What Is A Captive Insurance Company?

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What is a captive insurance company? Captive insurers are organizations that create a licensed insurance company that are owned by the insureds.

What Is A Captive Insurance Company?

What Is A Captive Insurance Company?

So what is a captive insurance company? A captive insurance company, or captive, typically refers to a company formed by a particular business (or by multiple organizations, typically within the same industry). Its purpose is to provide insurance coverage for that owner's/business' assets.

Further, the captive's business operation is controlled by its owner/company. In theory, the very earliest insurance operations were captive arrangements. Most jurisdictions treat captives as non-admitted insurers; therefore captives acquire the assistance of a fronting company.

Why Captive Insurers Are Created

Originally captives were formed, not as an alternative to traditional insurance, but as a last resort (because an insurance option was unavailable). The earliest captives were created by entities needing protection against highly hazardous loss exposures that were either unavailable or only available at a prohibitive cost though the traditional insurance marketplace.

The failure to respond by many traditional insurance companies led to the explosive growth of "offshore" captive insurance companies and to the development of the 1986 Federal Risk Retention Act (FRRA). This act made it legal for similar or related businesses or groups to be formed and combined for the purpose of buying liability insurance. In addition, many insureds could not find affordable insurance coverage for their liability exposures, had to forego traditional insurance coverage altogether and "went bare."

These companies simply paid claims out of their operating income. Many companies in both traditional and non-traditional arrangements began putting risk management programs in place to reduce or eliminate loss exposures.

What is a captive insurance company? Captive insurance companies were first created in the 1950s. At that time, many large companies wanted to form "offshore" insurance facilities to be used to finance their loss exposures. This risk transfer mechanism lowered insurance costs for the corporation. The technique also allowed "premiums" to be deducted from taxes as legitimate business expenses. Shortly afterwards, the Internal Revenue Service (IRS) became aware of that strategy and made any tax advantages subject to strict rules, including accounting tests that verified an actual shifting of risk ins such arrangements.

In spite of that, and because of the volatility of traditional commercial insurance companies in the United States, the number of captives continued to grow. Even though the tax deduction benefit was removed, offshore captives continued to operate and prosper, because corporations wanted to reduce the costs of dealing with risk by at least reducing or eliminating the expense component of traditional insurance premiums.

Many large corporations wanted the investment income generated from not only the premiums paid to captive insurance companies but also on the loss reserves generated by those premiums. This provided even more motivation to form captive insurers. Sophisticated corporate risk managers realized they could benefit from any of a number of insurance premium-related investment income opportunities. This was seen as yet another advantage over purchasing commercial insurance coverage from an insurance company that controlled premiums, loss reserves and the interest income that those funds generated.

Note: Due to the growth and increasing viability of the captive insurance marketplace, now middle-market and even smaller businesses have access to captives.

Initially, most offshore captives were "pure" captives, insurers established by a non-insurance parent company solely for the purpose of underwriting risks for the parent company and its affiliates. As time passed, many pure captives found even greater tax advantages if they insured organizations unrelated to their parent company. Unfortunately, a number of former pure captives became insolvent because of poor business practices due primarily to writing more business than they had the capacity or expertise to handle properly.

Around the same period, and due to the same forces, the concept of group or association captives became popular. These were insurance companies established and capitalized by a group of businesses to underwrite and insure their own collective insurance risks. In addition, many trade associations formed and funded association captives to underwrite and insure risks of the members of a particular trade association.

The implementation of the Federal Risk Retention Act encouraged formation of captive insurance companies known as Risk Retention Groups (RRGs). These were formed under the federal law to write liability insurance for members of the group. The continued viability of risk retention groups and the existence of brokers and special management groups providing underwriting, claims and other administrative services for captives in the United States encouraged many states to adopt captive insurance laws to attract captive programs.

Captive Insurers Domiciles

Vermont, the first state to become a United States domicile for captives, allows risk retention groups with a minimum capitalization of $500,000 but most captives receiving approval have far more than the minimum capitalization. The following states are United States Captive Domiciles:

These states benefit from the Federal Risk Retention Act, because it requires that the domicile of a risk retention group be on-shore and not at any offshore site.

Both state and offshore domiciles actively campaign to attract captive companies and encourage them to locate in the domicile location. The reasons are that captive or alternative market operations generate considerable revenue without some of the problems that might accompany other types of businesses, such as air pollution with a manufacturing concern.

