What is a captive?

Captives are part of what is broadly known as the Alternative Risk Financing market (ARF). Alternative risk financing mechanisms, such as captives, are designed to find more resourceful ways to manage risk. A captive is an insurance company that is a lawful entity created, wholly owned, and controlled by a person or a financial, industrial, commercial, or governmental party (or parties) to underwrite all (or a portion of) the risks of that party and its affiliates. The meaning of a captive can also be extended to encompass insurance of risks of other parties. Captives are most often domiciled in a particular location, and may be either onshore or offshore. There are two basic types of captives: those owned by risk financing service providers and those owned by the insured.

Characteristics of Captive Insurance

  • Captives are distinguished from commercial insurers because they require the insured to contribute risk capital.
  • Owners of captives are also the beneficiaries of their profitability.
  • Captives are owned and controlled by their insured. Unlike non-captive commercial mutual insurance companies, captive owners actively participate in the running of the company.
  • Owners of captives take the risks and reap the rewards of using their own capital.
  • Captives enable the insured to satisfy their risk financing objectives.

Types of Captives

Captives come in any shapes and sizes. Each has it’s own benefits and burdens. There are a broad range of insurance institutions organized under the “captive” umbrella. For example, some captives are owned by a single parent, and write business only for that parent, others are owned by and underwrite for an association or industry group. Sometimes, a party unrelated to the insured owns the captive, but “rents” the captive surplus to a firm who wants to set up a self-insurance program. The choice depends on the sponsoring entities goals and objectives. Some captives engage in active underwriting through risk classification and pooling. Some are simply a conduit through which the assumed risks are transferred to international reinsurance markets.

Common Types of Captives
  • Segregated Portfolio Companies (SPC)
    A Segregated Portfolio Company (SPC) (sometimes called a Protected Cell Company (PCC) or Segregated Accounts Company (SCC)) is an insurance or reinsurance company that operates as a single legal entity allowing liabilities and assets to be allocated between separate sheltered cells or segregated portfolios within the organization.
  • Rent-A-Captives
    A Rent-A-Captive is an arrangement where an owner of a captive makes available to others a segment of the captive for a fee. A Rent-A-Captive insures the risks of its renters and returns investment income and underwriting proceeds to the insured. Some companies “rent” their surplus to entities that want to establish a self-insurance program but prefer to capitalize their own captive.
  • Association Captives
    An Association Captive is a company owned by a trade, industry, or service group for the advantage of its members. Ownership rests with the association or its members. In most cases, there is a financial specialist at the association level who retains primary responsibility. Sometimes this responsibility is managed by a broker, management company, or consultant.
  • Single Parent Captives
    Often called “pure” captives, a Single Parent Captive is a reinsurance or insurance company that is a wholly owned subsidiary of an entity created to insure the risks of its non-insurance parent or affiliates. Single Parent Captives are usually monitored by a risk manager or financial officer of the parent company. In some cases, a domiciled insurance management company oversees management.
  • Group Captives
    A Group Captive (Stock or Mutual) is an entity created and jointly owned by several companies to supply a vehicle to meet a universal insurance need.

Advantages of Captives

Captives have many advantages. They can help your organization reach financial, insurance, and tactical goals in a number of important ways, including:

  • A Reduced Dependence on Commercial Insurance
  • The Ability to Create a Profit Center
  • Access to Reinsurance Markets
  • Reduction of Expenditures on Risk Management
  • Enhanced Cash Flow
  • Reduced Government Interference and Regulation
  • Price Stabilization
  • Access to the Advantageous Underwriting Intrinsic in Captives
  • Possible Tax Advantages
  • The Ability to Tailor Insurance Programs
  • Provisioning of Cover Where Otherwise Unavailable
  • Opportunities to Improve Control and Claims Handling
  • Formalized Allocation of Deductibles for Self-Insurance Retention within the Entity

The control available to the parent through ownership of a captive is useful because it permits the tailoring of insurance products and underwriting standards to the specific needs of the insured. It is particularly useful when insurance may be otherwise prohibitively expensive or not available.

Captive ownership also provides the parent an enhanced degree of control when determining appropriate claims settlement and litigation strategies. Such control allows for meeting the needs of the parent instead of those of the indemnifying insurer.

