Why Would a Business Consider a Captive Insurance Company?

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Greater control- The greatest benefit a captive offers companies is significantly greater control over their risk-management program.

Improved cash flow- Beyond achieving lower premium costs, the use of captives can benefit organizations by improving cash flow. This can be achieved through developing precisely tailored coverages, improving claims handling and stabilizing insurance budgets.

Custom Tailored Coverage- Buying insurance is similar to buying clothing. In a highly simplified analogy, we say buying from a commercial carrier is like buying clothes off the rack and having the choice of small, medium or large; whereas, buying through a captive is like buying clothes through a tailor who custom makes the clothes for one individual to achieve a perfect fit. A captive simply provides an organization with more risk financing options to create the best fit.

Improved Claims Handling and Reporting- The premiums a company pays to a commercial insurer are based in large measure on industry-average claim-processing costs. The claims your company incurs are handled by the insurance company’s claim administrators. This will be either the insurer’s own administrators or more often, a contracted third-party administrator (or “TPA”). How well the TPA performs in terms of the time and cost to resolve claims will be a key factor in determining your premium costs. The challenge for you is that although there may be steps you could take to have a positive impact on those costs, you have no control over the TPA. Contrast this scenario with one that puts you in charge of setting claim-management policy, influencing claim-management strategy and ultimately having a direct impact on claim-management costs. This is the opportunity that a captive presents because it takes away the commercial-insurer layer between you and the claim manager (whether that manager is in-house or contracted).

Stabilized Budgets- Just as there are many types of financial risk, there are a variety of ways to manage them. The methods fall within three primary categories: avoid the risk, retain the risk or transfer the risk. Avoiding the risk through business-process or business-structure measures is always a preferable strategy whenever it is possible. But to the extent that it is not possible to avoid risk altogether, a company must decide whether it will retain the risk or transfer it.

If a company chooses to retain the risk, it should do so only after complete evaluation of the alternatives. A competent actuary should be retained to perform an analysis of level of risk and potential losses, as defined by potential frequency and severity of the insured-against event.

If a company chooses to transfer the risk to a traditional, commercial-insurance carrier, that company will be among many others who are insured by the same carrier. These other companies will represent a wide variety of industries and will present loss profiles that vary widely in type, frequency and severity. Despite this non-homogeneous pooling of risk, premiums may be uniformly imposed without reflecting the diversity in level of risk. This means companies with excellent safety records, great training and loss ratios far below the average in their industry will pay the same premium as companies with much higher loss histories. If, on the other hand, a company chooses to retain its risk inside a captive, the premiums will be based exclusively on that company’s unique loss profile.

Incentive to Control Losses- A captive insurer does not have the same operating expense structure, overhead, or profit requirements of a commercial carrier. Moreover, a captive does not have to maintain higher average rates to ensure it can cover the losses associated with the high-risk members of its pool of insured. A captive's concern is sharply focused on one company as opposed to the entire industry, thereby allowing it to directly reflect that company’s efforts to lower insurance costs through better risk-management. Through a captive strategy, improving risk management practices will directly impact the insured’s cost of insurance.

Direct access to wholesale reinsurance markets- Reinsurance is coverage purchased by commercial insurance companies. When an insurance company assumes its insureds’ risks, it often does not retain those risks for itself—at least not completely. Instead, it obtains its own insurance to compensate it for the claims it may have to pay on behalf of its insureds.

Positive Tax Benefits- The deductibility of premiums is a very important benefit of establishing and running a captive. Companies who have been self-insuring at least a portion of their risk will understand the benefits immediately.

With traditional self-insurance, companies only get a deduction for claims paid. A captive gets a current deduction to fund reserves for future liabilities. When a captive is utilized to pre-fund a business’ high-frequency, low-severity claims, the business takes a current deduction for this pre-funding. In addition, the captive gets to deduct the cost of covering these claims if it has reinsured them. If the business had instead used some form of traditional self-insurance such as an equity fund to cover catastrophic losses, it would have had to reserve a significant dollar amount which would not be tax-deductible until losses occurred and were paid.

The tax impact of operating a captive is very complex and should be considered only with the advice of a competent accountant with a background in captive insurance.

Other benefits- There are many other benefits to including a captive insurance company in an overall risk-management strategy. Some of these include:

  • Increased insurance coverage as well as capacity
  • Flexibility with funding and underwriting
  • Reduced deductible levels for operating units
  • Better allocation capabilities
  • Additional negotiating leverage for underwriters
  • Creation of a market (such as pollution liability) where there is no established market;
  • Additional investment income to help fund losses
  • Greater stability in coverage and pricing;
  • Reduction in the cost of insuring certain high-quality risks
  • Reduction in expenses associated with transferring risk
  • Enhanced asset protection/estate-planning/wealth transfer