AN OVERVIEW OF CAPTIVE INSURANCE

Introduction

A business faces numerous risks in its day-to-day operations, and managing this risk is paramount to a thriving and successful company. Rising insurance costs coupled with increasing self-insured risk is a major issue faced by many businesses. Despite sound risk management programs and reductions in losses and claims, premiums often rise, seemingly indiscriminately, ebbing and flowing with insurance market cycles.

In order to mitigate these risks, an increasing number of businesses are implementing captive insurance programs. A captive insurance company is a subsidiary or affiliate of the business entities that is formed to insure or reinsure the risks of those entities. Reasonable insurance premiums paid to a properly structured captive are deductible by the affiliated companies. This article will describe the origin, advantages and types of captive insurance in brief.

Captive

Captive insurance refers to a subsidiary corporation established to provide insurance to the parent company and its affiliates. A captive insurance company represents an option for many corporations and groups that want to take financial control and manage risks by underwriting their own insurance rather than paying premiums to third-party insurers.

A captive is a closely held insurance company established primarily to insure the risks of its parent company and affiliated groups. Day to day operations is controlled by the owners, who will also be the principal insureds. These operations include: underwriting and claims decisions as well as an investment policy of the captive.

In its simplest form, a captive is a wholly owned subsidiary created to provide insurance to its non-insurance parent company (or companies). Captives are established to meet the risk-management needs of the owners or members. They are essentially a form of self-insurance whereby the insurer is owned wholly by the insured.

Once established, the captive operates like any commercial insurer. It issues policies, collects premiums and pays claims, but it does not offer insurance to the public and it is regulated as a captive, rather than as a traditional insurer.

The International Association of Insurance Commissioners (IAIS) defines a captive as “an insurance or reinsurance entity created and owned, directly or indirectly, by one or more industrial, commercial or financial entities, other than an insurance or reinsurance group entity, the purpose of which is to provide insurance or reinsurance cover for risks of the entity or entities to which it belongs, or for entities connected to those entities, and only a small part if any of its risk exposure is related to providing insurance or reinsurance to other parties”.

Functions of Captive Insurance Companies

Captive Insurance Companies are responsible for:

1. Collecting Premiums
2. Issuing insurance or reinsuring a fronting company
3. Setting aside reserves sufficient to pay potential claims.
4. Issue dividends to insureds (mutual) and owners.
5. Manage the investment policy of the captive.

Historical overview of Captive Insurance Industry

It is generally believed that captives originated over 500 years ago in the 1600s when ship owners in London met in Lloyd’s coffee shop to write down their names and value of cargo. Even earlier, ship owners in Italy’s seaport villages were making similar risk sharing arrangements. These are believed to be the first private agreements to share risks associated with shipping fleets and cargo.

In the 1800s, New England textile manufacturers formed a group to share risks due to high fire insurance rates. In the early 1900s, the Episcopal Church formed the Church Insurance Company to cover risks associated with member churches. At the end of World War II, the use of captives expanded with the industrial boom.

The term “captive” was coined in the 1950s by Fred Reiss, known as the father of captive insurance, when in 1958 he formed American Risk Management. During this time, U.S. regulations made it prohibitively expensive to form and operate captives in the US. Bermuda in 1962 assisted Reiss in forming what is believed to be the first modern day captive. By the end of the 1960s, there were approximately 100 captive insurance companies.

Bermuda was the clear leading domicile and it and the Cayman Islands emerged as global financial centers accommodating these and other sophisticated hybrid legal vehicles. By 1978, Bermuda became the first country to formalize the captive industry with comprehensive legislation and standardize licensing and oversight procedures.

Cayman Islands immediately followed and wrote captive legislation targeting the healthcare industry. Harvard’s medical hospital formed one of the first pure Cayman Islands captives to supplement and control professional and medical liability risks due to increasingly expensive commercial market insurance and to improve claims and loss control.

Reasons to form a Captive Insurance Company

The focus of the pure captive is to economically assume risk that is currently self-insured. This may include increasing deductibles on existing policies, assuming all or some of the risk of traditional insurance, or merely taking on the risks of existing deductibles and exclusions. Certain types of coverage are unavailable or difficult to obtain, often due to historic loss experience for a sector or industry, such as medical malpractice, or conditions such as environmental, construction defect, earthquake, or wind and weather.

In addition, conventional insurance is typically provided on a guaranteed cost basis and there is little incentive to improve risk management since there is no participation in the profitability of the insurance program. However, with a captive insurance company, the parent or related companies will benefit from good claims experience, and surplus in the insurance company inures to its shareholders.

