Captive Insurance: Liability, Programs, Costs & More
September 22, 2020
What is Captive Insurance?
One definition of captive insurance programs is they are an alternate form of risk management that offers insurance coverage generally not available to companies through commercial insurance programs. Another primary use is to provide supplemental insurance that extends the coverage of a company’s current commercial insurance program. The inception and growth of the captive insurance industry came about to fill a need. The need was due to the commercial insurance industry’s inability to create risk management products and services for many businesses.
Typically, private companies create captive insurance programs to augment standard commercial insurance company plans to lower their insurance costs. Captive insurance companies generally form as a subsidiary of private companies seeking formal methods to manage retained losses with the cooperation and guidance of the state insurance departments where they do business. Sometimes a captive insurance company is formed to serve a specific niche such as a health insurance captive.
The first captive insurance company in the United States was launched for Youngstown Sheet & Tube Company in 1953 in Youngstown, Ohio. It was such a popular concept that by 1960 there were more than 100 captive insurance companies in the United States. The initial interest was to lower insurance premiums. Also, stimulating growth was realizing a new source of significant revenue, and equity for captive owners was a welcome byproduct of creating a captive insurance company.
The progress of captive insurance programs continued with the help of favorable congressional action. By the mid-1980s, the number of captives surpassed 2,200, with annual premiums greater than $7 billion. Captive ownership helped mid-sized businesses improve their odds of survivability because they can now manage their risks efficiently.
The growth of all captives continued, and by 1992, the number of reported captives had reached 3,150, with annual premiums paid exceeding $11 billion. By 1998, 80% of Fortune 500 companies owned captives; by 2010, Swiss Re reported that captive insurance company premiums worldwide had reached $60 billion annually.
Who Needs Captive Insurance?
The most apparent applicants to become a captive insurer is a company with high insurance premiums, low claim frequency, predictable operational cash flow, and acceptable risks. There are, however, other reasons for some companies to consider establishing a captive insurance company. For example, a firm may benefit from merging the overall enterprise’s risks into a captive or group captive insurance plan. And by combining employee benefits, healthcare, workers’ compensation, and warranty programs, they lower insurance premiums and create a new profit center.
According to captive management firm, Caitlin Morgan, answering these questions help to determine which companies make an excellent captive candidate:
● Is your company’s loss ratio better than the industry’s average?
● Is your business profitable?
● Is there a positive cash flow?
Are you currently using self-insurance, or are you using a large deductible?
Types of Captives
A review of the captive insurance industry shows that a captive insurance company can come in a variety of types with each created to fill an organization’s needs for a specific insurance policy and risk management services, including:
Single Parent Captives (Pure)
A Single Parent Captive (SPC) or Pure Captive is the most prevalent type of captive and is mostly used by larger entities. In such cases, the captive owns and controls the related company or its affiliates, and it is set up to insure the risks of associated companies.
SPCs are closely held insurance companies that primarily insure their owners’ operations, both the original insured and the principal beneficiaries. The captive insurance company’s parent provides the capital in forming the captive and has direct involvement and control over the captive’s primary operations, including underwriting, claims, and investments. The SPC can choose its retention level, reinsurer, aggregate stop limit, service providers, and may write any line of business, including coverage and policy limits that aren’t available throughout the insurance marketplace, such as credit risk and terrorism.
Sponsored Captive Insurers
Sponsored Captives Insurers are either have a single-owner or group-owned rental captives and most often take a segregated cell company. Sponsors do not always have capital at risk. Depending on the domicile, a sponsor must be either an insurance or a reinsurance company.
Group Captives are formed when a group of individuals or entities align to own a captive insurance company jointly. In some cases, the groups are homogeneous, meaning their group of insureds are in the same industry. Alternatively, a heterogeneous Group Captive owns the captive jointly to cover a group of insureds even though they come from entirely distinct industry groupings.
Group Captives are formed by small to midsize businesses with premiums volumes too low to fund owning or operating an SPC. Members share risks, pool resources, and split profits and losses. Costs are kept down by only allowing well-managed businesses that emphasize safety to join a Group Captive. Thus, their collective risks are much lower than those found in a general insurance pool. The most typical types of coverages provided by Group Captives are:
● Workers Comp
They require a minimum premium for each insured and use a predetermined structure, retention level, aggregate stop limit, and service providers. Association Captives are like Group Captives, except that they are sponsored or owned by a group of entities within a particular organization with common insurance needs and similar exposures.
Protected Cell Captives
Protected Cell Captives (PCC) are formed by a sponsoring entity that creates and owns a principal company that sells or rents the cells to businesses that need it. PPCs were designed to help smaller enterprises use stand-alone captive advantages without the cost to form and administer one. The parent company provides working capital, surplus, and licenses to the group insureds. It also is responsible for administrative, claims, engineering, reinsurance placement, and admitted fronting services. In a PPC, risks are not pooled between cells.
PPCs shield the assets and liabilities of its independent insureds. As such, individual cell assets remain secure and protected from the creditors of other cells or the parent captive. By creating a regulatory and accounting wall around individual cells, members are protected from the detrimental effects of adverse selection, losses, and underwriting.
