5 Questions To Ask When Considering a Captive Insurance Company

Why Establish a Captive Insurance Company?

A captive insurance company is a subsidiary or program you establish for your business to insure against the risk of loss, such as property and casualty, general and product liability, workers compensation, automobile liability, and medical malpractice. A captive insurance company enables you to purchase insurance directly from reinsurance companies at significant cost savings. Under the right circumstances, a captive insurance company can provide myriad benefits and, increasingly, mid-to-large firms are looking to form or join a captive insurance company.

The following discussion covers how captive insurance companies operate, the different types of captives, and five key questions to ask when considering whether to form a captive insurance company.

1. Are you paying premiums of over $1 million annually?
2. Have your firm's historical losses been low?
3. Are you struggling to cover all risks?
4. Is your firm comfortable with risk?
5. Will there be dedicated leadership?

How Do Captive Insurance Companies Operate?

A captive insurance company is defined as an appropriately licensed special purpose subsidiary or affiliate formed by an entity or individual to provide specific types of commercial insurance to its owner/affiliate. The captive assumes a portion of the risks insured, and the balance is assumed by another insurance company known, depending on the specifics of the transaction, as a "fronting" company or a "reinsurance" company.

The benefits for the captive are as follows.

1. The transaction takes place between insurance companies at wholesale premium rates that are generally less than would otherwise be available in the commercial market.
2. The portion of the premium allocable to the captive is accumulated in an investment account pending payment of losses with the earnings accruing to the captive.
3. In some cases, risks that are uninsurable in the commercial market can be insured in the captive market.

Frequently, captive insurance companies are incorporated offshore because of favorable regulatory climate, established professional infrastructure (captive management, legal, and accounting firms), and occasionally favorable taxation. Bermuda and Cayman Islands are the most frequently encountered offshore domiciles. Domestically, half the states in the United States have captive insurance legislation. At the time of this writing, Vermont is the largest, followed by Utah, Delaware, Nevada, Hawaii, North Carolina, Montana, and South Carolina. The defining issue for a domestic captive is a legislative/regulatory regime that recognizes the captive insurance concept as well as professional infrastructure to support it.

Types of Captive Subsidiaries

Single-Parent

Single-parent captives are wholly owned subsidiaries of the parent company. As such, the lines of insurance and the structure of the program can be readily customized to meet individual company or corporate-wide needs. Single-parent captives can also insure related or unrelated (third-party) risk at the discretion of management. Typically, an annual premium of at least $1.5 million is required to achieve the desired cost benefit.

Multiple Parent

Multiple parent captives are jointly owned by a group of companies or persons in the same industry. They are also known as group, homogeneous, or joint venture captives. Group coverage allows for customizing for your specific needs. Multiple parent captives consist mainly of workers compensation, auto liability and damage, and general liability. Typically, an annual premium of $500,000 is required to make your participation financially attractive.

Heterogeneous

For companies of similar size but from varying industries, heterogeneous captives provide an opportunity to pool resources and form a joint venture captive. This is also known as an association captive. Participants in a heterogeneous captive share risks at a predetermined layer. Typically, an annual premium of $500,000 is required to achieve the desired cost benefit.

Rent-a-Captive

For companies within the same industry not large enough to take advantage of forming their own captives, a rent-a-captive provides them an opportunity of obtaining benefits similar to owning a captive. There is generally no sharing of risk among the participants. The owner of the rent-a-captive charges the participants a fee. Over time, if the captive proves successful, the underwriting profits plus investment income may be returned to the participants. Rent-a-captives have higher fixed costs and minimal entry barrier expenses (legal, licensing). Typically, an annual premium of as little as $250,000 is required to achieve the desired cost benefit.

Segregated Cell

Individual cells in a segregated cell captive enjoy legal insulation of assets and liabilities. Legislation has been approved in all major domiciles. Cell segregation varies by demographics, risk profile, and lines of coverage.

Is Captive Insurance Right for You?

Under the right circumstances, a captive can provide myriad benefits and, increasingly, mid-to-large firms are looking to form or join a captive insurance company. Here are some key considerations when determining if a captive insurance fund is right for your firm.

1. Are you paying premiums over $1 mill annually?

Start-up costs, plus the ongoing expenses related to operating the fund, tend to make captives cost prohibitive for firms with insurance costs below this threshold. Subsequently, firms with annual expenses much higher than $1 million annually are more likely candidates for self-insurance.

2. Historically, have your firm's losses been low?

If so, but you are still experiencing annual premium increases resulting from commercial market cycles, then captives are an excellent option.

3. Are you struggling to cover all risks?

Captive insurance companies are specifically designed to support those industries and lines of insurance that have fallen out of favor with the commercial market. These industries with prohibitively expensive premiums, like medical malpractice, are typically overcharged or not provided the amount of insurance to properly operate the business. Captive funds can help bring that back into balance.

4. Is your firm comfortable with risk?

Given that captives are a form of self-insurance, unexpected losses will necessarily impact the profits of the parent firm (especially single-parent captives). Make sure your firm is risk tolerant enough to support a captive insurance subsidiary.

5. Will there be dedicated leadership?

Captives are complicated entities subject to all manner of regulatory rules and guidelines. Given both the risk of unexpected losses and the potential profit center opportunities, it is critical that your captive subsidiary be operated by an experienced project manager operating with the full faith of and access to senior management.

Conclusion

In conclusion, forming a captive is detailed and complex, but the long-term cash and risk management benefits can become a substantial advantage in your business's portfolio. 

(Reprinted with the permission of Comerica Bank.)