This post discusses captive insurance and captive insurance plans.

WHAT IS A CAPTIVE?

A captive insurance company is a subsidiary formed by a private company to finance its retained losses in a formal structure based on the guidance of an appropriate insurance sector regulator. A captive insurance company is an insurance subsidiary of a non-insurance entity or parent-owned by the insured. Captive insurance companies are normally formed to supplement commercial insurance, allowing companies to retain the money that would otherwise be spent on insurance premiums. 

Captives are a form of self-insurance whereby the insurer is owned wholly by the insured. Once established, the captive operates like any commercial insurer. A captive insurer issues policies, collects premiums, and pays claims but does not offer public insurance. Captive insurance is an attractive alternative to self-insurance. It is regulated as a captive rather than as a traditional insurer. 

Generally, a captive insurer is an insurance company wholly owned and controlled by its insureds. Its primary purpose is to insure the risks of its owners, and its insureds benefit from the captive insurer’s underwriting profits. A captive insurer is a subsidiary formed to insure the loss exposures of its parent company (or companies) and affiliates whose primary purpose is to reduce the parent’s cost of risk.

THE PURPOSE OF A CAPTIVE

While it is true that a purpose of a captive insurance company is to generate revenue, there are other reasons for creating a captive insurance company. Captive is licenced to operate as a bona fide insurance company. The purpose of an insurance company, including a captive, is to pay losses (that is, own losses) and to afford the organisation (which is the owner) more control over its risks and losses that occur. This is necessary because the captive must settle claims and secure future losses. 

Captives are an alternative risk transfer mechanism used by organisations to finance risks. It is essential to view a captive as a cost-effective solution and structure it in a way that enables the company to participate in the profits of its own risk and not just accept the additional costs without the added benefits. To achieve real cost-savings, a captive should be adequately financed and well-structured to undertake significant risks. Captives are neither inherently mysterious nor illegal nor suitable for all situations.

Captive insurance is utilised by insureds or organisations that decide to:

1. Put their capital at risk by creating their own insurance company.
2. Work outside the commercial insurance marketplace.
3. Achieve their risk financing objectives. 

When the products offered by commercial insurers do not meet an insured’s risk financing needs, the best option might be to form a captive insurer. The main reasons for utilising captive insurance by organisations include:

1) High premium of commercial insurance contracts,

2) Broader coverage, 

3) Stability in pricing and availability, 

4) Improved cash flow, and 

5) Increased control over the programme.

CAPTIVES VERSUS TRADITIONAL INSURANCE

Traditional insurance transactions begin by providing an insurance company information for underwriting and determining premiums, which are paid as a consideration in a contract (policy) issued by the insurance company that obligates the company to repay the policyholder’s losses under the specified conditions of the contract. However, suppose circumstances warrant, as they often do. In that case, other options may be sought where alternative risk financing and transfer mechanisms may prove helpful in addressing companies’ unmet needs from traditional insurance. One of these options is captive insurance.

The best captive insurance companies are those created and utilised by companies that understand their risk profile better than the traditional market, with superior loss histories and more robust risk management. These captives are run and operated by sophisticated companies looking for greater control over their risk and their risk financing. When premiums are due, components of the premium can be “unbundled” so that the captive owner can see rates and pricing on a granular level. This gives underwriting access that can be leveraged in a way that is more consistent with risk data and risk experience. This unbundling helps control costs and gives direct insight into how ongoing risk management techniques and practices directly affect premiums.

While there are numerous differences between traditional insurance companies and captives, it is essential to state that alternative risk financing is not opposed to conventional insurance. Many traditional insurers own or work very closely with captives and the alternative risk financing market. Conventional insurance companies, possessing significant financial strength, will often be needed to reimburse claims resulting from large or even catastrophic losses. At the same time, they usually prefer insureds to retain costs associated with less severe risks. In this case, a captive can be used to shift costs to the insured. Other cost-shifting techniques are deductibles, retentions, and coinsurance. All these options, including a captive, provide a mutually beneficial situation offering more control to the insured and eliminating certain costs for the insurer.