Risk Retention Groups (RRGs)
Risk Retention Groups are a type of captive insurance company that uses a combination of state and federal laws under the auspices of the Federal Liability Risk Retention Act (LRRA) to form liability insurance companies owned by their members. An RRG allows businesses with comparable insurance requirements to create an insurance company to pool their risks and operate under state-regulated guidelines. In an RRG, all insureds must be owners of the RRG, and all RRG owners must be insured. RRGs have the option to form under either a state’s captive or traditional insurance laws. Although an RRG may domicile in one state, it may license to operate in any other state by completing a registration process and designating the state’s commissioner as agent for service of process.
Benefits of a Captive Insurance Company
There are numerous substantial benefits to a captive insurer, including:
● Provide coverage without higher premium pricing or that is otherwise unavailable.
● Designed to meet the insured’s specific needs and risk profile.
● Lower overall operating costs.
● Avoids the standard conventional market costs and markup for marketing, acquisition costs, administration, and profit.
● Use the margins from having premiums paid upfront with losses funded over time to accumulate investment income in a tax-free domicile. And to use such funds to both pay for losses and create a subsequent reduction for additional captive funding.
● Maintain lower costs by managing the captive’s loss experience and claims handling expenses.
● As a captive, companies can relinquish extended warranty program premiums, which allows them to take their margin into income instead of showing it earned on a curve or pro-rata.
● Take the tax advantages offered by a tax-friendly domicile to determine the accumulation of underwriting and investment income, while having the ability to deduct the insured’s paid premiums, among other tax incentives.
● Use the investment income from their captive operations to help to fund losses.
● Access reinsurance markets directly, which avoids the intermediary markups incurred by companies without a captive program.
Create custom insurance programs that offer greater control over claims policy terms, claims handling, and procedures. Essentially a captive has the option to finance only those risks it chooses to cover.
A traditional insurance company must license, pay fees, taxes, and expenses in all states where it does business. A standard insurance company has a large overhead. From premium payments, it pays for regulatory fees, marketing, compliance, claims, underwriting, and maintaining employees everywhere where it operates. Customers of the insurance company absorb those expenses.
A captive insurance company uses a self-insurance whereby the business creates an insurance company to insure its risk. Because the company pays premiums into its captive, it can invest the premium that makes more funds available to satisfy claims against the captive as it grows.
The companies that should consider the option to form or join a captive insurance company will meet the criteria listed above for good captive candidates.
To set up a captive program, a company will need to select partners to help it manage it. Types of partners include a U.S. consultant, a domicile manager, a risk-sharing entity, attorney, accountant, banker, and an actuary.
The manager or consultant prepares or helps prepare the business plan required to gain regulatory approval and risk-sharing backing.
Officers and directors are required to form a company, and bringing them on is the responsibility of the domicile manager or its attorney. The domicile manager will help with the necessary extensive referencing, which is sometimes daunting to potential participants.
Selecting a risk-sharing partner is vital to the success of the captive. That is because this partner bears the largest and most frequent claims. Typically, such partners are U.S. licensed and admitted insurance companies. Besides risk-sharing, these entities offer many necessary services, including underwriting, risk engineering, loss adjusting, claims reserving, litigation, and regulatory support. They can issue insurance certificates to third parties when the captive’s certificate is insufficient to ensure coverage.
Since both the captive and its risk-sharing partner depend on each other to grow profitably, the business plans may contain restrictions and requirements from the sharing partner on practices, procedures, and vendors that can determine the captive’s viability. As such, it is imperative to establish and maintain a trustworthy and transparent relationship between both parties.
How to Operate a Captive
Typically, a captive operates as the risk-sharing partner’s reinsurer, which means it takes on the preset risk and accompanying premiums. As a reinsurance company, the captive will need reinsurance for itself. Captive owners must establish and populate appropriate committees, including underwriting, claims, investment, and audit.
The Investment Committee is the most important to launch first. Funds are received at inception and must be wisely invested in ways to make them available to pay claims. Investment earnings can become substantial and grow to be the primary reason to maintain the captive. Conversely, if investments are managed poorly, they lead to significant losses that threaten the captive’s existence. Although the domicile manager does the investing and provides guidance, they do not make investment purchase decisions.
The Underwriting Committee will establish underwriting standards, lines of authority, and procedures should the captive wish to take on risks beyond those of the owners. Obtaining adequate reinsurance is another responsibility of this committee.
A Claims Committee is necessary. It will be required to review claims reports, underwriting violations, and the company’s reserve practices. The committee will help with the hiring of adjusters, reserve management, and in some cases, attorneys.
Captive Insurance Costs
There are startup costs and annual operating costs involved with launching and running a captive insurance program. While every situation is unique, budgeting for up to $20,000 for both the startup and annual operating costs is a good ballpark figure.
Best Captive Insurance Programs
Without a doubt, planning to set up a captive insurance program is a challenging task. Success in the formation and operation of a captive compliant with federal and state laws requires hiring and working insurance and legal professionals with the proper proficiency.
On the Program Business Market Directory, you will find a top tier option with Caitlin Morgan Insurance. It provides program management and development services to administer an entire captive program. Its team of insurance specialists provides innovative captive products designed to meet a client’s financial and risk management goals and objectives. Through its wide array of insurance products, Caitlin Morgan Insurance delivers maximum flexibility in program design. Its experienced underwriters and sales professionals are well versed in all aspects of captive operations. They know how to create the best tailor-made, customized captive programs. Management expertise includes program development, reinsurance placements, claims management, accounting services for group captives, and underwriting services for individual or group captives.