What To Consider When Establishing and Operating a Captive Insurance Company
The use of alternative risk transfer vehicles, which includes captive insurance companies, has become an important part of the risk management strategy rather than an innovation for larger organizations, following the hard co
mmercial insurance market cycle of the late 1990s. These vehicles represent roughly half of the U.S. insurance market; yet captive insurance companies, or captives, are still somewhat of a misunderstood alternative for organizations that do not currently operate one.
Most risk managers or financial executives of mid to large corporations know the term “captive insurance”, but they are still often unfamiliar with how these entities are formed and how they affect a company’s day-to-day operations. Therefore, these executives often rely on their insurance agents or brokers to present them with the best available alternative. Unfortunately, while most insurance agencies and brokerage firms of a certain size have captive specialists on staff, many of the agents and brokers in the field are uneasy with recommending the captive as an alternative risk transfer (ART) vehicle, or are not fluent enough to identify when a captive should be considered. The following discussion will provide
some basic information about captive insurance companies, the steps required to determine whether a captive might be a viable solution, and information on how a captive is formed and managed.
What Is a Captive?
There are many definitions used to describe a captive insurance company. This is primarily due to the different ways in which a captive can be structured and utilized by its owners or insureds. The American Institute of Certified Public Accountants and Towers Perrin provide the following definition:
- “Wholly owned subsidiaries created to provide insurance to the parent companies.” (AICPAAudit and Accounting Guides)
- “A closely held insurance company whose insurance business is primarily supplied by and controlled by its owners, and which the original insureds are the principal beneficiaries. A captive insurance company’s insureds have direct involvement and influence over the company’s major operations, including underwriting, claims management policy, and investment.” (Towers Perrin)
By reading between the lines, one can deduce that at the end of the day a captive is really one form of alternative risk financing, or in other words, a structured form of self-insurance. Previously restricted to large corporations, the recent creation of new captive formations, clarification around tax and accounting implications of captive participation, and the insurance market cycles have led organizations ranging from publicly traded companies, to mid and large privately held and tax exempt entities, to groups of
individuals, to look to captive insurance companies as a possible solution to their insurance problems.
Structured Form of Self Insurance
Just like other self-insurance mechanisms, such as policy self-insured retention (SIR) and large deductible programs, a traditional captive arrangement allows an organization to retain part of its risk internally. However, unlike these common risk management tools, a captive insurance program will require prefunding of the risk. Once formed, a captive will operate more or less just like a commercial insurer, issuing an insurance policy and therefore assuming the risk of its parent/owner in exchange for the payment of a predetermined insurance premium. The captive will be licensed as an insurance company in its “domicile” and, though not unlike commercial insurers subject to insurance regulation, will have a more flexible regulatory environment. In this era of Sarbanes-Oxley and increased emphasis on internal controls and transparency, the regulatory environment in which captive insurance companies operate can bring a significant additional level of comfort to executives across all industries, ensuring that their retained risks are accounted for properly in their financial statement.
Why Form or Join a Captive Program?
So why do so many companies now have a captive subsidiary? What are the key reasons or benefits of forming a captive?
- Reduced insurance costs:
During the recent hard market, many companies saw double digit increases in their insurance premiums even though their loss experience remained virtually unchanged. By using a captive they were able to continue charging themselves a premium equal to their historical loss experience.
- Stabilized insurance budgets:
While the use of alternatives such as large deductible programs and SIRs helps to reduce overall insurance costs, it may also subject the users to large year-over-year swings in their insurance budget, depending on their claims experience. By using a captive, an entity may be able to set insurance reserves equal to ultimate expected losses, therefore providing for some consistency in insurance expense. From a subsidiary’s perspective, the captive provides for more consistent year-over-year insurance premiums, as retained earnings in the captive are used to absorb worse-than-expected results in bad years.
- Coverage availability:
The recent medical malpractice and other industry crises have resulted in several commercial insurers pulling out of certain states or lines of coverage altogether, leaving insureds with no insurance options. Many of these insureds have grouped together and formed captive insurers to step in and replace the commercial market.
- Direct Access to the reinsurance market:
A captive provides insureds with direct access to a market they could not access otherwise, or at least not in a very efficient basis – the wholesale reinsurance market. Since reinsurers have lower cost of operation and regulatory barriers, they can often provide coverage at more affordable rates.
- Improved claims handling and data collection:
Under a fully insured or large deductible program, insureds often rely, or are required to rely on their insurer to keep a historical database of their claims activity. Insureds too often discover several years later that the information was not kept in a very useful format or is very difficult to access, especially if they are no longer doing business with the insurers. By using a captive, insureds can often un-bundle claims administration services to Third Party Administrators (TPAs), who specialize in the lines of coverage insured and take control internally of when, what, and how information is reported.
- Possible tax benefits:
Captive insurance taxation is a very complex topic, but in short, there are some tax advantages available only to insurance companies. Under the right set of facts and if structured properly, these tax advantages may be available to a captive program.
- Profit center creation:
While captives are typically used to insure the risk of its parent(s), under the right circumstances and depending on the risk appetite of the captive owner, the entity could be used to insure third party or controlled unrelated risk such as risk of customers, vendors, or franchisees. If managed properly, insuring unrelated risk could become a profitable endeavor to a captive owner.
- Negotiation tool:
Once formed, the greatest benefit of owning a captive is probably the additional negotiation power it provides during discussions with the commercial market. An insured can easily and rapidly decide to insure a risk or a portion of a risk in its captive if it is in a situation of being overcharged by the commercial market. It is not unusual to see an insurer adjusting its rates downward when faced with the likelihood of losing a piece of business to a captive, since once a risk is insured in a captive, it very rarely returns to the market.
The information provided in the Captive Insurance sections courtesy of our captive insurance administration partner, Pro Group Management. Pro Group Captive Management Services was named Captive Manager of the Year, 2013