Posted by Nigel Wallis, a partner at Legal Futures Associate O’Connors
Wallis: captives enable law firms to back their own skill and judgment
“Control your own destiny or someone else will” – Jack Welch, one-time chairman of General Electric and global business guru
An increasing number of law firms are now using captives for their insurance arrangements as firms take proactive steps to regain control of their own destiny and secure direct benefits from their good risk management and efficient operation.
What is a captive and who can own them?
A captive is an insurance company owned by a non-insurance parent. The term captive derives from the early insurance companies set up by large corporates to ‘capture’ some or all of the insurable risks. The use of these types of captive is now widespread, with most FTSE companies and many large private companies now having at least one captive within their group.
The introduction of lower-cost captive models since the early 1990s, including captive cells within protected cell companies and incorporated cell companies, has opened up the captive insurance market to many more organisations. Many professional firms, including law firms, now enjoy the benefits of owning a captive or a captive cell. Others are increasingly keen to explore the potential benefits for their firm and their clients.
Ownership of a captive can be very flexible. In the case of law firms, owners tend to be the law firm itself or an entity or group of individuals closely associated with the law firm. The decision around ownership is firm specific and depends on the firm’s particular legal structure, profit-sharing arrangements and tax strategy.
How do law firms use captives?
Law firms use captives either to insure their own risks, such as professional indemnity, or to insure the risks of their clients, such as after-the-event (ATE) insurance or conveyancing and probate risks. Own-risk captives are also known as first-party captives. Client risk captives are also known as third-party captives.
Detailed five-year financial forecasts will illustrate the value of using a captive compared with traditional market insurance and this is the starting point for every law firm captive project.
Most, though not all, law firm captives are reinsurance arrangements where the insurance policy is issued by a UK-licensed insurer on a fronting basis. The fronting arrangement means that the UK-licensed insurer takes on 100% of the risk and then reinsures with the law firm’s captive, usually on a quota-share basis. A quota share is a formula for allocating premium receipts and claims costs as between insurance entities. A stop-loss arrangement is commonly put in place to limit the captive’s liability and as a means of fixing the risk gap for solvency purposes.
How can captives benefit law firms and their clients?
A captive set up by a law firm to insure its own risks, such as professional indemnity, enables the law firm to manage its aggregate excess layer more efficiently and potentially retain some risk in the captive itself. It also enables the firm to access the reinsurance markets and potentially buy greater levels of cover for less premium, subject to any minimum terms.
Over a number of years and subject to the level of claims, such an arrangement can enable a law firm to build up reserves in its captive and start to reduce its overall cost of risk. Due to the direct correlation between claims and captive profit, it is common to see law firm captive owners bringing an even sharper focus to risk management within their firm and begin to see a virtuous circle emerging.
A captive set up by a law firm to insure the risks of its clients, such as ATE insurance for commercial or personal injury cases, enables the firm to build a long-term strategic partnership with a supporting insurer. This can lead to cover being more readily available for more cases and on better terms, the objective being the development of a sustainable insurance product that is always in the best interests of the firm’s client.
The use of a captive also enables a law firm to back its own skill and judgment in terms of case selection and case management, and ultimately participate in any underwriting profit in the captive that results from such skill and judgment.
A law firm’s ability to retain its share of any underwriting profit depends on a careful analysis of the regulatory principles appertaining to the captive structure, most notably the requirements for client disclosure and the securing of client’s informed consent. Overcoming these regulatory hurdles is achievable but requires highly specialist advice.
Five tips for a successful law firm captive
- Stress test the sales pitch – captives are certainly not suitable for every firm and there are a few snake-oil salesmen about.
- Pick experienced advisers and service providers – select those who can demonstrate to your satisfaction a track record of successfully delivering captive projects for law firms.
- Don’t settle for second best when selecting your supporting insurer – you need an insurer who will be with you through thick and thin, and only the very best have deep enough pockets to commit for the long term.
- Don’t ignore the regulatory hurdles – take advice from a specialist regulatory law firm with onshore and offshore expertise in Financial Conduct Authority, Solicitors Regulation Authority and EU regulation.
- Be crystal clear about what it is you want from the project and how insurance fits with your overall client proposition – captives are a long-term play and suitable only for law firms that are professionally run and have a strong focus on risk management and client needs.
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