Pooling Prosperity: The Benefits of Risk Pooling in Captive Insurance

Risk pooling allows an organization to exchange a portion of its own risk for a share in the combined losses of all pool members within a captive insurance structure. Essentially, each captive member allocates a portion of its direct written premium to the pool, effectively purchasing reinsurance and, in return, assuming an equivalent amount of risk from fellow participants. This concept aligns with Internal Revenue Service (IRS) Ruling 2002-89, a safe harbor provision indicating that a captive insurance company meets the risk distribution requirement if at least 50 percent of its premiums come from third parties. 

The success of larger captive pools and the growth of captives formed to leverage the Section 831(b) election under the Internal Revenue Code resulted in a proliferation of small captive pooling facilities in recent years.  

In essence, risk pooling spreads risk while offering a tax benefit. 

How Risk Pooling Has Changed 

Risk pooling has changed markedly over the past decade, driven by domicile-specific regulatory shifts, innovation, and a rise in captive uptake among small and medium-sized businesses (SMBs) looking for long-term, reliable, and cost-effective insurance solutions. 

"Over time, pooling structures have become increasingly sophisticated, allowing captives to participate in shared risk without being tied directly to the volatility of the broader insurance market," said R. Wesley Sierk, III, a managing director at Risk Management Advisors. "This change has been a game-changer, especially for smaller businesses, which now have lower entry barriers and a predictable cost structure for their coverages. Today, by pooling risks across hundreds of captives, businesses of all sizes can benefit from economies of scale that were once exclusive to only the largest captives." 

Tanja Korff, Bermuda client services leader and senior vice president, Marsh Captive Solutions, said that there has been an increase in risk pooling over the past decade, both in terms of the structures themselves and the risks being insured by them. She said one of the driving factors is a lack of affordable capacity. 

Danny Linton, senior consulting actuary at Pinnacle Actuarial Resources, who works extensively with public entity risk pools, said, "The use of public entity risk pooling within captives has evolved significantly. Initially, these pools explored captives as a means to manage rising insurance costs and gain greater control over their risk management strategies.  

"This shift was driven by the hard insurance market, where traditional insurance became more expensive and less comprehensive. Captives allowed pools to retain certain risks and exclusions, providing a more tailored approach to their specific needs. 

"As the concept matured, public entity risk pools increasingly adopted captives to diversify their risk management portfolios. This trend was bolstered by the flexibility captives offer in terms of investment and coverage options.  

"The strategic use of captives has enabled these entities to negotiate better terms during renewals and focus on specific exposures that are otherwise difficult to insure, particularly in high excess layers. Overall, the last decade has seen captives become a crucial tool for pools aiming to stabilize their risk management and financial planning." 

Best Practice for Risk Pools 

In addition to risk distribution at the individual level, best practices dictate that risk pools use governance and control protocols to ensure structural stability and financial integrity. These include providing timely and accurate reporting, demonstrating underwriting control with new and renewing participants, and maintaining the pool's overall financial strength. 

The risk pool must also be independent or run separately from the members, with separate books and records. Pool managers' focus is to protect all participating members. 

There are several different pool structures available. These include a reinsurance treaty, pooling entity, or fronting company. 

Pooling arrangements can include a range of different coverage lines but generally fall into two broad risk categories. These are more predictable long-tail lines such as workers compensation, general or product liability, or auto liability, which are typically high-frequency, low-severity risks. They also include less predictable high-severity, low-frequency risks such as earthquake, wind, storm, excess liability, and other property lines. 

Pooling arrangements with high-frequency, low-severity risks should produce more stable results than those offering low-frequency catastrophic lines. 

The makeup of the pool depends on the number of members, the amount of premium, the exposures insured, and the volume of claims. In general, as the number of members and diversity of insured exposures increases, so does the pooling effect. In short, the greater the diversification, the more stable the pooled losses should be.

Ms. Korff said that the key consideration for companies looking at risk pooling structures as a form of insurance is their track record.

"For newer pooling structures, it's therefore important to look at the procedural and structural safeguards in place to support adequate pricing, stable loss results, and the solvency of that entity," said Ms. Korff. "It's also important that all of the members of that pool have a like-minded focus on safety, risk mitigation, and loss control." 

Benefits of Risk Pooling 

There are a host of benefits associated with being in a risk pool, not least the fact that they are a more affordable solution for small captives. These include the following. 

• Broader risk diversification of an organization's underwriting portfolio. 
• Reduction in variability of retained captive losses by trading its own losses for a smaller portion of a large pool of more diversified losses. 
• Stabilization of premiums and cash flow. 
• Access to third-party premium in support of the captive's status as an insurance company for tax purposes, thus enabling the captive to deduct premium and accelerate the deduction of losses. 
• Customized coverage and greater control. 
• Profit sharing and reduced claims impact. 
• Improved capital use. 
• Cost efficiency. 

"Public entity risk pooling offers numerous benefits, including significant cost savings through economies of scale and more stable premiums by spreading risk across multiple entities," said Mr. Linton. "It provides enhanced and tailored coverage options that might be otherwise unaffordable, and it improves overall risk management by leveraging shared expertise and resources.