Captives were usually formed at locations outside of the United States or "off-shore." Foreign and "off-shore" captives had the advantage of not being subject to the premium taxation and insurance regulations of any state. Bermuda was a major domicile location for offshore captives but other popular locations included the Bahamas, Barbados and the Cayman Islands. These groups contributed to the viability of the alternative risk market because they represented another method of insuring risk beyond the traditional insurance mechanism.

Foreign Captive Insurers Locations

The locations that offer the greatest flexibility and potential profitability (as well as most flexible tax treatment) exist outside of U.S. borders. Current foreign domiciles include the following:

The formation of captives and the level of alternative market use are affected significantly by changes in insurance pricing and coverage availability in traditional markets. Businesses that were forced to self-fund during past hard markets have learned from that experience and have become more committed to using alternative markets. In addition, since many of these alternative markets are better able to control their insurance costs, they are less vulnerable to the pricing volatility regularly seen in the traditional market.

Some businesses are forced into self-funding or "went bare" in the past return to the traditional commercial market as rates drop, pricing becomes more attractive and coverage forms broaden. However, some larger concerns have developed effective self-funding techniques and have either decided not to return to the traditional market or return to it only with high deductibles or at higher attachment points.

Many corporate clients of risk management consultants become familiar with alternate risk funding mechanisms when the traditional market hardens, prices increase, capacity decreases and coverage terms constrict and become narrower. Often, this hard-earned familiarity leads to permanent, more sophisticated use of the alternative market.

Lines Of Business Written By Captives

Decades ago, modern captive arrangements were first formed to provide coverage for medical malpractice and pollution liability exposures. Today, captives (in various forms) are used to insure a wide variety of lines of business for its owners, such as professional liability, commercial auto, employer's liability, product liability, and property damage.

Captives also provide a source of protection for non-traditional (property and casualty) sources of loss such as:

Benefits of Using A Captive Insurance Company

The typical advantages of forming and using a captive insurer include reduced cost of protection, greater access to insurance and reinsurance, more control over managing risks, more efficient use of financial resources, etc. Specifically, the following are solid reasons for use of a captive:

Less Dependence On Commercial Insurance Marketplace

A well-funded captive that has the proper capacity to handle possible losses may be a reliable source of protection that may end the need to deal with the problems of the commercial insurance marketplace; particularly with availability and pricing issues. Reduced dependence on the traditional insurance marketplace can be particularly important when newer and unforeseen sources of operations liability develop.

Access To Reinsurance

A successful captive operation permits its owner to secure its own source of reinsurance coverage. Since such coverage is acquired directly, the cost of reinsurance would be reduced. Specifically, the captive sponsor does not have to pay the expense loads charged by commercial carriers. Use of a properly funded and operated captive also increases the likelihood that the desired amount of reinsurance will be available.

Special Group Expertise

Insurance availability problems have spurred development of groups or associations forming multiple-owner captives. Since such groups are made up of entities operating in the same industry or environment, each member gains valuable access to expert advice. Owner/members share information on how to address industry-specific (or profession-specific) exposures. They also share insights on loss prevention or mitigation. This level of insight is rarely available under traditional insured/insurer arrangements.

Access To Broader Coverage

Depending upon where the captive insurer is formed (U.S., Bermuda, Cayman Islands and many other locales), the captive's owner may be able to insure a much wider variety of risks such as strikers liability, political risks, property seizure (by government authorities), corporate espionage, hazardous manufacturing processes, etc.

Tax Benefits

Such benefits are highly dependent upon the structure of the captive and the laws of where the captive is domiciled. However, in certain instances, a captive may allow special tax treatment of a captive's funds used in loss reserves, deductibility of premiums, and favorable treatment of accumulated income from underwriting and investment actions, and reduced premium taxes. However, forming a captive primarily as a basis to gain tax benefits is among the poorer reasons for doing so. Actual tax benefits are extremely difficult to determine and it takes lengthy consultation with expert sources to be able to quantify such savings.

Addition of a Profit Center

A party establishing a captive could benefit from its full control of funds that, otherwise, would be paid to an insurer in the form of advanced premium. The enhanced cash flow could create opportunities for greater investment income. Further, a successful captive may also generate underwriting income, evolving into a new area of revenue for its corporate owner.

Greater Control

Ownership of a captive offers the benefit of creating far greater control. The parent company would oversee the captive's efforts in controlling cost, providing needed coverage and maintaining control of claims, loss investigations and related expenses.

