Captives 101: What Are They, and Why Do I Want One? (2023)

The cyclical nature of insurance, coupled with both changing and emergingrisks, will always influence the insurance and financial industries. Newalternatives are being sought to address both unmet needs and a lack ofcapacity. Alongside these new alternatives are creative ways to employ moremature solutions. In the wake of the challenges caused by the hard market andthe uncertainties and questions resulting from the experience of the COVID-19pandemic, one solution that many companies are turning to or returning to—andexpanding upon—is captive insurance.

This article will explain some of the elementary aspects of captives andhighlight reasons as to why this solution is receiving renewed attention. Theviews here are simply meant to add a few points on the map, as it were, forinquiring minds who hope to better understand and navigate the captivelandscape.

What Is a Captive?

To begin with, it is essential to define terms. What is a captive insurancecompany? In the most simplistic terms, a captive insurance company is aninsurance subsidiary of a noninsurance entity or parent and is owned by theinsured.

The Purpose of a Captive

While it is true that a purpose of a captive insurance company is togenerate revenue, this is not the fundamental reason, nor can it justify,absolutely to all parties, the existence of formation and ongoing operations ofa bona fide insurance company.

To be very clear, the purpose of an insurance company and, therefore, acaptive is to pay losses (your own losses) and to afford you (the owner) morecontrol over your risk and any losses that do occur.

Put another way, captives are an alternative risk transfer mechanism used tofinance risk. They are neither inherently mysterious nor illegal, but neitherare they a silver bullet for all situations. The fact that the insured, or anentity closely related to the insured, is the owner/operator is a separate anddistinct fact, which may or may not intrude on the captive transaction.

Captives versus Traditional Insurance

Traditional insurance transactions begin by providing an insurance companyinformation used for underwriting and determining premiums, which are paid asconsideration in a contract (policy) issued by the insurance company thatobligates the company to repay losses of the policyholder under the specifiedconditions of the contract. However, if circumstances warrant, as they oftendo, other options may be sought where alternative risk financing and transfermechanisms may prove quite useful in addressing the unmet needs of companiesfrom traditional insurance. One of these options is captive insurance.

The best captive insurance companies are those created and utilized bycompanies that understand their risk profile better than the traditional marketdoes, having superior loss histories and more robust risk management in place.These captives are run and operated by sophisticated companies looking forgreater control over their risk and their risk financing.

When premiums are due, components of the premium can be"unbundled" so that the captive owner can see rates and pricing on agranular level. This gives underwriting access that can be leveraged in a waythat is more consistent with risk data and risk experience. This unbundlinghelps to control costs and gives direct insight into how ongoing riskmanagement techniques and practices are directly affecting premiums.

While there are numerous differences between traditional insurance companiesand captives, it is important to state that alternative risk financing is notopposed to traditional insurance. Many traditional insurers own or work veryclosely with captives and the alternative risk financing market. Traditionalinsurance companies, possessing significant financial strength, will often beneeded to reimburse claims resulting from large or even catastrophic losses,while they usually prefer insureds to retain costs associated with less severerisks. In this case, a captive can be used to shift costs to the insured. Othercost-shifting techniques are deductibles, retentions, and coinsurance. Allthese options, including a captive, provide a mutually beneficial situationoffering more control to the insured and eliminating certain costs for theinsurer.

The Captive Option

One of the many reasons to choose the "captive option" is becauseof accounting and tax rules, which allow for the deduction of insurancepremiums by insurance companies. Again, as a captive is an insurance company,reserve funds held for the payment of future losses are deductible. If acompany simply increases its retention, the funds held in reserve do notconstitute an insurance premium, and, therefore, the tax benefit is notrealized. As for the self-insurance option, it is possible, of course, but as alegal form, it is often difficult, complex, and usually used for only verylarge risks or risks that the market has no appetite for.

It is important to consider a captive as a cost-effective solution andstructure it in such a way as to participate in the profits of your own riskand not just accept the additional costs without the added benefits. To achievereal cost-savings, you must structure the captive so that you finance more thansimply small risks.

For these costs-saving economic advantages, certain elements are required.In most cases, premiums paid must be sufficiently large (e.g., over $750,000annually), and/or coverage necessary to the operation of the parent company orgroup must be unavailable in the traditional market. If it is your intention toestablish a new profit center, the projections of the insurance business ofothers will further make a case for the captive option.

