Captive insurance is an increasingly popular form of commercial self-insurance in which the insurance company is a wholly-owned subsidiary of the insured. The insured may be a single parent company or a group of companies. The captive insurer is usually created by the parent company or group to fulfill unique risk management needs that are not fully answered in the commercial insurance market.
Aside from their relationship to the insured entity, captive insurance is subject to many of the same rules as other forms of commercial insurance, including capitalization, reserve requirements, financial reporting and oversight by state insurance regulators.
How does captive insurance work?
Captive insurance is regulated under special purpose laws that recognize that captive insurance is a tool used by sophisticated business insureds who require fewer policyholder protections than coverage that is offered to the general public.
State departments of insurance regulation would generally consider a sophisticated insured to be a large business enterprise, although in some cases, a captive insurance parent may be a non-profit organization, an industry association or another group. In any case, the insured must have capital resources commensurate with insurance of its potential risks.
Captive insurance helps companies manage risks unique to their operations or their industry. A company may have a high frequency of risks or low frequency but with high severity so that conventional coverage is simply unobtainable. For example, businesses in the manufacturing industry may face high premiums due to the increased risks within the industry, but captive insurance offers the potential to secure lower premiums by providing loss records that demonstrate the company’s commitment to worker safety and risk management.
Captive insurance can also provide direct access to reinsurance so that risk can be further mitigated by purchasing coverage from other insurers.
More Control, More Profit, Lower Taxes
In addition to gaining more control over their unique coverage needs, captive insurance may also allow parent organizations to realize tax advantages and to share in underwriting profits that would have been retained by a conventional insurance company. In most cases, the profit motive is more theoretical than practical, as most captive insurers accumulate any surplus rather than distributing profits.
Some businesses arrive at the decision to establish a captive insurance company after a claim has been denied, or after a protracted fight to settle a claim. Others look to captive insurance after a premium increase. In many cases, a large company that already has a robust safety and loss control culture is a ready candidate for captive insurance.
The Development of Captives
The term “captive insurance” was originated by Frederic Reiss, a Harvard trained engineer who specialized in property protection. In 1962, Reiss established the first captive insurance company in Bermuda, chosen for its tax advantages as a domicile.
At first, captive insurance was something of a novelty, but there are now more than 7,000 captive insurers. Captive insurance now provides coverage for about 90 percent of the Fortune 500.
Captive Insurance Domiciles
For federal income tax purposes, captive insurers generally choose a domicile in tax-advantaged jurisdictions, such as Bermuda, Guernsey, Ireland, Luxembourg or the Cayman Islands. Some are also located in U.S. states. Vermont is the leader, with more than 600 captive insurance companies. However, Bermuda remains the largest domicile globally, due to its experience in the industry and the availability of managers and service providers with captive experience.
Growth Driven by Liability
Beginning in the 1970s, juries became increasingly likely to hold companies liable for injuries, awarding large damages to plaintiffs. This brought about a change in the demand for insurance against personal injury, with less emphasis on individuals insuring themselves against the cost of being injured and more emphasis on potential defendants insuring their organization against the cost of being held liable for an injury.
The response of the insurance industry was predictable: companies with a high frequency or severity of risk saw their premiums climb to unaffordable levels or had their coverage canceled altogether. For companies with products or operations carrying inherently higher risks, forming their own licensed insurance company offered a new option.
Why Companies Establish Captives
The decision to establish a captive insurance company requires an independent, entrepreneurial spirit, as the company must put its own capital at risk, instead of reliance on premiums paid to an insurance company.
Captive insureds make a conscious choice to risk their own capital rather than paying to use the capital of a commercial insurer. This choice may be based on either the view that captive insurance is superior to conventional commercial insurance, or on the simple fact that affordable insurance coverage is simply unavailable in the commercial market.
Other objectives of forming a captive may include:
- Coverage for their unique risks may be unavailable
- Needed coverage exceeds the limits of traditional insurers
- Premium prices are excessive for traditional insurance
- Broader coverage is needed to manage unique risks
- Employee benefits require risk distribution
- Special insurance coverage for professional liability
- Cash flow requirements taking priority over premiums
- Leadership seeking control over claims administration
A captive insurance company can provide specialized coverage that is designed to fit the specific risks as well as the actual costs and budget of the insured, features that are not often available with the boilerplate terms of commercial insurance.
Benefits Can Increase Over Time
As the captive develops its risk management capability and accumulates capital, the company can be more assured of the stability of continued coverage, gaining control over its risk mitigation services, tax savings and insurance premiums.
When loss control is more effective, the gains from invested premiums are retained by the company, rather than earning profits for a commercial insurer.
Companies with captive insurance generally find that safety and loss control practices assume higher importance when the company’s own capital is at risk, so there are built-in rewards for effective risk management as a cornerstone of company culture.
Lower Costs, Greater Control
With a captive insurance company, the company also has more incentives to control the fixed costs and variable expenses of the captive insurance operation. Industry figures indicate that commercial insurers, on average, expect 60 percent of collected premiums to be paid out for losses, while 40 percent is allocated to expenses and profit. Because captives have a more focused purpose and structure, their expenses range from 15 to 30 percent.
