23 Apr What’s a Captive?
There seems to be a growing interest among several E&O Plus agencies in considering a captive program for some of their specific clients. Several insurance articles noted a resurgence with increased captive formations over the last few years.
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.
The purpose of a captive insurance company is to pay losses (your client’s losses) and to afford the owner (your client) more control over their risk and any losses that occur. Certainly revenue generation and increasing shareholder (owner) value also figure into the purpose of a captive.
A key question that needs to be asked (and answered) is, “Is it right for your insured?” Whether to suggest 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 and use of a knowledgeable tax consultant, it can still be a viable option for clients to manage and participate in their own risk and the risks of those like their own.
This type of structure is not for everyone and may not be right for every agency as it requires unique handling and expertise. Providing your client with an objective analysis of the risk and market is key to enabling the client to make an informed decision.
There are some potential advantages for your client, including more stability over market/pricing cycles and allowing businesses to better manage their risk and costs associated with that risk.
There is a capital risk associated with being part of (or owner in) a captive program, and your client must be comfortable with this issue and be able and willing to invest their own resources into all aspects of the captive insurance process, understanding they can earn revenue and shareholder value from its overall profitability through dividends.
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.
Captives have been known to create a defensive strategy. A captive can provide coverage and limits that are not widely available (or unavailable) 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, such as product liability exposure.
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
Is it easy to get out? 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 exiting 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 the shareholder/owner obligations, if any, after leaving the captive program?
Prospective captive owners must understand that sometimes, captive programs fail and need to unwind. Understanding this and recognizing exit strategies is good planning. 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, which could take years. Therefore, it is important to understand all your risks when determining captive participation.
Is it right for your agency? Discussing a captive structure with clients is 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 client discussions and strongly consider presenting a standard marketplace approach vs. a captive approach in the proposal. The goal is to enable the client to make a fully educated decision.