CAPTIVE INSURERS

(March 2019)

A captive insurance company, or captive, refers to a company formed by a particular business or by multiple organizations within the same industry. Its purpose is to provide liability insurance coverage. Further, the captive's business operation is controlled by its owner/company. In theory, the very earliest insurance operations were captive arrangements. Most jurisdictions treat captives as non-admitted insurers; therefore, captives require the assistance of a fronting company.

Why Captives Are Created

Originally captives were formed, not as an alternative to traditional insurance, but as a last resort (because an insurance option was unavailable). The earliest captives were created by entities that needed protection against highly hazardous loss exposures that were either unavailable or only available at a prohibitive cost through the traditional insurance marketplace.

A milestone event for captives was the development of the 1986 Federal Risk Retention Act (FRRA). This act made it legal for similar or related businesses or groups to be formed for the purpose of buying liability insurance. In addition, many insureds could not find affordable insurance coverage for their liability exposures, had to forego traditional insurance coverage altogether and "went bare." These companies simply paid claims out of their operating income. Many companies in both traditional and non-traditional arrangements began putting risk management programs in place to reduce or eliminate loss exposures.

Captive insurance companies were first created in the 1950s. At that time, many large companies wanted to form "offshore" insurance facilities to be used to finance their loss exposures. This risk transfer mechanism lowered insurance costs for the corporation. The technique also allowed "premiums" to be deducted from taxes as legitimate business expenses. Shortly afterwards, the Internal Revenue Service (IRS) became aware of that strategy and removed the tax advantages. Even though the tax deduction benefit was removed, offshore captives continued to operate and prosper, because corporations wanted to reduce the costs of dealing with risk by at least reducing or eliminating the expense component of traditional insurance premiums.

Many large corporations wanted the investment income generated from not only the premiums paid to captive insurance companies but also on the loss reserves generated by those premiums. This provided even more motivation to form captive insurers. Sophisticated corporate risk managers realized they could benefit from any of a number of insurance premium-related investment income opportunities. This was seen as yet another advantage over purchasing commercial insurance coverage from an insurance company that controlled premiums, loss reserves and the interest income that those funds generated.

Initially, most offshore captives were "pure" captives, insurers established by a non-insurance parent company solely for the purpose of underwriting risks for the parent company and its affiliates. As time passed, many pure captives found even greater tax advantages if they insured organizations unrelated to their parent company. Unfortunately, a number of former pure captives became insolvent because of poor business practices due primarily to writing more business than they had the capacity or expertise to handle properly.

Around the same period, and due to the same forces, the concept of group or association captives became popular. These were insurance companies established and capitalized by a group of businesses to underwrite and insure their own collective insurance risks. In addition, many trade associations formed and funded association captives to underwrite and insure risks of the members of a particular trade association.

The implementation of the Federal Risk Retention Act encouraged formation of captive insurance companies known as Risk Retention Groups (RRGs) which provide liability insurance for its participating company. Essentially, they are limited, well-defined self-insurance pools.

Lines of Business Written By Captives

Decades ago, modern captive arrangements were first formed to provide coverage for medical malpractice and pollution liability exposures. Today, captives (in various forms) are used to insure a wide variety of lines of business for its owners, such as professional liability, commercial auto, employer's liability, product liability, and property damage. Captives also provide a source of protection for non-traditional (property and casualty) sources of loss such as:

· Credit risk liability

· Sexual harassment liability for childcare, educational and/or religious institutions

· War risks

· Private mortgage insurance

· Pollution/environmental liability

· Animal feed contamination

· Warranty liability

o equipment maintenance

o auto dealer extended service warranty

o major appliance extended service warranty

· Certain types of stop loss liability

Benefits of Using A Captive

The typical advantages of forming and using a captive insurer include reduced cost of protection, greater access to insurance and reinsurance, more control over managing risks, more efficient use of financial resources, etc. Specifically, the following are solid reasons for use of a captive:

Less Dependence on Commercial Insurance Marketplace

A well-funded captive that has the proper capacity to handle possible losses may be a reliable source of protection that may end the need to deal with the problems of the commercial insurance marketplace, particularly with availability and pricing issues. Reduced dependence on the traditional insurance marketplace can be particularly important when newer and unforeseen sources of operations liability develop.

Access to Reinsurance

A successful captive operation permits its owner to secure its own source of reinsurance coverage. Since such coverage is acquired directly, the cost of reinsurance would be reduced. Specifically, the captive sponsor does not have to pay the expense loads charged by commercial carriers. Use of a properly funded and operated captive also increases the likelihood that the desired amount of reinsurance will be available.

Special Group Expertise

Insurance availability problems have spurred development of groups or associations forming multiple-owner captives. Since such groups are made up of entities operating in the same industry or environment, each member gains valuable access to expert advice. Owner/members share information on how to address industry-specific (or profession-specific) exposures. They also share insights on loss prevention or mitigation. This level of insight is rarely available under traditional insured/insurer arrangements.

