What is Captive Insurance

A captive insurance company typically is defined as an insurance company that an entity that is or affiliated with its policyholders owns and controls. Its primary purpose often is to insure the risks of its owners or its owner’s affiliates. And, its owners (and, sometimes, its policyholders) benefit from the captive insurance company’s underwriting profits and investment income.

The owner of a captive insurance company chooses to:

put its own capital at risk when it chooses to create its own insurance company,
work outside of the traditional commercial insurance marketplace,
achieve its risk management and financing objectives on its own terms.

Let us review these three essential features of a captive insurance company:

OWNERS OF CAPTIVE INSURANCE COMPANIES PUT THEIR OWN CAPITAL AT RISK

Anyone who chooses to own a captive insurance company must be willing and able to invest its own resources. In return, the owner of a captive insurance company benefits from its profitability.

WORKING OUTSIDE THE COMMERCIAL INSURANCE MARKETPLACE

Both the owners and the policyholders Insureds of captive insurance companies need to recognize that they are working outside of the traditionally regulated commercial insurance marketplace. The regulatory environment of traditional insurance companies tries to “protect” the policyholder from failings of the insurer. Regulations are expensive to implement and costly to monitor, although they sometimes fail. Their main focus is to restrict what an insurer may do and how it may be done in order to protect the policyholder from the insolvency of and discrimination by the traditional insurer.

On the other hand, captive insurance companies often have significantly less capital than commercial insurers, and their policyholders enjoy no protection from state guaranty funds. But those entities who own and use captive insurance choose to participate in the risks and rewards associated with using their own risk capital, rather than paying to use the capital of commercial insurers. They make this choice believing that captive insurance offers something superior to commercial insurance.

In addition, commercial insurance is not always available or, if available, has significant “gaps” in its coverage, either of which exposes its owner and/or policyholders to uninsured financial risk.

Finally, since they are not traditional commercial insurers, captive insurance companies are considered a part of what is often called the “alternative market,” or “alternative risk transfer (“ART”) market.”

TO ACHIEVE RISK MANAGEMENT AND FINANCING OBJECTIVES ON ITS OWN TERMS

When the products offered by traditional insurers do not meet a policyholder’s risk management and financing needs, the best option often is to form a captive insurance company. The main reasons why organizations wish to better control their risk management programs are excessive pricing, limited capacity, coverage that is unavailable in the traditional insurance market, or the desire for a more cost-efficient risk financing mechanism. Reasons for utilizing captive insurance may be summarized as including:

Broader coverage. Many captive insurance companies are established; because, the insurance in the standard insurance market is prohibitively expensive, poorly matched to the owner’s/policyholder’s needs, or not available at all. A captive insurer can provide coverage for difficult risks that is tailored to fit the exact needs of the owner/policyholder, provided that the captive insurance company must operate within sound underwriting, actuarial, and regulatory guidelines.
Stability in pricing and availability. A captive insurance company achieves pricing stability over time as it matures and expands its own risk retention capability. The more capital that is accumulated, the greater the captive insurance company’s ability to retain risk and insulate itself from pricing changes or market cycles in the standard commercial insurance market. A captive insurer also is able to provide stability in the availability of coverage.
Improved cash flow. Cash flow improvements are achieved in several ways. For example, losses retained through a captive insurance company reduce or eliminate underwriting profits; reducing those losses through aggressive risk mitigation programs increase them. Because captive insurance inherently offers financial rewards for effectively controlling losses, safety, and loss control get a higher level of attention, and there is a more visible correlation between expenditures on risk mitigation programs and increases in operational profit.

Moreover, the underwriting profits and gains from the invested premiums that otherwise would be held by a standard insurer are retained within the captive insurance company. Even with conservative investment portfolios, the dollar amounts are substantial due to the high levels of capital and surplus typically held.

Finally, cash flow is improved by reducing the expense factors associated with commercial insurance. For many lines of commercial insurance, traditional insurance companies allot two-third or less of premiums taken in to the payment of incurred losses. The remining one-third or more covers its operating expenses, commissions to its insurance agents or brokers, and profit. Captive insurance companies have far fewer expense components than do commercial insurers. And,

Increased control over the program. The fact that ownership and control rests with its owner/policyholder distinguishes a captive insurance company from a standard commercial insurer. Ownership does not rest with shareholders nor control rest with management whose goal is to maximize the shareholders’ return on their investment. Rather, ownership rests with its owner and its control fits completely within the owner’s strategic business purpose.

Captive insurers offer increased control in several other ways as well. For example, owners of a captive insurance company have more control over insurance-related services such as safety and loss control, and claims administration. Safety and loss control services established by a captive can be tailored to each policyholder’s individual needs, resulting in safer operations and products, and more favorable loss experience. Claims handling services are unbundled and separately arranged or may be retained in-house with the captive management company. Strict guidelines can be drafted and enforced by the captive. This situation often is preferable to allowing a commercial insurer, whose interests in dictating how claims are handled might be more self-serving than what an individual policyholder desires.