A captive also provides for direct access to reinsurance markets that can reduce the cost of laying off risks. Through captive ownership, a parent can reap the benefits of advantageous loss experiences enjoyed by the captive.

A captive can also reduce dependence on the commercial market place. When structured correctly, captives provide the needed flexibility for business challenges. Captives make it possible for companies to provide or obtain coverage that would not necessarily be available from the commercial market. Captives can also help widen coverage and simplify insurance contract terminology. Captives are useful for companies seeking ways to gain broader access to existing cost structuring services and alternative risk financing markets.

Through the use of captives, premiums, which frequently surpass the amounts repaid to cover losses, it is possible to capture’ the proceeds that have been paid to commercial insurers.

With captives, operational costs are likely less than the expenses incurred by commercial carriers.

Because captives have control over premiums, its investments may be determined by the business decisions of its own Investment Advisors and/or Board of Directors. By offering insurance to associated third parties such as franchisees, captives can also provide coverage for unrelated third parties using reinsurance pools or treaties (within limits provided by the domicile). By centering all information in one body, a captive can help appraise and gauge the financial impact of a risk management program.

Lastly, captives can utilize and take advantage of the premiums. The timing of premium and claim payments to best match the parent can supply cash flow advantages not available in the conventional market.

Common Questions about Captives

What differentiates a captive from other self-insurance pools and risk purchasing groups?
A captive is a licensed insurance company. It can buy insurance, issue policies, and receive commissions from reinsurers. With captives, unlike other self-insurance pools and risk purchasing groups, risk is transferred to the captive and the captive has a contractual responsibility for payment, not just administrative responsibility.

What kinds of risk can be insured by a captive?
Many captive programs can manage risks that traditional commercial programs will not or cannot cover. Speculative business risk is one such risk captives can cover that traditional insurers may not. Unlike commercial insurers who only underwrite risk that is profitable and can be statistically calculated from the risk pool, captives can underwrite a risk that provides a financial or other benefit to its insured. A captive can insure unique risks that would otherwise not be accepted by traditional underwriting methods because the underwriting class is composed of so few insureds. Finally, unlike commercial insurers, captives can insure those who have numerous risks.

Do captives do more than simply function as risk financing mechanisms?
Captives can be used to facilitate the management of operational risk. Its use in the risk management process improves the ability to quantify risk and provides an incentive to control its financial impact. Captives can insure risks that commercial insurance cannot. They can insure risks that an organization chooses not to insure commercially. In addition, captives are valuable because they can be used to facilitate the management of all facets of operational risk.

How are captives different from selfinsurance?
Captive insurance has the advantages of selfinsurance without the disadvantages of commercially available insurance. Provided the captive is sufficiently funded to pay all losses and it is not structured to raise or lower a policy premium to an amount equal to expenses and policy losses incurred during the term of the policy, unlike self-insurance, the captive is a true mechanism of transferring risk. The liabilities that are assumed by the captive are consolidated with shareholder financial results, however a captive policy can transfer the risk of loss from operations to the captive, as long as the captive is not owned by the operating company incurring the risk. Finally, a captive allows the insured, through control or affiliation with the captive, to benefit from underwriting profitability.

Are captives cost-effective mechanisms for managing risk?
Captive expense ratios are lower than those of commercial insurers when the captive writes on a direct basis. The use of a fronting company eliminates the differential. The real cost reduction comes from using a captive to control cash flow and increase an insureds willingness and ability to retain more risk. Using captives enables the insured to share in underwriting results and cash flow benefits. In addition, having a captive available can result in commercial insurance reductions simply because of price competition. Lastly, captives enable unbundling of costs usually included in the premium, such as inspections and other policies. Unbundling services reduces premium taxes paid by the insured.

What about taxes?
The captive form of insurance may provide a tax benefit to the parent firm. Contributions to a self-insurance pool are not recognized by the IRS to be tax-deductible business expenses, although the actual losses are deducible as they are paid. Premium payments to an insurer are, however, permissible business expenses that may be used as an offset to taxable corporate profits. In general, premium payments to a wholly owned captive should be tax deductible if the captive writes a substantial amount of business that is unrelated to the parent company. The tax and accounting treatment of insurance allows the insured and insurer to recognize the ultimate expected cost of the risk the year the losses are incurred. The tax and accounting treatment of insurance may provide advantages to the owners of captives, with the amount of benefit determined by the captive program structure and the types of risks insured. We recommend you discuss the benefits of captives with a qualified tax professional.