Since the client has control of the insurance company, policies can be custom designed. This flexibility allows the captive owner to craft the policy to meet its specific needs from time to time in terms of deductibles, scope of coverage, levels of risk and premiums. Control of the captive also allows for control of the claims process – this is important as there is often litigation with third party insurance companies regarding coverage issues. Control of the captive also means that the client has investment control of its assets, a major benefit not available for premiums and surplus paid to a conventional property and casualty company.

Insurance coverage provided by a Captive Insurance Company

One of the most common abusive practices with captives is to insure a business “risk” with an extremely low probability of occurring. There are numerous acceptable risks that are commonly insured through captives includes the following:

Property

This type of coverage includes fixed asset protection (buildings, equipment, plant), motor (own damage and third party), stocks, work in progress, all risks and contents, business interruption and consequential loss, natural catastrophes (including earthquake, typhoon, wind storm, tornado and flooding), e-commerce (especially disruption of production and service following a virus) etc.

Casualty

Under this type of coverage, workers’ compensation, employers’ liability, general liability, auto liability, public liability, product liability, product recall, medical malpractice, environmental, accident and health, life cover, etc. are included.

Other insurances

Areas such as life, health, employment practices, punitive damages, disruption of supplies are covered.

Advantages

The advantages of captive insurance includes the following

1. Direct access to reinsurance markets

The captive insurances are able to bypass the conventional insurance market and, as an insurer, directly access reinsurance markets. By doing so, markup costs from the primary insurance market are avoided

2. Cost reduction/stabilization

Captives are often formed by insureds that have grown tired of the vagaries and undulations of the retail insurance market. Bypassing the retail insurance market can often lead to cost savings through the elimination or reduction of profit loads, broker commissions and administrative costs.

3. Low overhead

The captive insurances generally have no employees, no marketing expense, no physical property and minimize necessary administrative overhead through careful outsourcing of needed services to professional captive service providers.

4. Provide coverage for strategic partners

Assuming it is actuarially sensible, captives can write risks for industry peers, wholesalers, contractors or any other area where the traditional market’s rate is undesirable.

5. Improve Risk Management

Captives will positively influence operational behavior and enhance loss controls. The tremendous amount of data housed in the captive will help the parent company identify areas for improvement. Captives have traditionally been formed by companies seeking to recapture lost income due to high premium. Subsidizing the poor claims of the larger risk pool or increasing retail insurer profits can create a drag on a company’s bottom line.

6. Stabilization of pricing over time

Insurance market fluctuations have considerably less impact on captive insurance compare to traditional insurance. It is so because the pricing method of captive insurance is based on the insured’s individual loss history rather than the loss history of large and in many ways, unrelated, base of insured.

7. Customization of coverage

Where coverage is unavailable or unaffordable in traditional insurance, a captive is able to manuscript its own customized policy to cover a specific or unusual exposure

8. Improved cash flow

Investment income from unearned premiums can be realized over the full duration of claim exposures. It improves the cash flow of captives.

9. More control over claims handling

A captive establishes and controls it own claims handling policies and procedures and has full access to all claims data.

10. Ability to direct investment options

Captive reserves and surplus are invested at the direction of the captive owner (subject to regulatory liquidity guidelines) and can include not only traditional investment vehicles but also certain investments back into the parent company.

Disadvantages

Captive insurance business has some difficulties as well. The disadvantages includes

1. Capital Commitment

In addition to initial captive formation costs, a parent company will have to meet the mandatory minimum capitalization requirements of the domiciliary jurisdiction. These costs vary widely depending upon the captive domicile and service providers.

2. Administrative Duties

The day-to-day operations and technical aspects of operating an insurance company are generally contracted out to a captive manager and other professionals, the captive owner does have to dedicate time and effort to oversight responsibilities.

3. Mergers and Acquisitions

Ownership of a captive insurance company may complicate merger or acquisition activity.

4. Volatility of the Reinsurance Market

The captives escape the volatility of the primary insurance market, to the extent that they have transferred risk to reinsurers, captives remain susceptible to broader market fluctuations in reinsurance pricing.

5. Closure and Run-off

Depending upon the nature of the risk insured by a captive, liabilities may remain on its books for years thus making the captive difficult to shut down. An exit strategy should be developed as the captive is being formed so as to minimize this potential problem.

Types of Captives

01. Single Parent Captives

Single Parent Captives are separate legal entities that insure the risks of its parent and affiliated companies. They may also accept business from third parties if appropriately licensed and capitalized.