Improved Insurance Program

Because of the high level of control, a captive insurance company can result in more effective insurance coverage. In order to meet the needs of its owner or owner group, a captive can tailor its program to provide precise coverage and rapid response to losses (the latter facilitated by creating and maintaining its own claims-handling procedures). The coverage may also correspond with a more effective loss prevention/mitigation strategy.

Enhanced Risk Management Program Tracking

A parent captive insurance company operates as its own financial entity and that includes the development and reporting of its separate financial results. The operation's balance and P&L documents are a tangible source for measuring the effectiveness of the parent operation's use of risk management dollars.

Reduction In Level Of Regulations

Although every domicile provides some level of regulation for captives it approves, captives still are far less regulated than licensed insurers. Shrewd captive owners are in a good position to run their insurer in a manner that maximizes both coverage and overall goals.

Underwriting Advantages

A captive may be able to price and underwrite its own exposure more effectively since it would have access to all critical information regarding losses. Its parent's or ownership group's claim activity/history may be scrutinized in far more depth, permitting more accurate assessment of future loss exposure.

IBNR Calculations

While the owners of a captive may need to get an actuary's assistance in establishing initial and maintaining Incurred But Not Reported (IBNR) losses, a captive is typically in a position to out-perform insurers in this area. The captive's sponsoring company allows its insurer access to a variety of financial tools to assist in calculations, especially in regards to tracking claims and near-claims activities. The latter, crucial information, the depth of loss history or level of detail is rarely available to a licensed carrier when it insures a particular business.

Disadvantages Of Using A Captive

The formation and use of a captive by some organizations has been a mistake, done without proper planning and, in some instances, pursued on a whim or as part of a trend. While there are several substantial reasons that justify captives; there are other considerations. A captive may be inappropriate if an ownership entity:

How Captives Are Formed

The requirements for forming a captive insurer may vary according to the jurisdiction selected as the domicile. However, formation typically involves the following steps.

Formally Determining The Need For A Captive: This is usually done by performing a feasibility study that examines the organization's exposure situation, relevant financial information and non-financial resources (particularly personnel). The study should also consider the likely tax consequences, and legal issues. These are critical in order to determine whether forming a captive is a proper move.

Establish The Captive Type: Document its purpose (line of business written) and form of ownership (single, association, third party, etc.).

Capitalization: The owner or ownership group has to determine the amount that will be used to initially fund the proposed captive. Naturally, the minimum amount must be the minimum amount required by the applicable jurisdiction. A captive's sponsor will then have the ongoing, critical duty of maintaining proper funding. Traditionally, adequate capitalization has always been a major concern of regulators.

Determining Board of Directors and Chief Officers: How many persons (and who) will make up the captive's board and its executive officers. The secretary position is particularly important since he/she is generally the executive who routinely interacts with insurance authorities.

Naming the Captive: This may seem trivial, but some jurisdictions insist that it be done early in order to clear the name for use. Authorities require this in order to avoid approving captives with the same (or similar) name as an existing insurer. This helps preserve an authority's ability to regulate and monitor its jurisdiction's captives.

Fronting Arrangements: This requires working with a chosen fronting entity to determine claims procedures, forms (particularly policy language), reinsurance, fees, reports, etc.

Collect and Submit Captive Application Forms/Information: Typically a package that must be submitted for a captive's approval includes:

Additional Implementation Strategy: If not done in other steps, the potential captive owner should determine on-going funding, coverage/limit provisions, securing reinsurance, creating a loss mitigation/prevention plan, etc.

Completing And Submitting Other, Applicable Forms (Such As)::

Types of Captives

There are various versions of captives. The variations are based upon the party that forms the captive and how the captive is structured. There are no official categories as different captive sponsors, associations and jurisdictions often use different terms. Further, as time passes, different ideas develop concerning how captives may be used, so new terms are being created to reflect new uses or combinations of ownership. Following are a number of types of captive arrangements:

What Is A Captive Insurance Company? - The Bottom Line

We hope this article on what is a captive insurance company? has been informative. Captives have long established themselves as a credible method for an operation that wants to play a major role in handling their exposure to loss and their related costs. Currently, more U.S. and International jurisdictions are opening their doors to facilitate the formation of captives in their various forms. Annual statistics indicate an increase in the numbers and kinds of captives.

Unfortunately, as captives grow as an alternative method to address risk for a wider range of businesses, it is also growing as an area for fraudulent activity. It is important that businesses that contemplate use of a captive seek professional guidance to assure that they create a valid, legal risk management vehicle.

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