Access to Broader Coverage

Depending upon where the captive insurer is formed (U.S., Bermuda, Cayman Islands and many other locales), the captive's owner may be able to insure a much wider variety of risks such as strikers liability, political risks, property seizure (by government authorities), corporate espionage, hazardous manufacturing processes, etc.

Tax Benefits

Such benefits are highly dependent upon the structure of the captive and the laws of where the captive is domiciled. However, in certain instances, a captive may allow special tax treatment of a captive's funds used in loss reserves, deductibility of premiums, favorable treatment of accumulated income from underwriting and investment actions and reduced premium taxes. However, forming a captive primarily as a basis to gain tax benefits is among the poorer reasons for doing so. Actual tax benefits are extremely difficult to determine and it takes lengthy consultation with expert sources to be able to quantify such savings.

Addition of a Profit Center

A party establishing a captive could benefit from its full control of funds that, otherwise, would be paid to an insurer in the form of advanced premium. The enhanced cash flow could create opportunities for greater investment income. Further, a successful captive may also generate underwriting income, evolving into a new area of revenue for its corporate owner.

Greater Control

Ownership of a captive offers the benefit of creating far greater control. The parent company would oversee the captive’s efforts in controlling cost, providing needed coverage and maintaining control of claims, loss investigations and related expenses.

Improved Insurance Program

Because of the high level of control, a captive insurance company can result in more effective insurance coverage. In order to meet the needs of its owner or owner group, a captive can tailor its program to provide precise coverage and rapid response to losses (the latter facilitated by creating and maintaining its own claims-handling procedures). The coverage may also correspond with a more effective loss prevention/mitigation strategy.

Enhanced Risk Management Program Tracking

A parent captive insurance company operates as its own financial entity and that includes the development and reporting of its separate financial results. The operation’s balance and P&L documents are a tangible source for measuring the effectiveness of the parent operation’s use of risk management dollars.

Reduced Regulation

Although every domicile provides some level of regulation for captives it approves, captives still are far less regulated than licensed insurers. Shrewd captive owners are in a good position to run their insurer in a manner that maximizes both coverage and overall goals.

Underwriting Advantages

A captive may be able to price and underwrite its own exposure more effectively since it has access to all critical information regarding losses. Its parent's or ownership group's claim activity/history may be scrutinized in far more depth, permitting more accurate assessment of future loss exposure.

IBNR Calculations

While the owners of a captive may need to get an actuary's assistance in establishing initial and maintaining Incurred But Not Reported (IBNR) losses, a captive is typically in a position to out-perform insurers in this area. The captive’s sponsoring company allows its insurer access to a variety of financial tools to assist in calculations, especially in regard to tracking claims and near-claims activities. The latter, crucial information, the depth of loss history or level of detail is rarely available to a licensed carrier when it insures a particular business.

Disadvantages of Using a Captive

The formation and use of a captive by some organizations has been a mistake, done without proper planning and, in some instances, pursued on a whim or as part of a trend. While there are several substantial reasons that justify captives, there are other considerations. A captive may be inappropriate if an ownership entity:

· Does not have the financial resources to properly administer captive operations such as addressing underwriting and taking care of claims, including accompanying infrastructure expenses as well as the initial cost of capitalization.

· Is involved in a merger or acquisition….a captive's existence may complicate the process (if the captive has to be dissolved, the associated expenses would be treated as regular operating expenses to the owner).

· Is not in a position to commit time and personnel to operating the captive.

· Is unable to attract and retain the necessary expertise to handle a captive.

How Captives Are Formed

The requirements for forming a captive insurer may vary according to the jurisdiction selected as the domicile. However, formation typically involves the following steps.

Formally Determining the Need for a Captive

This is usually done by performing a feasibility study that examines the organization's exposure situation, relevant financial information and non-financial resources (particularly personnel). The study should also consider the likely tax consequences, and legal issues. These are critical in order to determine whether forming a captive is a proper move.

Related Article: Captive Feasibility Study

Establish Captive Type

Document its purpose (line of business written) and form of ownership (single, association, third party, etc.).

Capitalization

The owner or ownership group has to determine the amount that will be used to initially fund the proposed captive. Naturally, the minimum amount must be the minimum amount required by the applicable jurisdiction. A captive’s sponsor will then have the ongoing, critical duty of maintaining proper funding. Traditionally, adequate capitalization has always been a major concern of regulators.

Determining Board of Directors and Chief Officers

How many persons (and who) will make up the captive's board and its executive officers. The secretary position is particularly important since he/she is generally the executive who routinely interacts with insurance authorities.

Naming the Captive

This may seem trivial, but some jurisdictions insist that it be done early in order to clear the name for use. Authorities require this in order to avoid approving captives with the same (or similar) name as an existing insurer. This helps preserve an authority’s ability to regulate and monitor its jurisdiction’s captives.

