FOCUS ON RISK MANAGEMENT
Can a "Captive" Insuror Cut Your Malpractice Premiums?
It's worth exploring, but the pitfalls are numerous.
BY EDWARD J. KUPCHO

Stung by years of steadily rising medical malpractice premiums, ophthalmology practices have been eager to explore alternatives that could provide adequate insurance protection at lower cost.

And though those responsible for purchasing medical malpractice insurance have recently seen the availability of coverage improve, pricing is still unfavorable for many physicians and physician groups. Of the several alternative insurance concepts currently being considered by medical practices, the most popular is what has been termed the "captive company."

In this article, I'll explain what a captive company is and discuss both the possible advantages and the potentially serious drawbacks to adopting this form of insurance protection in an ophthalmology practice.

The Captive Concept

Though it differs from a traditional insurance company in several ways, the most important distinction is that a captive entity protects a small, well-defined and homogeneous group of insured parties. The captive company uses all generally accepted principles of insurance, but the concept has been promoted as a way to gain favorable terms and pricing in certain lines of insurance, including medical malpractice.

Captive insurers have tended to be formed in offshore locations such as the Cayman Islands and Bermuda, where the regulatory environment for this type of entity is favorable. The capital required to form a company in these jurisdictions is usually significantly less than what is required in the United States. In addition, offshore locations usually allow the creation of a number of separate cells in the captive structure, permitting groups to form "rent-a-captive" operations. This feature makes it relatively easy to develop an insurance program without the need to raise start-up capital for a separate company. The "rent-a-captive" concept has not (yet) been approved for use in this country.

The captive structure has also been touted for offering tax advantages if it's established in certain offshore jurisdictions, but a 4.5% excise tax on insurance premiums paid to foreign-based entities may make these tax advantages illusory.

The Road Can be Rough

Although captive operations are worth investigating as an alternative structure for at least some types of risks, long-term pricing benefits shouldn't be automatically expected, even in a well-managed captive entity. In fact, only large well-capitalized captives can hope to reach the critical mass necessary to smooth out fluctuations in premiums.

Theoretically, alternative insurance structures that insure physicians should be able to operate on a limited amount of start-up capital. With proper actuarial data, responsible rate-setting and underwriting discipline, premium relief should result. That's because there would be no commission loads and profits to inflate expenses. However, the liability risk and loss profile of medical professionals is so difficult to predict that captives with insufficient funding to deal with variations in claims experience can't guarantee a stable premium. In a small program, one loss can alter the pricing model to a point where a significant capital infusion is needed to continue doing business. If that money isn't available, the program fails and there is no coverage.

What You Must Know

If you contemplate choosing a captive as an alternative to commercial insurance, ask the following questions:

What capital is available in addition to earned premium to offset losses that are associated with the exposure assumed under the program? If the program has only minimal amounts of capital, there is a good chance more cash infusion will be needed down the road. Even the accepted industry benchmark that calls for starting a captive with $1 million in capital can easily prove to be insufficient if a major claim occurs early in the captive's existence.

What are the underwriting guidelines for accepting risk? Underwriting discipline is very important to captives. If the guidelines aren't stringent and losses mount up, then the program's chances of survival aren't good.

What are the expenses associated with the captive? Generally, the expenses associated with administration and distribution are in the area of 25%. If they're higher, it would be prudent to ask for a copy of the pro forma to review the cash flow.

Is there reinsurance? Usually, an agreement is consummated between the captive and a reinsurance company to assume a portion of the exposure in return for a percentage of the premium. In practice, there are numerous ways to apply reinsurance. Notwithstanding the expense, it's a very important element in protecting the integrity of the captive.

What are the options for reporting claims when a physician leaves the practice or retires? Most standard carriers won't provide "prior acts" (retroactive coverage) for physicians coming out of nonstandard or alternative programs that aren't rated. If the captive doesn't allow for a reasonable exit from the program, future prior acts protection may be jeopardized.

Hospital-Based Captives

The emergence of captive programs has led to a movement by hospital systems to provide medical professional liability coverage to nonemployee, affiliated physicians.

Hospitals that have made captives available to their nonemployee practitioners have made a serious commitment to provide affordable coverage to credentialed staff, but significant downside risks exist that can be catastrophic. You should know about these risks if you're invited to insure through a hospital-based captive.

Though properly funded in most situations, hospital-based captives are vulnerable to losses that can appear in a relatively short time, especially in situations where "prior acts" coverage is offered to the applicants.

Prior acts coverage is one of the most misunderstood areas of medical professional liability coverage because it really builds a "bank" of liability known as IBNR (Incurred But Not Reported) exposure that drives the premium. Because it takes about 18 to 24 months for injuries to manifest themselves into a full-blown claim, the exposure to an alleged medical event increases with time, at least to a point out about 5 years. Each year, in calculating the premium level for a given risk, an underwriter must consider the chances of a claim arising out of services delivered in prior years to assure there is enough rate in the policy to cover potential claims and expenses.

Prior acts coverage is especially dangerous to newly created captive companies because it exposes them to claims resulting from doctor/patient interactions that can go back years and that are finally being litigated. These mature risks can create losses for the captive entity in the first year, before the captive even has a chance to get its capital in place.

Some Flee the Captives

Commercial carriers have restored much of their strength over the past 3 years by reducing their books of business, strengthening reserves, and implementing significant rate increases that have fueled a recovery in the business. Physicians who met the underwriting standards of these carriers have renewed their coverage, leaving the remaining physicians to the higher-priced, nonstandard market. This means the hospital captives are now losing their most insurable physicians, making it difficult to allow premium savings to continue as losses develop.

As the environment for medical professional liability insurance improves, captive policyholders will look for better rates, forms and financial strength in the commercial market, and will leave the captive to absorb the losses with no additional premium income. Unless there is proper reserving and reinsurance to maintain the ability to pay obligations, hospital-based captives will need to infuse additional capital, which could significantly affect the bottom line.

A group that makes it as a captive must have pricing, surplus, underwriting discipline and a little luck to make it. The pricing part is what causes captives to fail, because the premium must ultimately reflect the claims experience. Good claims experience brings good pricing. Bad experience brings unfavorable pricing. It's as simple as that.

Get Expert Advice

Although it's worth the effort to explore -- and even for some practices to consider adopting -- the captive option, it makes sense to have an insurance agent who will monitor the adequacy of your coverage on an annual basis so that your protection isn't compromised.

Edward J. Kupcho is founder and president of Medical Risk Management Services, Inc., in Akron, Ohio. He can be reached via e-mail at ekupcho@mrmsinc.com