Captive insurance companies can provide advantages in risk management, insurance savings, wealth transfer and taxes. They are established to finance the risk of its parent company, or a group of related companies, and sometimes for these groups’ clients. A form of alternative risk transfer, they are used by major corporations, nonprofit organizations and medium-sized businesses.
This alternative risk financing approach can help elevate an organization’s focus on core risk management principles.
How Does a Captive Work?
The owners of a group of businesses may decide to retain some of their own risk and form their own insurance company, a captive insurer, instead of purchasing insurance from a third-party carrier. This is an attractive option for companies who find a limited availability of certain types of insurance coverage in the commercial market or find that those coverages will be a significant expense. In some cases, the captive insurer may decide to insure the group’s customers as well. The primary jurisdiction in which the captive insurance company is organized is called a domicile.
There are many types of captive arrangements, but most companies in the middle market focus on three options – pure/single parent captives, group captives and micro-captives.
Benefits of Captives
Properly structured, captives can bring the following advantages as alternatives to other risk financing plans, including:
- Reduced cost of risk
- Cash flow benefits
- Coverage not available from commercial insurers
- Direct access to the international market of reinsurers, which can be more flexible
- Increased bargaining power with commercial insurers (if the captive holds a percentage of insurance)
- Centralize retained losses spread throughout subsidiaries
- Cash flow advantages on income taxes; premiums paid to a captive insurer can be tax-deductible, depending on several factors:
- The transaction is a bona-fide insurance transaction under a defensible business plan
- The captive’s owner is organized such that subsidiaries pay premiums to the captive
- The captive writes a substantial amount of unrelated business (e.g., third-party risk, warranty risk, etc.)
- Ownership is arranged such that insureds are not the same as shareholders
See how one company saved more than $1 Million with captive insurance!
Is a Captive Right for You?
Captives can be valuable strategic risk management tools, but they are not the best approach for every organization. For some risk profiles, they are not feasible and could ultimately cost more than traditional insurance. If your business is considering setting up a captive, you must first clearly establish the financial and business goals and objectives of the company through effective communication between senior management, including the CFO, risk manager/safety personnel and business unit heads. Together, consider the following aspects of your company:
- Background and financial goals
- Actuarial or data issues, including loss data or exposure information and insurance expenses
- Reinsurance marketplace potential
- Tax and regulatory issues
- Desired captive design
- Administrative resources
Having concluded that a captive may be a good fit, take the following steps to more carefully study the appropriateness for your organization:
- Review relevant background information
- Discuss financial implications of captive formation
- Generate projections of expected loss experience
- Estimate operational expenses associated with the captive to determine premium
- Determine appropriate capital levels or margin of risk to support the written exposure, considering local legislation
- Describe qualitative factors, including location, ownership, support or other issues
- Prepare financial statements with balance sheets and income statements for the captive over a five-year period under different scenarios
- Compare the captive with the status quo on both financial and non-financial criteria
Once you determine that a captive is right for your organization, seek professionals experienced in actuarial, accounting, tax and legal issues to help you set it up. They can assist you with the following additional steps:
- Selecting the Domicile: Select an onshore (within 50 states) or offshore (outside the United States) domicile. Here you must consider ease of regulation in the area and the quality and quantity of support services. A visit to the domicile may assist.
- Selecting Partners: Selecting the right risk-sharing partner is critical to the success of the captive. This is the entity responsible for claims, generally a U.S.-licensed and admitted insurance company. The partner could be your current, traditional insurer or you could have time to form a new relationship. Keep in mind that the partner will likely have strong opinions on your plan and may have restrictions or requirements on practices and procedures.
- Operating a Captive: The captive will be an operating insurance company. It must receive funds immediately and invest them prudently so they are available to pay claims. This can be a source of revenue for the captive but can also cost the owner substantial sums if improperly managed. Assigning roles and responsibilities and conducting frequent analyses on the captive’s financial health is essential to ensuring it is bringing the desired benefits to the organization.
Understanding captives and the types of companies best suited for them will help you determine if a captive program is worth considering. If you have any questions, please contact your local CBIZ insurance representative or a member of our team.