For many insureds, the most important feature of a captive insurance company is increased control of risk management as an element of their business strategy. Tools like safety policies, loss control initiatives and claims handling can be structured to operate under guidelines that are interpreted and administered for the benefit of the company and its stakeholders.
Who can establish a captive program?
Today, almost any company with sufficient capital reserves can consider captive insurance. The company can form its own subsidiary to underwrite the risks of the parent, or the company can join a group captive in partnership with similar businesses, leaving the management to a professional team.
Forms of Captive Insurance Companies
Captive insurance can be established in various ways, based on the coverage needs and risk management strategy of the parent. Here are some of the most common forms of captive insurance:
Pure Captive
Pure captive insurance companies cover the risks of one parent company and any subsidiaries, affiliates or other entities under the direct control of the parent. Single parent captives are often used to work with reinsurance companies for workers’ compensation.
Association Captive
Association captive insurance companies are group captive companies in which ownership is limited to the members of an association and their affiliates.
Branch Captive
Branch captive insurance companies are entities with a foreign domicile that has been licensed to provide coverage through a branch in the jurisdiction where the insured is located.
Group Captive
Group captive insurance companies are licensed for insurance that is limited to the risks, hazards and liabilities of its group members. Shares in the group captive may be owned by the insureds or by non-insureds.
Industrial Captive
Industrial captive insurance companies are group captives that cover the risks of one or more insureds and their affiliated companies, which are operating in the same industrial insured group.
Micro Captive
Micro captive insurance companies provide coverage with an annual written premium of less than $1.2 million. Micro captives offer a captive option for entities that are too small to organize and fund standard captive insurance.
Sponsored Captive
Sponsored captive insurance companies are formed with the capital of the sponsors, and risks are underwritten outside the commercial regulatory sphere. However, a sponsored captive is not an insurance company formed by its insureds. Rather, their group captive investors are referred to as participants.
Rental Captive
Rental captive insurance companies allow unrelated parties to obtain coverage from an existing sponsored group captive insurer for a fee, avoiding the cost of forming and operating a new company. Some participants in rental captives may not be required to contribute capital as captive owners and in some cases may be non-insureds, such as insurance agents.
Segregated Cell Captive
Segregated cell captive insurance, also known as protected cell insurance, is similar to rental captive insurance, except that the assets of each user are legally separate, so that the assets of one underwriting account may not be used to satisfy liabilities of another account.
Risk Retention Groups
Risk-retention captive insurance was created by the Risk Retention Act of 1981, allowing insurers to underwrite all types of risk (except workers’ compensation) to avoid the inconvenience of compliance with licensing laws in many states.
When a Captive is Not the Right Choice
When a company has high-risk operations that make coverage unaffordable or unavailable, a captive plan may be the best solution. But every management team must weigh the pros and cons to make the right decision for their stakeholders. Here are a few reasons why some companies chose not to go with captive insurance.
Distraction from Core Business
While a captive insurance company can improve risk management control and generate new profit, senior management may regard running an insurance company as an unwanted loss of focus on the core mission of the business.
Expensive to Form and Operate
A large company that already has adequate coverage, despite high insurance premiums, may not see a large benefit to pure captive insurance with its attendant costs, regulations and management requirements.
Unwanted Attention from the IRS
Although captive insurance is a lawful strategy for tax avoidance, some parent companies have pushed their operations into the realm of malfeasance. Even when the captive insurer is carefully structured for legitimate function, senior management may still see the potential for attracting an Internal Revenue Service audit.
Better Uses for Capital
While a captive can be profitable, results will seldom meet a large company’s required rates of return on the cost of capital. The company CFO may have strong opinions about using those funds for operational investments with better returns, lower risk or both.
Limited Tolerance for Risk
Some companies have a limited tolerance for the added risk of captive insurance. Although all large companies must self-insure to some degree to avoid over-spending on commercial insurance, many will choose to tolerate more cost rather than more risk.
Summary
Put simply, captive insurance is an alternative to traditional insurance companies in which the insurer is established to insure the risks of its owner. Companies risk their own capital to create a wholly-owned insurance subsidiary, working outside the commercial insurance market to control their own risk strategy.
A captive owned by the insured is known as a pure captive. A captive owned by unrelated parties is called a sponsored captive. Pure captives may have a single parent or may be a group captive with multiple owners. A sponsored captive that charges a fee for access may be referred to as a rental captive or, in cases where underwriting accounts are kept legally separate, a cell captive.
As with all risk capital invested in the business, the company owners expect returns, which may include improved cash flow, coverage tailored to their unique risks, advantaged tax treatment, or, in some cases, the ability to simply obtain coverage when unavailable through commercial insurers.
Captive insurance is considered an option for sophisticated insureds. Generally, these are larger companies that do not require the protections of more closely regulated commercial insurance. While captive insurance is not the right choice for every company, thousands of companies worldwide have made it the foundation of their risk management strategy.
Every captive is different, and not all coverages will work for all captives. With this in mind, we recommend discussing your needs with a seasoned captive insurance specialist. Contact us today to learn more.
