the services of insurance professionals such as accountants, actuaries, attorneys, and auditors to operate the company and meet all regulatory requirements of the domicile.
In this example, the premium would be the $1 million of expected claim costs plus the overhead and operating expenses of the captive, and any regulatory taxes (a hot topic in recent years), licenses, or fees. For a captive of this size, those expenses would likely total to about $75,000. The regulators in the domicile require that additional funds, over and above the premiums, be contributed, to provide a backstop or cushion in the event the actual claims and expenses exceed the premiums charged. These additional funds are called “capital and surplus.” Surplus also includes any retained earnings as profits build up in the captive. Note that the $75,000 of annual operating expenses use up most of the savings in this example. However, there are potential benefits to using the captive, including the ability of the company to keep better track of the financial implication of its decision to retain risk. The captive’s financial statements essentially summarize the impact of making this decision. This noneconomic “management” benefit is often the only thing that captive owners are seeking to accomplish, at least when they initially form their captives.
The experienced captive professional will note that there are some regulatory hurdles to overcome to do what’s described above for health insurance, where there are special regulations at the state level. As such, the structure described above would require a few additional steps, including requiring that the parent/employer actually retain some of the risk, and then the captive takes the residual risk (up to the specific and aggregate limits underlying the insurance policy with a commercial health insurer).
But for other types of insurable risks of companies and employers, such as workers' compensation, general liability, auto liability, and property, similar cost-benefit analyses are also done. Large companies often hire full-time professionals, called “risk managers,” who analyze risks faced by the company, and purchase insurance to protect the assets of the company where needed. Risk managers, often in consultation with hired experts, are experienced in identifying cost-effective solutions to managing risk. These solutions often involve captive insurance companies.
In the United States, workers' compensation is the risk that underlies the largest percentage of premiums paid to captive insurers. Insurers categorize risks by policy types, also referred to as “coverages” or “lines of business.” The workers' compensation line of business is mandatory in all 50 states, but each state has different workers' compensation statutes. Like the health insurance example above, retaining risk can often reduce frictional costs and result in savings to the employer. After performing a cost-benefit analysis, the employer will select the level of risk to retain, expressed as an amount per accident/occurrence. The selected amount of retained risk should be a relatively predictable amount of total retained risk per year so as to not jeopardize the company’s assets, while also reducing frictional costs.
In some states, the most cost-effective way to retain risk is to have a “large deductible” policy, where a licensed insurer writes the policy, pays the claims, and is reimbursed by the policyholder for the cost of claims up to the deductible level. Unlike the employee example where the deductible is a total amount for all claims during the year, the deductible for most other types of insurance is on a claim-by-claim basis (i.e., for each accident/occurrence). For individual claims exceeding the deductible amount, the insurer is responsible for amounts in excess of the deductible. Deductibles are a form of retained risk.
In other states, it is more cost-effective for the employer or company to apply for permission to insure the risk themselves—here, the company is considered to be a qualified or approved “self-insurer.” This is another example of retained risk. Because workers' compensation has no policy limit, however, employers that choose this option are normally required to purchase insurance above some per claim level—exactly as in the employer health insurance example above. This protects injured employees against large and unusual events for which the employer either lacks assets, or that would cause a significant adverse financial event for the employer. Most states also require that the self-insurer post some sort of collateral to provide a backstop in the event that it cannot pay for the retained risk.
Once an employer or company has retained risk for workers' compensation, whether it’s from a large deductible or from being a self-insurer, the risk financing question comes into play—pay as you go or prefund in a captive insurer. If a captive is chosen, the policies would reimburse the parent/owner for payments made either to insurers (under the large deductible structure), or directly to claimants (under the self-insurance structure). As described above, these are reimbursement policies that provide some protection to assets, but that’s not the main purpose of the captive. The main purposes of the captive in the example are to a) centralize the company’s retained risk into a segregated account for tracking the actual cost against the estimated cost of retained risk, and b) potentially qualify for favorable federal tax treatment with respect to liabilities for unpaid claims, also known as “reserves.”
There are a number of other reasons for owning and operating a captive, and there are specialized uses of captives, generally for risks other than workers' compensation. For example, a captive can be used as a conduit to transfer risk to outside parties, as opposed to insuring retained risk. Here, the most cost-efficient way to transfer risk is to buy “reinsurance,” which is insurance for an insurance company. Some insurance vehicles (“reinsurers” or other similar risk pools) are structured to only accept risk from insurance companies. Using a captive insurance company allows the parent company to access this reinsurance market, with the goal of transferring risk as opposed to retaining risk.
In almost all cases, using a captive is aimed at either reducing the cost of risk, or at improving the efficiency of managing risk. And in terms of premium dollars, most captive premiums are for reimbursement policies on claims with well-defined policy limits and/or per claim limits that are not large enough to threaten the viability of the captive or its parent. While there is some asset protection, the owner/parent is willing to take on this retained risk with or without a captive—it’s cost-effective to do so, much like with the employee and company in the health insurance example. Prefunding the retained risk in a wholly owned, subsidiary/affiliate insurer can provide additional benefits, both economic and noneconomic, i.e., in management.
One more item on retained risk—uninsured risk. For some types of risk, there is no insurance available, or the insurance is prohibitively expensive. For example, risks related to asbestos or pollution are excluded from most liability policies. Until recently, cyber risk fell into this category as well. For risks that are essentially not insurable in the commercial market, organizations may choose to evaluate other available risk-financing options, such as a captive. Deciding to do nothing simply means that the risk is retained by the parent company on its balance sheet.
Also, the discussion above focuses on captives that insure a single entity and its affiliates (“single parent captives”). Captives can also be formed by multiple owners or policyholders. These so-called “group captives” function in much the same way as single parent captives, except that multiple entities own and are insured by the captive.
Captive insurance is generally fairly straightforward. For single parent captives, the owner pays premium to a captive, a wholly owned subsidiary, to insure retained risks. Many people think of this as formalized self-insurance because the parent owns the insurance company. Regardless, the process is essentially the same: a) a decision is made to retain risk; and b) then the method for financing that retained risk is chosen. Normally, retained risk is simply retained on a pay-as-you-go basis. That can work until the annual volume of losses reaches a critical level, and a more formalized way to finance the retained losses, such as through a captive, becomes a better risk management solution. And health insurance, both at the employee level and the employer level, provides a good way to think about how captives work.