Fronting Arrangements

This requires working with a chosen fronting entity to determine claims procedures, forms (particularly policy language), reinsurance, fees, reports, etc.

Collect and Submit Captive Application Forms/Information

Typically, a package that must be submitted for a captive's approval includes:

· A completed application/questionnaire for each director and officer (accompanied with valid photo identification and background checks)

· A set of financial and general references for all proposed captive officers and directors

· Up to five years of an entity's loss history

· A proper bank account for the proposed entity

· A completed, multi-year business plan with premium and loss projections

· A complete set of audited company financial statements

Additional Implementation Strategy

If not done in other steps, the potential captive owner should determine on-going funding, coverage/limit provisions, securing reinsurance, creating a loss mitigation/prevention plan, etc.

Completing And Submitting Other, Applicable Forms (Such As):

· Loss Reserve Certification Form/Application

· Authorization For Captive's CPA Firm

· Letter of Credit

· Applicable Affidavits

· Other forms as required by applicable domicile

Types of Captives

There are various versions of captives. The variations are based upon the party that forms the captive and how the captive is structured. There are no official categories as different captive sponsors, associations and jurisdictions often use different terms. Further, as time passes, different ideas develop concerning how captives may be used, so new terms are being created to reflect new uses or combinations of ownership. Following are a number of types of captive arrangements:

Agency Captive

Formed and owned by one or more independent insurance agents and used as a vehicle to write risks controlled by the applicable agent(s). The risks written by an agency captive are restricted to very high premium and high-quality risks.

Association or Group Captive

Refers to a captive formed by an association's members in order to insure the risks of that particular membership. Such captives are usually called a risk retention group.

Captive of Insurer

A form of single parent (pure) captive that is formed by a licensed insurer or reinsurer. Writings are restricted to its owner's business.

Captive Writing Third Party Business

This is a version of a single parent captive (pure) captive. It is a separate insurance entity that is created and owned by either a licensed insurance company or by a reinsurance company. Its business consists of supplementing its parent company’s writings with premium from risks that have no relation to the business of its owners (including its affiliates, subsidiaries, etc.).

Composites

A form of captive that writes both life and general business insurance.

Diversified Captive

Refers to a captive that writes business from parties other than its parent company.

Industrial Insured Captive

An industrial insured is an organization (entity) that meets a given jurisdiction’s net worth requirements, which uses an employee as a full-time insurance manager/buyer to cover its own exposures and which has at least 25, full-time employees. Such entities that insure the risks of its affiliates also qualify as an industrial insured captive.

Micro Captive

A captive that is formed and owned by an entity or a group that insures risks protected by micro insurance products.

Multi Owner Captive

A captive that is formed and owned by at least two unrelated entities. The resultant captive only insures the risks of its respective owners (including their affiliates/subsidiaries).

Protected Cell Captive

A captive that is created and owned by unrelated entities. It is formed for the express purpose of offering captive accommodations to any interested organization that pays the required fees to do so. The liabilities of each "renter" organization are kept separate. The participants do not pool either premiums or losses; therefore, individual entities are shielded from financial consequences involving other renters or cells.

Rent-a-Captive

A form of captive insurer that is designed for entities that do not choose to (or are unable to afford to) assume the full financial risk of establishing a captive company. Use of a rent-a-captive provides some limited benefits compared with using traditional insurers. This form of captive is popular with agents, brokers, as well as managing general agents and underwriters.

Segregated Cell Captive

This is a modification of a rent-a-captive. There is a significant difference. In the rent-a-captive approach, all premiums of the renting participants contribute to the group as a whole and the poor results from one renting participant affect all the others (since premiums exist in a single pool). In a segregated cell captive, the premiums, losses, reserves and investment income of each renting participant is separated from those of every other renting participant.

Single Parent (Pure) Captive

This is the simplest form of captive ownership. Such captive insurers are formed, owned (and usually run) by just one entity. Naturally, the parent entity is likely to be a larger operation since such firms are in the best position to fund and operate a captive with their own pool of resources. The captive's only purpose is to insure its parent's risks (including affiliate and subsidiary operations).

Special Purpose Vehicles (‘SPV’s)

Special purpose vehicles are captives that reinsurance companies that issue reinsurance contracts to their parent company and then cede the risk to the capital markets by way of a bond issue.

Sponsored Captive

Another term for Rent-a-Captive.

Continuing Trends

Captives have long established themselves as a credible method for an operation that wants to play a major role in handling their exposure to loss and their related costs. Currently, more U.S. and International jurisdictions are opening their doors to facilitate the formation of captives in their various forms. Annual statistics indicate an increase in the numbers and kinds of captives. Other developments involve the formation of reinsurance captives as well as micro-insurance captives.