TYPES OF CAPTIVE INSURANCE PLANS

There are various types of captives, depending on the parent company or owner’s needs. Most captives insure only the risks of their parent. This is a pure captive. The types of captives continue to evolve and proliferate to address the growing need for alternative risk transfer.

Types of captive insurance include:

1. Pure captive, 

2. Group captive, 

3. Risk retention group, 

4. Agency captive, 

5. Rent-a-captive, 

6. Protected cell company, 

7. Association captive, 

8. Industrial captive, 

9. Branch captive, and 

10. Special purpose captive.

CATEGORISATION OF CAPTIVE INSURANCE COMPANIES

Captive insurers can be classified into two main categories: 

1. Pure captives, and 

2. Sponsored captives.

PURE CAPTIVE INSURERS

Pure captives are captive insurance companies that their insureds fully own, directly or indirectly. A captive group is formed by individuals or entities that jointly own a captive insurance company.

SPONSORED CAPTIVE INSURERS

Sponsored captives are captive insurance companies owned and controlled by parties unrelated to the insured. Sponsored captive insurers, sometimes called “non-owned” or “non-affiliated” captives, have some elements of pure captive insurers.

IDEAL FIRMS FOR CAPTIVE

The use of a captive should be considered for firms that meet the following six criteria: 

1) Profitable business entities seeking substantial annual adjustable tax deductions.

2) Businesses with multiple entities or those that can create numerous operating subsidiaries or affiliates. 

3) Businesses with high net worth and sustainable operating profits.

4) Businesses with requisite risks and currently uninsured or underinsured. 

5) Business owners interested in personal wealth accumulation and family wealth transfer strategies. 

6) Businesses where the owners are looking for asset protection.

REGULATION OF CAPTIVES

The fundamental purpose of insurance regulation is to protect policyholders, investors, and other stakeholders. A captive is different from a commercial insurance company because it serves mainly its parent company. Like traditional insurance companies, captives are regulated by the state where their headquarters are located. 

Each domiciliary regulator requires an annual audited report by an independent firm (or its equivalent) with industry-specific experience in the insurance industry. Many domiciliary regulators also require a formal actuarial review of the captive’s pricing and loss reserve methodology policy. Hence, captives are regulated differently than conventional insurance companies that serve the public.

FRONTING ARRANGEMENTS AND REASONS CAPTIVE INSURERS USE FRONTING

What is Fronting?

Fronting refers to using a licensed, admitted insurer to issue an insurance policy for a self-insured organisation or captive insurer without transferring any risk. The self-insured or captive insurer retains the risk of loss through an indemnity or reinsurance agreement. The captive insurer is an unlicensed, non-admitted insurer except in its domicile. Generally, it is illegal for an unlicensed insurer to issue policies. So, the captive insurer often needs to contract with a duly licensed insurer to issue a policy even if the captive desires to be the main risk-bearer.

Why Do Captive Insurers Use Fronting Arrangements?

Fronting arrangements allow captives to comply with financial responsibility laws imposed by many states that require evidence of coverage written by an admitted insurer, such as for auto liability and workers’ compensation insurance. Fronting arrangements may also be used when business contracts with other organisations, such as leases, service contracts, and construction contracts, require evidence of coverage through an admitted insurer. 

The insured may face a contractual requirement stipulating insurers that meet a minimum financial rating to issue the insurance policy for a particular risk. By utilising a fronting insurer, the certificates of insurance and the policies would be issued using the name and licence paper of the fronting company, thereby meeting the contract’s requirements. An insured may also require a licensed insurance company to issue the policy for a particular risk. By utilising the licensing of the fronting company, the captive insurer does not have to maintain licenses in each state where the business is written.

See the video on Reinsurance: https://youtu.be/8SU1YgoOspE