Capital is provided by the parent of the captive insurance company. The Parent maintains complete control over underwriting terms, policy wording, reinsurance decisions and the investment policy.

Features of Single Parent Captives

1. These captives are responsible to one party only.
2. The profits in single parent captives are not shared and are earned by a single owner.
3. Decision making is generally more efficient in single parent captives.

2. Group Captive

A group captive is generally owned by a group of companies which are not related. They are looking to pool their risks into one company in which they can share the insurance risks and claims exposure.

Features of Group Captive

1. Group captives provide greater purchasing power for services and reinsurance, as they operate in a group.
2. The losses are diluted among all captive users and are not borne by only a single user.
3. The group captives have greater need to control losses and costs.
4. They have greater predictability of results.

3. Segregated Cell Captives or Rent-A-Captive

The policyholder is insured by the captive, but has less control over captive operations. The captive facility typically “rents” its capital and surplus to the policyholder and will provide administration and reinsurance services. Evolution of the Rent-a-Captive scenario involves the use of protected cell legislation.

Legal segregation exists between each of the accounts or cells within the captive and between the insured and the owner. Segregated cell companies can be either single parent captives, rent-a-captives or group captives. The capital provider is usually in charge of underwriting guidelines and investment decisions.

The primary advantage of this structure is a smaller barrier to entry. Capital requirements for cells are less than that of single parent captives.

Features of Segregated Cell Captives or Rent-A-Captive

1. These captives have low start up costs.
2. Under Rent-a-captive arrangements, captive management is already in place and this speeds up the process.

4. Risk Retention Groups

Risk Retentions Groups (RRGs) allow businesses with similar insurance needs to pool their risks and form an insurance company that they own and operate under state regulated guidelines.
The primary advantages are the avoidance of multiple state filing fees and the ability to create a more stable market for risk and rates.

5. Association Captive

An insurance company is formed and owned by an industry, trade or service group strictly for the benefit of its members is termed as association captive.

Setting up a Captive

Setting up a captive insurance involves a straightforward process. The important steps are as follows:

Step 1: Feasibility study

A feasibility study aims to gauge the economic viability of the business. The study should provide an in-depth analysis of the business opportunity, including the possible hindrances that may affect the success of the business.

Step 2: Preparation of Business plan

If the business is found feasible, then a detailed business plan is prepared. The business plan should include:
Mission statement

The purpose and type of captive being established (such as international business, domestic business and segregated account company)

Insurance coverage

The type of coverage to be provided by the captive

Operations

Operational management; service organizations (insurance manager, legal, banking, actuarial, tax and audit) to be hired, Projections such as premium written, profitability and capital adequacy are clearly stated in the business plan;

Step 3 – Apply for a license

Captive insurance companies can be formed as international business or domestic business. However the captive insurance company get proper licence from the Insurance Regulatory Agencies.

Step 4 – Start of operations

Once the incorporation procedure is complete and the insurance license has been granted by the ICB, the newly formed company can start business and enjoy the benefits of a captive.

Criteria for establishing successful Captive Insurance

The successful captives have emerged only when

1. They preserve a wide spread of risk either by maintaining a large exposure base within a single line of business or by diversifying risk exposure along multiple lines of business

2. They are formed for legitimate insurance driven purposes rather than for perceived tax advantages

3. They establish and follow strict loss control and risk management protocols

4. Their financial stability is protected by parent companies that refrain from routinely drawing out any accumulated surplus

5. They foster long-term fronting and reinsurance relationships since changing these partners can result in costly “collateral stacking” difficulties

6. They are formed by parent companies with a long-term commitment to operating the captive

7. They maintain the operational and philosophical flexibility to adapt to the changing needs of the parent company; and finally

8. They recognize that every captive has a natural life cycle and that there should be an exit strategy in place for when the captive no longer serves the purposes of its owner.

Conclusion

Captive insurances are an increasingly viable risk financing alternative for companies of all sizes particularly as traditional insurance market pricing has begun to harden. Traditional insurers do not meet every risk-management need for every business.

The captive insurance industry initially developed to formalize a large business enterprise’s self-insurance program. However, the captive insurance marketplace today is much more diverse than when it began.

A captive insurance company provides some businesses an effective means of funding self-insured risks, lowering the cost of certain types of insurance, and maintaining greater control of the risk management process.

If a captive insurance company makes sense for a business, exceptional opportunities exist to transfer substantial wealth to younger generations. Business owners should consult with experienced captive consultants and tax and legal advisors to determine if a captive insurance company is suitable to their circumstances.