As an insurance company, you must be able to pay claims and secure futurelosses. Full projected amounts in pro formas are rarely required to bedeposited in advance. However, the ability to ultimately pay claims arisingfrom losses must be demonstrable. Again, as an insurance company, the abilityto pay claims and remain solvent cannot be overemphasized.

It is necessary to recognize that a captive is a business separate and apartfrom your primary operating business, no matter what structure is ultimatelyselected. Close attention must be paid to the formation and operation of acaptive, or the consequences will nullify the advantages.

Determining the Feasibility and Goals of a Captive

The process of forming a captive begins with an actuarial analysis orfeasibility study of your loss history and past claims. This will determine theaccepted loss level and level of claims for your business and gives cleartrends and attachment points for premiums, costs, and reinsurance. It alsohelps determine if forming a captive is your best option. It is imperative todetermine in the early stages of formation if the proposal of using a captivewill result in any anticipated long-term solution.

Once the actuary has opined on the numbers, the next step should be tofurther develop the goal of the captive. The initial inquiry into forming acaptive may have been caused by high insurance premiums or even a lack ofinsurance, but there are additional reasons to consider forming a captive.These additional reasons include increased control over premium fluctuationsand changes in the market, more freedom of choice between vendors and serviceproviders, reinsurance structure options, personal tax advantages (in specificsituations), and possibly even creating a new profit center. While difficult toplace an exact dollar amount value on these considerations, they can materiallyaffect the view toward the cost-effectiveness of a captive.

Domicile Selection

With an actuarial/feasibility study complete and clear goals outlined, it istime to select a domicile. There are onshore domiciles (located within theUnited States) and offshore domiciles (located outside the United States, inthe Caribbean, Europe, Asia, and Latin America). There are many reasons formaking the decision on where to form the captive. Careful consideration must begiven to the regulatory environment and how the goals of the captive align withthat environment. That said, expenses and profits will likely be more affectedby the structure and choice of service provider than whether you are onshore oroffshore.

A key difference between onshore and offshore domiciles is the regulatoryapproach, how rigorous the regulators are, and how the regulations are applied.A distinction that is important to captive regulation, as opposed to theregulation of traditional insurers, is that the owner of the risk (the insured)is also the owner of the captive or insurer. When regulators acknowledge this,it creates a regulatory environment that is flexible, allowing for creativesolutions while simultaneously applying regulations appropriately for thehealth and solvency of the captive.

The best regulators have a highly developed and nuanced sense of the"principle of proportionality," which states that regulation shouldbe proportional to the risk. As long as you are well-informed, well-financed,and well-managed, you should have greater control and freedom to use thecaptive in unique ways with the full support of the domicile. The quality andquantity of regulation and support services should be seen to bring the bestfit to the goals of the captive.

Visiting potential domiciles and meeting with regulators in the initialstages of formation can help in choosing a domicile. Many regulators want tohave face-to-face meetings to get to know prospective captive owners.Maintaining a relationship with regulators is often important to thecaptive's success. Some domiciles do require annual meetings to be heldon-site, which can be a great opportunity to solidify relationships withregulators and local service providers.

Service Provider Selection

Following domicile selection, additional service providers will need to beselected. Depending on the specifics of the captive in question, a captivemanager, a reinsurance broker, a third-party administrator (TPA), an attorney,an accountant and tax adviser, a banker, and, of course, an actuary will needto be engaged and hired.

The manager or consultant will assist in the preparation of a business plan,which will be instrumental in gaining regulatory approval and risk-sharingsupport. The importance of the business plan for making a case for forming thecaptive cannot be overstated. A well-thought-out and presented business planwill support not only the formative period but also the captive company as itmatures. It is also critical that all service providers have a level ofexpertise about captives and be knowledgeable and supportive of your goals andexpectations for the captive.

Since a captive is a company or corporation, officers and directors areneeded. The captive manager and/or the attorney can handle incorporation anddrafting bylaws and other formal operating documents. Most domiciles requiresome referencing to ensure the directors and officers are in good standing.This should simply be seen as prudent caution by regulators and is often abackground check or Internet and court searches. Regulations on moneylaundering and transfer add materially to the time involved, so this activityshould run concurrently with other tasks.

