27 Aug Captives
Captives
What is a Captive?
A “captive insurer” is generally defined as an insurance company wholly owned and controlled by its insureds (typically a noninsurance entity or parent). Its primary purpose is to insure the risks of its owners, and its insureds benefit from the captive insurer’s underwriting profits, if applicable.
Purpose of A Captive
The purpose of a captive insurance company is to pay losses (your own losses) and to afford you (the owner) more control over risk and any losses that do occur. Revenue generation and increasing shareholder (owner) value are certainly the purposes of a captive.
Is it right for your insured?
Suggesting a captive structure for your client requires a lot of work, attention to detail, and extensive communication (and subsequent documentation) with your client. The appeal for a client pursuing this option varies based on the insurance marketplace, reinsurance availability, and the degree of regulatory and IRS oversight on issues such as tax and accounting treatment.
At one time, captive programs offered significant tax and accounting benefits. However, there has been greater scrutiny of certain captive structures recently, requiring good due diligence to determine the feasibility and goals of moving to a captive program. With the proper review, it can still be a viable option for clients to manage and participate in their own risks and the risks of those like their own.
The bottom line is that this type of structure is not for every client and, furthermore, not right for every agency. It requires some unique handling and expertise. As a result, the agency must provide the client with an objective analysis of the risk and market to enable the client to make an informed decision.
Captive Advantages
One of the goals of captive insurance is to stabilize insurance costs over market /pricing cycles, allowing businesses (as well as individuals) to better manage their risk and the costs associated with that risk.
A client must be comfortable with the capital risk associated with being part of (or owner of) a captive program. They must be willing to invest their own resources into all aspects of the captive insurance process, understanding that they also can earn revenue and shareholder value from its overall profitability through dividends.
Claims Management / Loss Control
To improve the success of the captive program, a solid claims management process and loss control/prevention program must be implemented and followed to help drive growth and profitability.
Flexibility/Strategically Manage Risks/Costs
Captives have been known to create a defensive strategy. A captive can provide coverage and limits not widely available (or even not available) in the market. Further, this strategy can be used to self-insure or reduce the cost of a specific risk that may be too expensive in the current marketplace. Examples would be an insured managing their product liability exposure, credit risk, terrorism, pollution, or a pandemic risk through a captive program.
Potential Tax/Accounting Advantages
A captive program can occasionally provide tax (or personal tax) advantages, but this requires a sophisticated and knowledgeable consultant.
Capital Requirements
To be part of a captive program, an owner must provide an initial level of capital based on the line of business to be insured within the captive and the actuarial analysis of future potential losses. This capital is needed to sustain the captive and to handle any claims or reinsurance obligations. Further, there is the possibility of additional capital being necessary based on the claims or financial performance of the program overall.
Required Resources
Insureds looking to become part of a captive program must seek expert advice from the following third-party resources:
- Captive management firms
- Claims services or professionals
- Loss control/prevention professionals
- TPAs/Actuaries
- Investment professionals
- Legal
- Tax
Some of these services may be satisfied within an agency or client, but others will certainly be reviewed and advised by third parties. To fully understand the risks/rewards associated with moving to a captive program, use of all, if not most, of these resources is required.
Spread of Risk
Insurance works best when there is a good spread of risk. Successful captive programs consistently maintain a good spread, use great third-party resources/services, and, as a result, generate strong financials. Often, the number of insureds (owners) in a captive start with a good spread of risk that then shrinks. Should that happen, total costs can vary annually, making it a challenge to determine the right amount to build into budgeted costs adequately. Further, should the spread continue to drop, additional capital may be required to improve the financial condition of the captive program.
Will Additional Staff Be Needed?
Prospective clients looking to join or start a captive program should assess the work required to handle any program oversight or administrative responsibilities.
Getting Out Could Be a Challenge
After joining a captive, this structure may not be the right fit for a client or agency in the long term. Some challenges to consider before existing an existing program are:
- Will the existing insurance marketplace readily accept the risk of being moved out of the captive?
- Will the rate outside the captive program be competitive?
- What are the financial and tax implications of leaving a captive program?
- What are my shareholder/owner obligations, if any, after leaving the captive program?
Captive Failures
Prospective captive owners must understand that sometimes, captive programs do fail and need to unwind. Understanding this and recognizing exit strategies is good planning. Most captives fail for one of three reasons:
- Ownership issues
- Undercapitalization
- Reinsurance
It is important to realize that once a decision has been made to shut down a captive program, the company is still “alive” until all claims and other obligations have been satisfied. This could take years. Therefore, it is important to understand all your risks when determining captive participation.
Is It Right for Your Agency/Client?
Discussions with clients on a captive structure are not something to take lightly. The agency should ensure they have staff fully knowledgeable on the requirements, issues, and solutions to enable the best review of a captive program.
The agency should have full disclosure in its discussions with clients with strong consideration toward presenting in the proposal a standard marketplace approach vs. a captive approach. The goal is to enable the client to make a fully educated decision.
If you are pursuing a captive for your client, it is best to review existing captives that have been in business for a significant period. This will allow the agency to provide information on the captive’s history and management.
While captives and interest in them continue to grow, understanding the needs and issues, along with the E&O risks associated with this work, is essential in protecting your firm’s assets and reputation.