The State of the Market for Healthcare Captives (Strategic Risk Solutions)

The State of the Market for Healthcare Captives

This article draws on information presented by Bill Cassetta and Julie Robertson of Honigman Miller Schwartz & Cohn LLP in  SRS's April 2008 webinar.

The Origins of Self-Insurance

Historically healthcare institutions have been concerned about the reimbursement of their costs under Medicare and other third party payment mechanisms. This made institutions risk averse preferring to pay a guaranteed premium which would be treated as an allowable expense rather than retain risk. While cost reimbursement remained an important consideration, institutions' risk-taking position began to change in the 1970s as self-insurance became an acceptable method of financing professional/general liability for Medicare cost reporting purposes. Once accepted, self-insurance expanded, particularly among tax-exempt institutions, which were not concerned about trying to create a tax deductible structure. Lenders and lessors also became comfortable with the structure.

In this initial phase the typical method of self-insuring was in a Trust. Under this structure, an independent fiduciary held the funds used by the institution to pay professional and general liability claims. The Trust provided favorable reimbursement treatment as well as several benefits to the institution over commercial insurance:

• Loss experience: the sponsor (or hospital) could benefit directly from improved loss experience. Even for loss sensitive insurance programs, the commercial insurance market doesn't reward good experience or punish poor experience dollar for dollar. The Trust gave the healthcare institution the most reward for its risk management efforts.
• Investment income: the sponsor retained the investment income and funds were invested per the sponsor's policy. Medicare didn't really restrict the way that funds could be invested except that the investment had to be consistent with whatever state law was applicable.
•  Tax treatment: there was favorable tax treatment for tax-exempt organizations. 

The Emergence of Captives

By the mid-1970s, Medicare cost reimbursement rules had changed, permitting use of captives. Until then captives were not available as an alternative to institutional providers. Captives  provided institutions with additional flexibility compared to a Trust. The most significant initial advantage was the ability to pool risk beyond the professional and general liability risk exposures of the institution. With a captive, pooling became possible with other institutional providers and physicians. It was also possible to pool other risk exposures, such as workers compensation, with the professional and general liability exposures. As a formalized risk bearing entity, a captive provided access to the commercial reinsurance market.One of the first healthcare captives established was formed by the Harvard medical institutions. The structure of the Harvard captive pooled the risk of its physicians and other providers with the institution, including the sharing of a single limit of liability. This structure became the model for many other tax-exempt healthcare institutions. The Harvard captive was also instrumental in establishing Cayman as a domicile as discussed below.

Second Wave of Growth

From the 1990s through the present, a number of factors spurred a significant growth in captives among those sectors left out of the first wave. This growth was driven by both changes in the insurance industry and the healthcare delivery system.

Insurance Industry Changes

• The Humana decision provided new captive opportunities for taxable institutions for which tax deductibility was important.
• The passage of the Federal Risk Retention Act in the late 1980s provided more options for captives. The RRG structure allowed smaller institutions and physicians to come together to pool risk. It also provided captive owners with an attractive onshore option and removed fronting costs.
• The hardening of the market in the late 90s and early 2000s fueled the growth in captive formations.

Healthcare Industry Changes:

The most significant change was how physicians began organizing themselves. Previously physicians had been organized in small offices with one or two providers. They lacked the resources and financial strength to retain risk and were reliant on the commercial market. That changed in the 1990s with the consolidation of physician groupswith the combined group acting more like an institution than a collection of professionals. These groups had more capacity to retain risk and became viable candidates for captive formation. At the same time there was an explosion in physician staffing companies and management companies needing insurance solutions which spread across a number of states. Commercial markets were often unable to provide a solution for them. 

The Market Today

Today captives have become the predominant risk financing structure for tax-exempt and taxable healthcare institutions. Trusts are no longer as common as they used to be as they don't have the flexibility of a captive. In certain situations, however, a Trust may be the optimal choice, used alone or in tandem with a captive. A Trust may also be a good first step in the self insurance world for smaller organizations, particularly where tax deductibility is not important. Trusts are typically less expensive to establish and operate than captives. The market for healthcare captives is mature with captives seen across most sectors of the industry. Some would argue that the market is saturated. Although formation rates have declined in the soft market, smaller regional providers continue to express interest in forming new captives. For existing captives, the soft market is providing an opportunity to improve their programs. This may include reduced reinsurance costs and improved coverage, including batch coverage for multiple claims arising from the same event. One of the biggest challenges is using surplus or releasing loss reserves as healthcare captives have generally been successful with good loss experience. Many captives are looking at ways to use that surplus to insulate themselves from the next hard market. 

Domiciles: the Healthcare Perspective 

Initially healthcare captives looked to either Bermuda or Cayman as a domicile. Cayman became the most common jurisdiction for healthcare providers early on following the acceptance of the Harvard captive for medical malpractice in the mid 1970s. Although Bermuda was the more established domicile, Cayman offered some advantages, including:

•  A willingness to allow hospital sponsored physician programs; and
•  A more favorable reimbursement impact due to flexible capital requirements

Now there are more domicile options available, including a number of onshore alternatives. Vermont, as the leading onshore domicile, has a strong healthcare captive sector. Several of the newer onshore domiciles have picked up healthcare captives, particularly risk retention groups and physician groups. However, Cayman remains the domicile of choice for both for-profit and tax-exempt captive owners due to the experience of the professionals involved. Understanding the unique business needs of the healthcare industry is a major advantage for Cayman.