How do I now the captive is operating like it should?
The captives operating and claims handling procedures must support the transfer of risk from the insured operating entity to accomplish the shareholders’ financial objectives.

How much risk should be retained in a captive?
The lines of insurance underwritten, the terms of the policies, the rating methodology, and the availability of capital and surplus determine how much risk can be insured. Consideration of efficient use of capital influences the actual amount of risk that a captive should retain.

What about captive reinsurance?
Direct access to reinsurance is one way an insured retains control over their risk financing programs and reduces their cost of risk.

How can a captive be used to allow an insured to finance retained risk off the balance sheet?
Because of its flexibility, captive insurance enables an insured to determine whether to finance risk off or on the balance sheet, taking into account which approach delivers the best financial benefits. Off balance sheet solutions include blended finite risk reinsurance. Alternative captive ownership structures, which include sponsored or cell captives, allow for the financial results of the captive to be excluded from consolidation with the insureds financial results. Captives can also be used as a special purpose vehicle for risk secularization, as in the financing of enterprise risks. Finally, group owned captive facilities can be used to facilitate credit enhancement for operational risk financing securities.

What about staying in compliance with the law?
Responsibility for whether the company achieves its business purpose lies with its’ directors. The captive’s directors appoint a management team to carry out the business functions of the insurance company. The captives underwriting documentation and associated contracts must support the captive’s business plan and provide evidence that the captive is legally involved in writing insurance. The captive’s financial records (whether internal or external) must supply adequate information to allow directors and regulators to assess the captive’s financial solvency. Captive meetings are held to support the captives risk management purpose. We suggest our clients consult a qualified legal professional for questions regarding captive law.

Structuring a Captive

here are two basic ways to structure a captive. One is to act as a reinsurer of a fronting’ insurance company, the other is to act as a direct writer and issue your own policies. The captive’s domicile, coverage offered by the captive, and the necessary services determine the way a captive can participate in its parent company’s insurance program. Legislation in some countries imposes limitations on the ability of captives not licensed in that country to write policies of concern to that country. Alternatively, captives can be structured to issue their own policies. A direct writing captive must supply, or sub-contract, all claims handling and loss control services that are required to maintain the insurance program. A direct program can be more cost effective than a fronted program and may provide a more adaptable approach to program structure.

Considerations When Forming a Captive

Not withstanding the many prospective rewards of creating a captive, several key considerations exist and the risks involved must be assessed when operating a captive facility.

Among others, key considerations include:

  • Increased administration burden
  • Volatility of the reinsurance market
  • Delegation
  • Run-off
  • Acquisition of expertise
  • Capital commitment
  • Merger or acquisition

A wholly owned captive does not automatically create risk transfer. The captive must pay the losses that fall within the captive’s custody underwriting discipline and simply forming a captive won’t erase bad loss history. Reinsurance can help protect against the risk of adverse operating consequences. The incorporation and operation costs of a captive entail a range of expenditures including organizational costs, annual operating costs such as management fees, actuarial fees, legal fees, audit fees, regulatory fees (license, review fees), and premium taxes. The operating costs can be balanced by investment income earned from the premium flow and paid-in capital.

Incorporating a single parent captive requires ample capitalization. Most domiciles provide enough elasticity in the capitalization requirements to permit resourceful alternatives such as letters of credit instead of cash. Depending on the domicile, regulators may call for the captive to maintain $1 of capital to every $5 of premium written on an annual basis. If a letter of credit is used to capitalize the insurance subsidiary, the company is required to appraise the opportunity cost of the use of its credit line to grant the necessary letter of credit to capitalize the captive appropriately. The captive owner could gain opportunity costs by placing money in the captive since the parent could invest such funds in working capital or in capital projects at rates of return that are larger than the interest rate earned on investments in the captive. Organizations have the flexibility to lessen the cost of capital through loans issued from the captive back to the parent.

Finally, a captive should not be viewed as merely a different type of insurance program that is easily altered. It is a new company that requires actuarial reviews, financial audits, and observance of a defined business plan. A long-term pledge to its success (at least five to seven years) is required.

Captives: An Overview 2004 DC Risk Solutions, Ltd.