Workers compensation is a part of commercial casualty insurance that is a requirement for the vast majority of businesses and continues to be one of the major overhead expenses for companies. As by statute, it provides indemnity and medical expense coverage for employees injured in the course of performing the duties of their job, without the burden of proof of negligence on the part of the employer. As such, many companies experience considerable claim activity. And perhaps more so than other casualty lines, the ultimate cost of workers compensation is dependent on the loss experience of the company.
Each employer is subject to experience rating that compares them to other companies in their industry and is based on frequency and severity. Recent changes to the rating formula allow for more weight to be applied to the amount of the individual claim than previously. So, a company with a substantial number of claims could pay twice as much or more compared to a similar-sized company with good experience.
But a favourable experience rating only goes so far when it comes to premium savings. And so, mid-sized and larger companies have looked for additional ways to save on their considerable worker’s compensation insurance overhead expense. Historically, carriers have offered retrospective rating plans to insureds to reward good loss experience. The downside was that, as the name implies, the actual cost was not determined until after the policy expiration, which was particularly problematic if the loss experience was adverse, causing additional premium to be incurred during the following year when the current premium had been budgeted for and was being paid.
Given some of the unfavourable aspects of retrospective rating plans, carriers in more recent years began filing for and offering workers compensation large deductible plans to sizeable companies to affect upfront premium savings for taking on a layer of risk. Obviously, for the employer, there is a strong incentive to control losses to capture profit from the premium savings, which could be 50% or more with a large enough deductible of, for example, $250,000 or $500,000.
The large deductible plan allows the insured to realize the upfront premium savings while having the carrier continue to handle claims. When the claim is settled, the carrier will then seek reimbursement from the insured for the amount under the deductible layer. But the premium savings, minus claims paid in the policy year, will flow to the bottom line of the company and be taxed. The disadvantage is that with the premium savings the company is not able to deduct the full policy premium. And with workers compensation having a longer tail, the annual loss estimate on which the premium savings is based is usually not paid out in the first year, and so the deductible premium savings is only reduced by the amount paid in the policy year.
The more efficient way to manage the large deductible programme and maximise the financial benefit is to utilise a captive to insure the large deductible. As an insurance company, the captive will be able to defer income by deducting reserves or, if it qualifies as a small insurance company, it may be exempt from tax on underwriting profits. The insured would purchase a deductible reimbursement policy from the captive and would thereby be able to deduct the premium paid to the captive just like the premium paid to the workers’ compensation commercial carrier for the standard policy. So, the insured will realise the benefit of deducting the full workers’ compensation insurance expense, while having efficiently transferred the large deductible risk to the captive.
However, for this to work, the captive has to qualify as an insurance company, which means it has to exhibit risk distribution. The most direct way for the captive to demonstrate risk distribution is by the insured having enough risk-bearing, operating entities to achieve it. A safe harbour has traditionally been twelve operating entities, but recent rulings and court cases have allowed for a smaller number of entities if there is enough risk diversification within those entities. A qualified tax professional would be able to advise the company as to whether risk distribution could be achieved with the corporate structure.
Another option would be if the insured had a captive in place issuing policies to third parties and was receiving third party premium, such as a warranty program. They could then issue a workers compensation deductible reimbursement policy and meet the standard of insurance as long as the majority of the premium in the captive was third party premium.
Perhaps the best option, which utilises the law of large numbers for risk distribution, is for the captive to participate in a risk pool with other similar members who would share their risks. The captives participating in the risk pool would share a primary layer of risk with the other pool participants. The risk pool would act as a reinsurer and return a share of its total pool of risks from all the participants to the individual participating captive in the same proportion as that paid to the pool, minus a small pool management commission. Thus, risk distribution is achieved.
Business owners today will find that a properly structured captive providing deductible reimbursement coverage is the most effective way to control and manage escalating workers compensation costs while providing an efficient and safe workplace for their employees.
Written by Jeff Ellington, vice president of business development at Atlas Insurance Management.
