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The CRO of Not So Nyce Place to Work (NSNPTW) is trying to find the optimal method of financing its workers’ compensation risk. NSNPTW is considering three risk financing techniques in order to address this loss exposure: a) retention (something similar to self-insurance); b) traditional third-party insurance; or c) formation of a captive insurance company. Assume all three methods will meet state requirements. Also assume any financial information (balance sheet numbers, loss expectations, etc…) will remain stable for the next decade and that NPTW’s internal rate of return is 10%.

You are asked by NSNPTW to decide which method of risk management is most appropriate for dealing with NSNPTW’s workers’ compensation losses over the next 10 years. Use the balance sheet information, as well as the addition information below, to answer each of the following questions related to NSNPTW and decide which method of risk management is best for NSNPTW.

NSNPTW has decided to use the working capital method to determine how much it is willing to retain. It has determined that NSNPTW is willing to retain 5-10% of working capital for its workers’ compensation risk. Management is adamant that it is not willing to retain any more than that. NSNPTW has reviewed its workers’ compensation claims history and determined that its workers’ compensation losses are roughly normally distributed with a mean of $100,000 and a standard deviation of $75,000.

NSNPTW has investigated the captive option. Management has determined that start-up costs for the captive insurance company would be $225,000 and annual premiums will be a level $110,000 over the next 10 years to ensure that the captive has the resources to pay for all workers’ compensation claims.

NSNPTW also has received a quote from a highly rated third party insurer who is willing to guarantee that NSNPTW’s insurance premiums will be $150,000 per year for the next 10 years for its workers’ compensation claims.

Question 1. What is the working capital for NSNPTW as of December 31st, 2017?

Answer: $6M - $4M = $2M

Question 2. What is the maximum amount, in dollars, that NSNPTW would be willing to retain?

Answer: 5-10% of $2M, so max is 10% of $2M or $200,000

Question 3. Given NSNPTW’s workers’ compensation loss distribution, should NSNPTW retain workers’ compensation losses? Why?

Answer: No. Mean losses are $100K, but two standard deviations above the mean gets you up to $250K, and the board is not willing to retain that much. Remember one standard deviation from the mean gets you about 68% of outcomes, 2 standard deviations from mean gets you 95% of outcomes, which means that 2.5% of all possible outcomes would be above $250K, well above retention limit.

Question 4. Ignoring the retention option discussed in questions 1-3, should the company start a captive or purchase workers compensation insurance from a third party insurance company? Why? Remember, this decision has a 10 year time horizon.

By purchasing insurance from captive insurer (vs. third party insurer) NPTW would save $40,000 per year (150K – 110K). The present value of $40,000 per year @ 10 % for 10 years is approximately $245,000. And after considering the $225K startup costs for the captive, the captive is cheaper by approx.. $20K in present value terms. At this point you could answer either way. Go for a captive, it saves $20K or if you answered that $20K is not enough of a savings to take on the risk that the losses could bankrupt captive, I also accepted that answer.

Question 5. Given all of your answers in questions 1 through 4, should NSNPTW form a captive workers’ compensation insurer, purchases workers’ compensation insurance from a third party insurer, or retain workers’ compensation losses? Why?

This question really just summarizes what we answered in the previous questions. Retention would be above what the board wants, captive is a positive NPV over third party, but may include some additional risk.