Claims and the Captive

October 2009

As with all insurance companies, captives are expected to and will pay claims. This statement may seem obvious or suspicious, depending on one's view.

by Michael R. Mead
M.R. Mead & Company, LLC

The risk manager of a corporation that owns a captive and uses it as an alternative risk finance structure doubtless plans on paying claims filed by the owner/insured. In fact, the good risk manager will have established a contractual relationship with a claims management firm or firms prior to the formation and licensing of the captive. Most captive domicile regulators will have required the identification of such firm(s).

There are many privately owned captives, used for a variety of purposes, which may not have considered the claims process for their risk finance structure. Now that the captive is more "their money" than the insurer's, the owner/insured may feel that claims should not be filed. They may wish to "keep their money," or assume that they will never have claims.

With either position, there exists an interesting consideration that is often overlooked—that the claims may not be covered by the policy. This may seem an odd fact when the captive is owned by the insured, insures the owners' exposures, holds the owners' funds, has officers who are or may be employees of the owner, and, in general, exists at the pleasure of the owner. How could an incident not be a covered claim? Read the policy.

When the captive is established and the comprehensive business plan filed, it will include a policy form and the actuarial feasibility study supporting the projected claim activity on the covered lines of insurance. The business plan will have been reviewed by the domicile regulator and the fronts and reinsurers, if any. Auditors will review the policy annually along with any claims that have been submitted to satisfy themselves that the claims have been properly addressed. Actuaries will have been contracted to opine on the adequacy of the reserves carried on the captive's balance sheet.

Claims Not Covered?

The above is all as it should be. Then a claim occurs which is not covered. What to do? The risk manager can choose to apply to the captive manager for retroactive coverage to be instituted. That will require the permission of the regulator who will want to determine how the claim and change in coverage will impact the balance sheet of the captive. Permission is given, and life goes on.

But, in some circumstances, the permission is not granted. The claim could have such an adverse effect on the balance sheet that the regulator or actuary or both may want more collateral to support the reserves. The owner/insured may feel that such a request is unreasonable. "I own the captive! It's my money! Pay it!"

Many Involved Parties

Now comes the captive manager to the board of directors. The captive manager is in the unenviable position of advising the board that not only is the claim not covered but that the approved policy and business plan never intended for such a claim to be covered and that covering it would negatively impact the balance sheet. The board is now in the spot, depending on whether or not they are employees of the owner/insured or are outside directors, of making a call on an entirely unanticipated event for which they may be completely unprepared. Now, in addition to the questions about the captive's balance sheet is the question of the potential individual liability of the directors.

It may strike some as impossible but the above scenario has resulted, more than once, in litigation between the owner/insured and the captive and its board. The basic issue here, which should be considered and addressed during the formation stage of the captive, is that the captive is indeed and always a separate corporate entity. Therefore, it has many masters, not just the owner/insured, as does a traditional insurer.

No matter who owns the captive, it is regulated and is contractually obligated to other parties who will be affected by the actions of the captive manager and the board. The front and reinsurers may be drawn in to unforeseen payments. The claims management firm may be in a compromised position. The regulator has a responsibility to the public. Employee/employer relationships may be strained and conflicted.

Conclusion

In the overregulated, overlitigated world of business of today, it is imperative to address these potential issues as they are real, have occurred, and will occur again. They are largely avoidable but are manageable. Not addressing them in advance can become a very expensive, time-consuming, and destructive option.

---

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.