Captive Insurance: A Strategic Solution for Private Equity Firms

Interest in captive insurance companies among private equity (PE) firms has been steadily increasing. This growing trend reflects the need for cost-effective risk management solutions in a challenging insurance market. Captives offer PE firms the ability to secure coverage for risks that may be difficult or expensive to insure traditionally while also enabling highly tailored coverage options. These include directors and officers (D&O) liability, errors and omissions (E&O), health insurance, and specialized lines like mergers and acquisitions (M&A) insurance.

"Private equity organizations have to deal with a broad range of risks, which plays well into the utilization of a captive insurance company," said Alan Fine, partner at Armanino Advisory. "Also, for every dollar you pay into the commercial marketplace, you never get that back unless you submit a claim, as opposed to if you pay an insurance premium to a captive and you have a favorable loss ratio, you get that dollar back to use or invest elsewhere."

Captive Benefits

Private equity firms can derive numerous benefits from using captives. Primarily, these include managing their own risks, covering the risks of their portfolio companies, and funding programs such as employee benefits.

Captives provide PE firms with five key benefits.

1. Cost Effectiveness. Unlike traditional insurance programs with fixed annual premiums, which can often lead to inefficiencies when losses are minimal, captives operate on a loss-sensitive model. In this model, premiums are directly correlated with losses incurred. When a portfolio company performs well with lower losses, premiums decrease accordingly. Over time, this profit-sharing mechanism can result in substantial cost savings, potentially reducing insurance costs by 25 percent to 50 percent compared to traditional premiums. Additionally, captives offer significantly lower insurance costs compared to the current hard commercial market.
2. Stability. Captive insurance programs provide stability and predictability, qualities highly valued in the dynamic PE investment landscape. Captive insurance renewals are typically lower than those in the standard market. By taking a proactive approach to risk management, firms can mitigate the effects of market fluctuations and external pressures on insurance costs. This stability supports long-term financial planning and enhances overall portfolio performance.
3. Better Risk Management. Captives allow PE firms to take control of their risk exposure, claims handling, and insurance solutions, tailoring them to their specific needs. By retaining a portion of the risk, firms align their interests with those of their portfolio companies, fostering a culture of risk awareness and mitigation. Participation in captive programs often includes stringent risk control measures and regular safety workshops, leading to operational improvements and reduced claims frequency. Improved control and loss ratios also result in savings on insurance costs and make portfolio companies more attractive to potential buyers.
4. Additional Asset and Deal Sourcing. Every PE firm seeks to source new deals. Group captives enable participants to network with business owners at captive board meetings, typically held twice a year. Beyond deal sourcing and risk mitigation, captives can also serve as valuable assets within a PE firm's portfolio. The reserves accumulated within captives can be leveraged strategically—for internal reinvestment, building a better insurance platform, or negotiating leverage during an exit. This additional financial flexibility strengthens the firm's investment strategy and potential returns.
5. Income and Tax Benefits. Captives allow PE firms to earn and leverage investment income to offset operating expenses. They may also provide potential tax benefits, though these must be carefully verified with tax advisors to ensure compliance with legal requirements.

"First and foremost, captives provide private equity firms with the opportunity to aggregate all of their operating companies' insurance purchasing through a consolidated lens—helping them drive down the overall cost of risk," said Prabal Lakhanpal, senior vice president at Spring Consulting Group. "Yes, there's value in saving dollars by using a captive, too, but the other main motivation for PE firms is to get a holistic sense of the risk across their portfolio of operating companies, especially firms that are taking large shares in these companies.

"PE firms are extremely keen at the PE fund level to better understand how the operating companies as a whole present from a risk profile perspective. For companies operating independently without a holistic risk management strategy, they could be under- or over-insured, and there's no way for them to get their arms around what the right amount of premium for the risk is."

Given the rising cost of healthcare insurance in the commercial market over recent years, captive insurance has emerged as a viable solution for PE firms. By leveraging captives for M&A insurance, PE firms can sell a portfolio company investment with minimal or no future liabilities. This approach removes potential obstacles that could delay deal closings or require funds to be set aside for possible liabilities.

In addition to establishing their own captives, PE firms have increasingly been investing in and acquiring captives and captive managers. Notable examples include Lee Equity Partners, which has invested in Captive Resources backed by Beyond Risk; Summit Partners, which has acquired several risk and insurance services companies, such as BevCap Management and GPW & Associates; and Integrum, which has invested in USI Insurance Services and Strategic Risk Solutions.

Despite the clear benefits captives offer, PE firms face challenges when investing in them. Chief among these is ensuring alignment in the visions and strategies of their various portfolio company holdings.

"The key challenge I frequently see with PE firms investing in captives is the need to align these investments with their overall goals and objectives for each portfolio company," said Anne Marie Towle, CEO of Hylant Global Captive Solutions. "Some PE firms have longer-term strategies that align well with captive insurance companies, as captives are inherently a long-term strategy.

"However, for PE firms with short-term holding strategies, the financial benefits of investing in a captive insurance company may not be fully realized."

Michael Serricchio, managing director and Americas captive consultant leader at Marsh Captive Solutions, said that the biggest challenge for PE firms is adapting to the regulated model of the captive as an insurance vehicle.

"It's all about educating PE companies on the fact that captives are well-regulated by the domiciles where they are based and that they don't need to tie up all of their cash in them," said Mr. Serricchio. "Once you address any preconceived notions they may have, they become much more receptive to the idea of having a captive."

Evaluating the Need for a Captive

To determine whether a captive is a good fit, PE firms must first conduct a feasibility study and perform a thorough analysis of their risk management practices, insurance needs, and claims history. They then need to evaluate the challenges a captive might pose against the potential benefits it offers.

While captive insurance programs may have been overlooked by PE firms in the past, their advantages are increasingly difficult to ignore. From cost savings and stability to enhanced risk management and strategic opportunities, captives present a compelling solution for firms seeking to optimize their insurance strategies and drive long-term value creation.

"There are numerous opportunities and options for PE firms to invest in a captive insurance company," said Ms. Towle. "For example, PE firms could leverage a sponsored or protected cell captive, allowing them to separate their different portfolio companies into individual cells.

"Another option might be a group captive for the PE firm, depending on the length of the holdings within the organization. The flexibility of captive structures makes them an attractive option for PE firms with medium- to long-term holdings."

Mr. Serricchio added, "There are so many different and flexible options available to PE firms. Whether it's dipping their toe in the water with a cell captive or setting up their own single parent captive, there's likely to be something out there that will be a good fit for them."

As the market landscape continues to evolve, adopting innovative risk management solutions like captives could be transformative for PE firms striving to stay ahead of the curve. For those that have already embraced captives, the benefits are yielding immediate returns. For those considering the move, captives offer a viable coverage option with numerous advantages.