Many times, captive board members have lots of expertise in their own industry, but little knowledge of insurance. Captive managers usually provide the insurance expertise. But captives can get a truly unbiased perspective by adding an independent directo

Captive to conflicting interests: many times, captive board members have lots of expertise in their own industry, but little knowledge of insurance. Captive managers usually provide the insurance expertise. But captives can get a truly unbiased perspective by adding an independent director to the board who knows the ins and outs of the insurance business

Patricia Vowinkel

While it’s unusual for a captive insurer to have an outside director, MedStar Health Inc. has added not one but two outside directors in the last three years.

“We were not driven to do this because we felt it was required,” says Larry Smith, vice president for risk management services at MedStar, a not-for-profit, seven-hospital, integrated health-care system. “No one factor drove us to do it. It was a combination of issues that all encouraged us that this was a real beneficial thing for us to do,” he says.

Maryland-based MedStar is unusual. Few captives have outside directors, and even fewer have outside directors with any insurance expertise.

“I don’t think it’s very common,” says Deborah Lambert, a partner at accounting and consulting firm Johnson Lambert & Co. She estimates that less than 5 percent of captives have an independent director on their boards.

Captive board members often have a lot of expertise in their own industry, but little knowledge of insurance. Captive managers usually provide that expertise, but many of them are subsidiaries of the major insurance brokers and their advice may not always be unbiased.

An outside director who knows the insurance and reinsurance business can help ask the right questions and be an invaluable asset to a captive insurer.

“I do think they need to bring somebody to the table who is an independent director who has outside insurance expertise,” says Lambert, a frequent speaker at conferences about captives and corporate governance.

Concern about the potential for possible client conflicts with the brokers began to emerge late last year after New York Attorney General Eliot Spitzer accused brokers of steering clients to insurers with which they had lucrative contingency-commission agreements.

The scandals and the lack of transparency surrounding transactions “really made people sit back and think about captive managers,” Lambert says. “It made them open their eyes a little bit,” she says. “(The insurance brokers) are names the captive world has heard about.” Companies usually rely on a broker, such as Marsh, Aon or Willis, for the formation of the captive, and then they rely on a subsidiary of the same broker for captive management, reinsurance brokering, claims administration and other services.

“The expertise is totally delegated,” says Andrew Baffle, an insurance and reinsurance consultant based in Rancho Santa Fe, Calif. “They’re relying totally on the broker.”

ALLIES NOT ENEMIES

Brokers, which at one time saw captives as a threat to their business, now enthusiastically promote captives because they not only get to keep the relationship with the client, they also can make money at all the steps along the way.

Captive managers bring a fair number of services to the captives, and sometimes those transactions are not all that transparent, Lambert also says. The captive managers “are insiders, and they do have their own business interests,” she says. “Oftentimes, they’re getting more than just a management fee.”

And those sums can be quite large. The captive may pay a modest fee for the captive manager’s services, but an affiliate of the captive manager may be paid a handsome brokerage commission by the reinsurer for the placement of the captive’s reinsurance.

Those payments may be entirely legitimate, but many times the captive’s board does not even understand how the money is changing hands.

“The problem is you don’t have anybody in the captive that can evaluate what the manager is saying,” says Barile, who has more than 40 years of experience in the insurance industry.

It is often not until a problem arises, usually when a captive has a dispute with the captive manager over its reinsurance recoveries, that captive board members start to think about the idea of having an independent director with insurance expertise, he says.

“There’s no place to learn these things,” Baffle says. “How would they know? They’re not going to know until they’re hit with the predicament.”

BEST PRACTICES

An independent director makes more sense for some captives than for others. For a single-parent captive, an outside director may not be all that critical, Lambert says. But because they are very similar to commercial insurers, outside directors would be especially helpful for a group captive. Unlike a single-parent captive, which is essentially a subsidiary of the parent, a group captive has multiple participants that are unrelated.

Lambert suggests that group captives consider having several outside directors with insurance backgrounds to provide a critical mass of expertise. The captives also would benefit by having directors with some background in reinsurance, she says.

“I think some of the best ones are people who have expertise in the reinsurance area,” Lambert says. “Captives generally rely fairly heavily on reinsurance, and (outside directors) just bring a whole expertise and understanding to the table that probably doesn’t exist otherwise,” she says.

Finding qualified outside directors, however, is easier said than done.

Good candidates exist. But because there has been no culture in the captive and insurance industries for this, it might be difficult for some captives to identify potential candidates, and the pool might not be very deep.

In addition, there is the question of compensation for outside directors. To get a qualified expert to sit on its board, a captive might have to compensate the individual.

In MedStar’s case, one of the outside directors on the captive’s board is an accountant, the other an outside physician. Neither one of the outside directors is compensated, Smith says.

Dennis Harwick, president of the Captive Insurance Companies Association, says the trade organization doesn’t have an official policy regarding the hiring of outside directors to ensure a captive board’s independence.

CHECKS AND BALANCES

Others, however, say captives do not necessarily need an independent director to get independent advice, says Charles Lee, managing principal of Tillinghast Towers Perrin.

“To suggest that the captive have external board members, I’m not sure that’s a requirement that’s going to get a lot of traction,” Lee says.

Captives can unbundle the services provided by the broker to reduce the risk of getting biased advice, says Dawne Davenport, a consultant with Tillinghast Towers Perrin. They don’t have to feel compelled to have an independent director.

Even so, there’s no harm in having an independent director or two, Lee says.

“I’m a big fan of independent directors. I don’t have any problem with that. Having that independent view and decision making is very valid,” he says.

But, he says, regulators should not force captives to have independent directors.

Guernsey, which is one of a number of domiciles for captives, is the exception and does require captives to have outside directors.

“I would prefer not to see that kind of thing legislated and mandated,” Lee says. “I would prefer to see it evolving because it is just the right thing to do.”

Because regulators in other domiciles have not mandated that captives have outside directors, change is taking place slowly. The corporate-governance scandals of the past few years and Spitzer’s investigations into broker practices, however, have got captives thinking about corporate governance and best practices.

“This is an evolution, not a revolution,” Lambert says. “I think there’s been an evolution towards raising of the bar on the way captives operate that’s ongoing. Not everyone is going to move in lockstep.”

PATRICIA VOWINKEL is a New Jersey-based writer. She can be reached at riskletters@lrp.com.

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