Critical to the success of the captive is the selection of the risk-sharingpartner. This is usually the reinsurer, another insurer, or an entity thatinsures the largest and most frequent claims. Generally, this is a licensedUS-admitted insurance company. It may also offer necessary additional servicesto the captive, including underwriting, risk engineering, loss adjusting,claims reserving, litigation, and regulatory support. If you need to issuecertificates of insurance to third parties, assuring coverage, and enter into afronting arrangement, these risk partners can help.

Risk-sharing partners can be your current, traditional insurer, or you mayhave to form a partnership. It is imperative that you begin exploring possiblepartners early in the captive formation process. The main risk-sharing partnerwill likely have strong opinions on your plan and service providers. Thispartner will rely heavily on the work of the actuary, so communication,professionalism, and responsiveness should not be overlooked.

Additionally, they may have restrictions and requirements on practices,procedures, and vendors that will impact the success of your captive, so solidrelationships are, again, essential. Management of this relationship should beconducted in such a manner that both sides are aware of all other arrangementsand are fostering each other's profitability and growth in accordance withbusiness plans.

Operating a Captive

With all of these elements completed, the captive is ready to beginoperations. The captive will likely be a reinsurer to the risk-sharing partner,accepting a predetermined level of risk and the accompanying premiums. Thecaptive is now acting as a reinsurance company. It will also likely purchasereinsurance itself. It behooves the owners to set up appropriate committees,such as underwriting, claims, investment, and audit.

In the early stages, one of the most important of these committees is theinvestment committee. Funds will be received almost immediately and must beprudently invested but also sufficiently liquid so that they are available topay claims. This is a major source of revenue for any captive, which previouslywent to the traditional, primary insurer. Earnings from these investments can,over time, be considerable and are a major motivating factor in the continuedexistence of the captive. Improperly managed investments can cost the ownersubstantial sums and imperil the continuation of the captive and even hurt theparent.

Captive managers or investment firms will often do the actual investing andoffer advice, with the owner ultimately deciding what instruments to invest in.Keep in mind any regulations in place that bear on investment activity. Abidingby all statutes and regulations is essential and not simply to maintain a goodrelationship with the regulatory authority in the domicile and to remain ingood standing but also to ensure the ultimate health and continued existence ofthe captive.

As surplus accrues and the familiarity and experience of the ownersincrease, the captive can consider taking on additional risks other than thatof the owners. When this takes place, an underwriting committee should furtherdevelop underwriting standards, lines of authority, and procedures. Theunderwriting committee may also be responsible for establishing and maintainingthe reinsurance arrangement. All of these options create opportunities to costsfrom the structures and policies in place before the captive existed.

Among service providers, TPAs will often be engaged if claims handling isnot done "in-house." If it is, a claims committee will be responsiblefor regularly reviewing claims reports and to determine trends, underwritingviolations, and reserving practices. It may also be involved in the selectionof adjusters, attorneys where appropriate, and reserve management. Again, thisis another area in which control can increase and costs can be improved fromtraditional placement.

Captive Advantages

There are many, many other considerations and possible captive structures.It can reinsure traditional lines such as workers compensation, generalliability, auto liability, and professional liability. A captive can also writecoverage for third-party risk and employee benefits. This is due to therelative ease and certainty of projecting losses and revenues with coverages inwhich claim payments occur years after the incident of loss, known as"long-tail losses." More and more captives are also entering propertylines and other more "short-tail losses." The traditional view ofrestricting captives to long-tail business has encountered the reality ofescalating prices and lack of availability in the traditional market.

A captive can also be used to provide coverage and limits not widelyavailable or even not available at all in the market, such as credit risk,terrorism, and pandemic risk. As previously mentioned, captives can, whenappropriate, provide a tax-sheltered approach to large retentions.

In addition to this, there are occasional personal tax advantages that canbe obtained with a captive, but these require a sophisticated, knowledgeableconsultant, and it is of the utmost importance to be intimately aware of thecurrent positions of the Internal Revenue Service, tax courts, and any othertax authorities who may have an interest.

Some captives have performed so well for their owners that they have filedfor licensing as an admitted insurer and offered primary coverage, replacingtheir risk-sharing partner.

If your approach is well-thought-out, properly executed, and diligentlymanaged, a captive can be an ongoing option to increase risk control, furtherfocus on risk management, and further afford owners flexibility in their riskfinancing approach when the tides of the traditional market change, as they sooften do. A captive can also become a source of profit that will support theprimary operating company or group for years to come.

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