Alternative Risk Transfer Captive Insurance
A captive insurance company represents an option for many corporations and groups that want to take financial control and manage risks by underwriting their own insurance rather than paying premiums to third-party insurers. Captive insurance companies are limited purpose insurance companies established with the specific objective of financing risks emanating from their parent group or groups. In the simplest terms, it is an in-house self-insurance vehicle. Captives usually represent commercial, economic and tax advantages to their sponsors due to the cost reductions they help create, ease of insurance risk management and the flexibility for cash flows they generate. Additionally, they provide coverage for risks that many times are neither available nor offered in the traditional insurance market.
Background
In just the last decade, the captive industry has grown substantially. From an estimated 1,000 captives in 1980 to over 5,000 by 2006, captives now account for more than 10% of all commercial insurance premiums collected worldwide. In the U.S. alone, captives were responsible for over $9 billion in premiums in 2005 and 80% of Fortune 500 companies own captives.
After the IRS lost its $600 million challenge against a captive owned
by UPS in 2001, the Service resigned itself to the legitimacy of captive
insurance companies and soon thereafter abandoned its economic challenges
to captives. The IRS has since issued a great deal of guidance to
assist captive owners in their proper structuring, management and
reporting.
Most large corporations have captives. More than half of the states
have now passed captive insurance enabling statutes, and more than
a half-dozen of those states now aggressively cater to the domestic
captive market.
Many advisors are only now becoming aware of the concept of the captive insurance company and introducing it to their clients. In addition to serving an insurance function, captives can also legitimately serve an intergenerational wealth transfer function when integrated with an advanced estate plan.
Types of Captives
There are several types of insurance captives, the most common are defined below:
Single Parent Captive - is an insurance or reinsurance company formed primarily to insure the risks of its non-insurance parent or affiliates.
Association Captive - is a company owned by a trade, industry or service group for the benefit of its members.
Group Captive - is a company, jointly owned by a number of companies, created to provide a vehicle to meet a common insurance need.
Agency Captive - is a company owned by an insurance agency or brokerage firm so they may reinsure a portion of their client’s risks through that company.
Rent-a-Captive - is a company that provides captive facilities to others for a fee, while protecting itself from losses under individual programs. They are also segregated from losses under other programs within the same company. This facility is often used for programs that are too small to justify establishing their own captive.
Two other types of insurance captives, which have recently developed are:
SPV - Although used extensively in the past for various financing arrangements, they have recently been used for catastrophic bonds and reinsurance sidecars.
SPC - SPCs can be formed as a rent-a-captive facility to enable those companies who lack sufficient insurance premium volume, or who are averse to establishing their own insurance subsidiary.
Commercial Advantages and Issues
The key issue with captive insurers is that they are conduits for risk. Unless risk is placed with the captive it remains with the owner. There are a number of commercial advantages to using captives to provide better risk management than the conventional insurance market.
Cost. Premiums charged by commercial insurers include amounts to cover the insurer's profit margin and overheads. Such overheads can be significant when considering insurers with large corporate structures to maintain.
Flexibility. When the market is soft, the captive can take advantage of the low rates by reinsuring a relatively large proportion of its risks. The low cost of reinsurance allows the captive to build its reserve base. When the market hardens, the captive is able to retain a larger proportion of its risks, and can maintain cover for its parent even when commercial insurance is unavailable or prohibitively expensive.
Claims management. The process of making a claim from a third party insurer can be long and involve a good deal of cost for the claimant. Where the insurer is a captive, the claims handling procedures can be dictated by management, cutting down on the delays and bureaucracy that are often a necessary part of the claims handling procedures of commercial insurers.
Claims experience benefits. Captives generally retain a portion of the overall risk and reinsure the remainder. For this reason, when claims experience is better than anticipated, the excess of net premiums over claims is retained by the group. The reinsurance taken out by the captive is tailored to minimize the group's exposure where claims experience is worse than projected.
Captives are becoming an increasingly important component of the risk management and risk financing strategy of their parent. A number of reasons have been put forward as the basis for the growth in the use of captives:
- increasing premium costs in almost every line of insurance coverage.
- difficulties in obtaining coverage of certain types of risk.
- differences in coverage in various parts of the world.
- inflexible credit rating structures which reflect market trends rather than individual loss experience.
- insufficient credit for deductibles and/or loss control efforts.
Partial List of Coverage
- Loss of contract
- Loss of referral source
- Loss of tenant
- Loss of key client
- Loss of key consultants
- Legislative changes
- Toxic mold
- Construction defects
- Death of key employee
- Adverse tax consequences
- Sarbanes/Oxley regulatory issues
- Errors and Omission liability coverage
- Directors and Officers liability protection
- Loss of business revenue due to a variety of factors
- Funding large deductibles from current P & C policies
- Exposure to an increase in expenses (materials, labor)
- Future declines in value (real-estate, commodities sold)
- Equipment that becomes obsolete faster than anticipated
- Funding deductible for Workers Compensation
- Adverse action from governmental regulatory authorities
- Health Insurance Portability and Accountability Act compliance
- Coverage now omitted from your P&C policy
We assist prospective captive owners and their advisors in evaluating, designing, and implementing captive solutions. We also review existing captive structures and suggest ways that they can be used more efficiently. We have relationships with experienced and reputable insurance managers, actuaries, underwriters, accountants and attorneys who specialize in captive insurance arrangements.
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