In its simplest form, a captive is a separate legal entity created by the owners of a company or related group of companies to provide insurance such company or companies. Captives are established to meet the risk-management needs of the owners and their businesses. Once established, the captive operates like any commercial insurance company – it issues policies, collects premiums and pays claims, but it does not offer insurance to the public. The operating company pays premiums to the captive and the captive insures the risks of the operating company. The premiums paid must correlate with the underlying risks.
The captive market has been around since the 1980s, but over the past two decades, there has been substantial growth. Today, there are more than 7,000 captives that do business around the world in more than 30 jurisdictions. Most new captives formed are now organized by family controlled businesses.
Why Companies Establish Captives?
The captive concept was originally created, and is still best used, to solve a problem. Historically, captive formation and utilization peaked during periods of rising commercial insurance costs and when there was difficulty in obtaining certain types of insurance coverage. This could happen after major events hit commercial insurers, such as terrorist attacks or hurricanes. Today, captive formation and growth continues to rise during both hard and soft markets. Most companies now establish captives for microeconomic reasons such as cost reduction, risk management or risk control.
Captives have become a popular risk-management tool for organizations seeking greater control over managing their insurance needs. Two main drivers for forming captives are risk management and risk financing. A captive allows a company to respond quickly to changes in the commercial insurance market and to identify the most efficient way to finance an identified risk. This could mean a lower cost of coverage than conventional insurance markets or obtaining coverage for risks that would otherwise be quite costly, or unattainable, in the commercial insurance markets.
When the products offered by insurers do not meet an insured’s risk financing needs, the best option might be to form a captive insurer. The main reasons why organizations wish to better control their risk management programs are excessive pricing, limited capacity, coverage that is unavailable in the “traditional” insurance market, or the desire for a more cost-efficient risk financing mechanism. Other reasons for utilizing captive insurance include
- Broader coverage;
- Stability in pricing and availability;
- Increased control over the program; and
- Potential tax advantages.
Many captives are established because insurance in the commercial market is prohibitively expensive, poorly matched to the insured’s needs, or not available at all. A captive insurer can successfully provide coverage for difficult risks that is tailored to fit the exact needs of the insured(s)–as long as the captive operates within sound underwriting, actuarial and regulatory guidelines.
Stability in Pricing and Availability
Pricing stability is achieved over time as a captive matures and expands its own risk retention capability. The more surplus capital that is accumulated, the greater the captive insurer’s ability to retain risk and insulate itself from changes in the commercial insurance market. A captive insurer can also provide stability in the availability of coverage.
Increased Control over the Risk Management Program
Captives offer increased control to captive owners through more direct control over insurance-related services such as safety and loss control, and claims administration. Safety and loss control services established by a captive can be tailored to each operating company’s individual needs, resulting in safer workplaces and more favorable loss experience. Claims handling services are unbundled and separately arranged. Strict guidelines can be also be drafted and enforced by the captive. This is preferable to allowing a commercial insurer, whose interests might be more self-serving than an insured desires, to dictate how claims are handled.
Potential Tax Advantages
In addition to the benefits outlined above, there are certain tax advantages that may exist with respect to forming and operating a captive, HOWEVER, such tax advantages should never be the primary reason why a captive is established. All U.S. jurisdictions require a business plan for regulatory approval and the foundational premise for a captive must be non-tax-related; in other words, the genesis of the captive arrangement must be a legitimate insurance need for a corporate parent or group. Nevertheless, there are important incidental tax benefits associated with forming captives. The principal benefit is the treatment afforded an insurer with regard to establishment of loss reserves under the U.S. Internal Revenue Code.
Specifically, §831(b) of The Internal Revenue Code offers small insurance companies a very powerful tax advantage that can provide financial resources to pay claims. This benefit assumes that legitimate risk is being transferred. This election makes the premiums paid to the captive not subject to income taxes. The reserves are accumulated, and the insurance company is only taxed on its investment income. The application of the 831(b) election is straightforward – any properly structured insurance captive (meeting certain risk diversification and risk transfer requirements) writing less than $2.3 million of annual premium (indexed to inflation) may take this election.
Companies form captives to mitigate their exposure to a wide range of underinsured and uninsured risks. Practically every risk underwritten by a commercial insurer can be provided by a captive (excluding life insurance). The majority of captives provide mainstream property/casualty insurance coverage such as general liability, product liability, workers’ compensation, director and officer (D&O) liability, auto liability and professional liability (e.g., medical malpractice).
Captives also provide specialized coverage for unusual or hard-to-insure risks (e.g., contractor default, deductible reimbursement, accounts receivable, litigation risk, etc.).. Other types of nontraditional insurance coverage that a captive could underwrite includes credit risk, pollution liability, equipment maintenance warranty and employee benefit risks, including medical benefits, personal accident and, in some cases, whole life insurance.
Captive insurance is utilized by insureds that choose to utilize their capital to create their own insurance company to achieve their risk financing objectives. Metzler Captive Solutions stands ready to help you understand how a captive might help you meet your financial and risk financing objectives and ultimately help you lower your Cost of Risk.