What Is the Difference between Self-Insurance and Captive Insurance?

Business ownership is filled with a variety of risks, those both known and unknown. Prudent business owners employ various forms of insurance to protect against financial loss. In a traditional commercial insurance arrangement, a business owner pays premiums to a third-party insurance company, effectively transferring some or all the business's risk. However, because commercial insurance companies make profits by charging premiums in excess of expected losses and they retain the entirety of the premium whether the customer has claims or not, sometimes self-insurance is a more logical and economical approach.

Self-insurance is a risk retention mechanism in which, rather than contractually transferring risk to a third party as it would in a traditional commercial insurance arrangement, a company sets aside money to fund future losses. For smaller or more predictable potential claims, self-insuring can improve a company's operating profits by reducing premium costs. Other benefits of self-insurance include gaining access to data that helps business owners make fully informed risk management decisions, being able to cover losses for which commercial insurance coverage may not be available, and being able to retain any premium funds that were set aside but not paid as claims.

There are many different mechanisms that a business owner may choose when deciding to self-insure. Most commonly, people think of self-insurance as a savings account in which funds are set aside to pay for potential future losses. By self-insuring in this way, a business owner can save money by eliminating the administrative overhead costs charged by commercial insurers. However, one potential downside of this type of self-insurance is the possibility that there will not be enough funds to cover a significant loss or a series of losses.

There is another type of self-insurance that is available to most business owners, regardless of the size of their enterprise, that offers all the benefits of a fully self-funded plan and also provides additional incentives and risk management. This type of self-insurance is called captive insurance. Like fully self-funded insurance, captive insurance is a risk mitigation strategy whereby a company insures itself against future losses. In a captive insurance arrangement, however, the insured creates a more formal arrangement for insuring against its unique business risks via the creation of its own insurance company.

By creating its own insurance company, business owners can protect their business against catastrophic losses, create coverage for unique risks that may be unavailable in a traditional insurance arrangement, and build a war chest of funds that will be available for future claims by taking advantage of pretax premium payments and underwriting investment. Captive insurers also retain the unique benefit of being able to purchase reinsurance, creating an additional layer of safety by reinsuring losses above a specific attachment point.

There are several different kinds of captive insurance arrangements that businesses can use to optimize their risk management strategy, depending on their size and the risks that they are looking to insure. Another advantage of captive insurance over fully funded self-insurance is that, in some of these types of arrangements, captive owners have the ability to share risk with other like-minded business owners. This not only allows for greater risk transfer and mitigation but also allows owners of small and medium-sized businesses, who may not have the size and scope to create their own pure captive insurance company, to take advantage of this kind of enterprise risk management. This type of risk distribution allows each participating insured to manage its own risks and generate underwriting profit with unused premium dollars while at the same time sharing a portion of the risk with other business owners.  

For example, a doctor, who is aware of the risks that could potentially be catastrophic to his practice, may seek to insure nontraditional risks like cyber liability or brand reputation. Finding commercial coverage for these types of risks to be unaffordable or unavailable, he is faced with three choices. The first, and probably the most common solution, would be to do nothing and hope these kinds of claims never occur. The second would be to earmark funds and set them aside in case a claim should occur. The third option would be to set up or participate in a captive insurance arrangement. This option would allow the doctor to use pretax dollars to fund the premium, purchase reinsurance to safeguard against catastrophic losses, and, depending on the type of captive insurance arrangement he chooses, share risk with other participants.

Financial historian Peter Bernstein said, "The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome." Alternative risk financing mechanisms, such as self-insurance or captive insurance, give business owners control and transparency not found when accessing the commercial insurance market.