"Additionally, public entities gain greater financial control, allowing for strategic investment and use of reserves. These advantages make pooling an attractive and effective strategy for managing risks efficiently."

Ms. Korff said the key advantages risk pooling provides are the availability of capacity at a reasonable price and risk diversification. This results, she said, in more stable loss results.

"If a captive owner is struggling to get capacity for a risk or the limits on the commercial market are unreasonably priced, then they can look to risk pooling facilities to obtain that," said Ms. Korff. "Equally, if they don't have that issue, they can focus instead on the stabilization of their results through risk pooling too."

Challenges of Risk Pools 

Despite offering multiple benefits, risk pooling also has its downsides.  The main one is that members have no control over the underlying loss control and claims management of other pool members from whom they are assuming losses, with some participants assuming risks they aren't familiar with or don't fully understand.

Therefore, when joining a pool, each member should be comfortable that all counterparties' profiles, including their loss histories, controls, and safety and claims management processes, have been vetted to ensure underwriting risk is fully mitigated. It's also key to use carefully crafted contract terms to clarify member expectations and responsibilities and mitigate counterparty credit risk.

In effect, members need to create a pool of low-frequency risks where loss activity is low or, conversely, a pool of high-frequency risks in which the exposure is more easily identified and less volatile. A sound pool should have similar risks, a common underwriting methodology, a pool manager, and the potential for loss or gain and be set up on an annual basis.

Additionally, the IRS has increased its scrutiny of pooling facilities with captives electing to be taxed under Section 831(b) amid concerns about whether the arrangement provides members with sufficient risk shifting and distribution and whether the coverage lines insured represent true insurance risks. Thus, it is vital captive owners and managers seek tax advice to support their own risk shifting and distribution position.

"Some of the IRS scrutiny we're seeing in the captive insurance industry today is, in my opinion, the result of risk pools that were poorly designed and loosely executed," said Mr. Sierk. "There have been managers who played to the 'letter of the law' rather than the 'spirit of the law', and that has come back to haunt all of us." 

Among the key challenges identified by Mr. Sierk are the following.

• Regulatory compliance and jurisdictional complexity. Capital reserves, financial reporting, tax treatment, and solvency standards vary significantly from one domicile to another. Some jurisdictions offer sophisticated pooling frameworks, while others may impose restrictive or ambiguous regulations. 
• Participant alignment and homogeneity. Misalignment in risk levels among members can drive up the pool's overall costs, as higher-risk members increase expenses that lower-risk members may inadvertently subsidize. 
• Operational transparency and trust. The stability of the pool depends on trust and transparency; any doubts about integrity or concerns over mismanagement can undermine confidence in the pool. 
• Adverse selection and moral hazard. High-risk members may join the pool with the intent of benefiting from shared costs, creating adverse selection. Additionally, moral hazard can arise when members take on riskier behaviors, knowing the pool provides coverage. 
• Financial stability and capitalization. Effective risk pooling depends on a robust structure, disciplined oversight, and transparent practices. The strength of the pool relies on these foundational elements. 

Mr. Linton said, "Public entity risk pooling presents several key challenges that captive owners and managers must consider. One significant challenge is adverse selection, where entities with higher risks are more likely to join the pool, potentially increasing overall costs.

"Additionally, moral hazard can arise, as members might engage in riskier behavior, feeling protected by the pool. The complexity of finding willing participants and agreeing on terms can also be a hurdle, requiring considerable time and effort.

"Captive owners and managers need to ensure the financial stability of the pool, maintaining sufficient reserves to cover potential claims. Conducting thorough risk assessments is crucial to set appropriate premiums and maintain a balanced mix of high and low-risk members.

"Effective governance and transparency are essential to manage the pool efficiently and maintain trust among participants. Overall, while public entity risk pools offer significant benefits, it requires careful planning and management to address these challenges effectively." 

Future of Risk Pooling 

Looking ahead, Mr. Linton emphasized that captive owners and managers involved in public entity risk pooling have several key opportunities to capitalize on. First, they can leverage economies of scale to lower administrative and operational costs, making risk management more efficient. Additionally, broader and more customized coverage options are available through pooling, offering a better alignment with specific risk profiles than traditional insurance markets.

Mr. Linton highlighted enhanced risk management as another advantage, noting that by sharing resources and expertise, public entities can implement stronger loss prevention and mitigation strategies. This collaboration, he said, leads to improved safety and reduced claim frequency. Financial stability is also a major benefit, as pooling helps absorb large, unexpected claims, enabling more predictable budgeting and financial planning.

Lastly, Mr. Linton pointed out that pooled funds can be used for strategic investments, strengthening the pool's financial health and potentially generating additional revenue. By capitalizing on these opportunities, captive owners and managers can build a more resilient and efficient risk management framework.

"Looking at the potential in risk pooling for captives, I see a powerful set of tools that can bring captives to new levels of financial control, flexibility and strategic advantage," said Mr. Sierk. "In a risk pool, members can achieve efficiencies that are nearly impossible on their own, but the key is knowing where to look and how to leverage these opportunities for maximum impact."