As the focus of the insurance and finance industries turn to new alternatives, a relatively mature solution is receiving renewed attention, that of a captive insurance company. This article is intended to inform those who have little understanding of captives and refresh the recollections of those who have looked into them previously. The views expressed may be different than those to which you have been exposed elsewhere. That is the purpose.

The Purpose of a Captive

The accepted definition of a "captive," an insurance company that is owned by the insured, is true, but not useful for decision making in a time of challenge. To begin, let us be clear that captives are all about money. You want one to make money. It will cost money to have one. You will pay your own losses, come what may.

Captives are another method by which risk to loss is financed. They are not inherently mysterious, or illegal, or a silver bullet for all situations. The fact that the insured, or an entity closely related to the insured, is the owner/operator is a separate and distinct fact, which may or may not intrude on the captive transaction.

Captives versus Traditional Insurance

To this point, you may have applied for insurance by giving underwriting information to a party who enters into a contract with you to provide repayment of losses under certain circumstances. There are many variations on this theme, but all of that is known as "traditional insurance." To go outside this structure is alternative risk finance, which can take many forms, one of which is a captive insurance company.

With a captive, instead of "just writing a check," you will see all the components of the premium and play a part in its pricing and delivery. This is called "unbundling."

Another critical point is that alternative risk finance is not in opposition, or the enemy of, the traditional insurance company. In fact, most traditional companies work daily with captives and other forms of risk finance. As a part of the process, someone of financial strength must agree to reimburse claims. For large losses, a large insurer is required. That is probably not the captive.

For small losses, the traditional insurer often prefers that the insured handle those. This provides an opportunity for the insurer to shift costs to the insured through the device of a captive. These costs can also be shifted through deductibles, retentions, and coinsurance, but a captive can create the illusion of control for the insured, while eliminating nuisance costs for the insurer. This illusion can be a highly successful marketing tool for a traditional insurer.

Structuring a Captive

Why a captive instead of deductibles/retentions or self-insurance? That is the magic of insurance. Current accounting and tax rules do not permit deductions for reserves held for the payment of losses in the future. But, if those funds are collectively called an "insurance premium," they are deductible. Self-insurance is a legal form that is difficult, complex, and really only for the very large risk.

Thus, if you are to consider a captive as a cost-effective solution, you must structure it in such a way as to participate in the profits of your own risk, not just accept unwanted costs. You must structure and partner in such a way as to achieve a real cost savings. To do that, you must finance more than small risks.

To gain the advantages discussed here, several elements are required. First of all, the premiums paid must be sufficiently large, say over $750,000 annually, to gain economic advantage, or coverage necessary to the operation of the business must be unobtainable. It is also possible, if it is your intention to establish a new profit-center, that the projections of the insurance business of others will make the captive seem like a good idea.

Second, you must be able to pay the claims, and secure the future losses. Full projected amounts are rarely required to be posted in advance, but the ability to ultimately pay must be demonstrable. This cannot be overstated.

Third, you must recognize that a captive is a business separate and apart from your other business, no matter what structure is ultimately selected. Close attention must be paid to the establishment and operation of the captive, or the consequences will eradicate any hoped for advantage.

Determining the Feasibility and Goals of a Captive

The process begins with an actuarial analysis of your past claims. This is a straightforward determination of the accepted level of claims for your business, which gives clear trends and attachment points for premiums, costs, and reinsurance. It also helps you determine if you wish to proceed, which is why this work is called a feasibility study. It is quite worthwhile to determine early in the game if the proposed solution has a chance to deliver the hoped-for results.

After the actuary has advised on the numbers, time should be spent on the goal of the captive. The original inquiry may have been driven by high insurance premiums, or even lack of availability, but there are other reasons to consider a captive. These include control of premium fluctuations, choice of vendors, choice of reinsurance structure, personal tax advantages, and even a new profit center. It can be difficult to place a dollar value on all of these, but they could materially affect the view toward cost effectiveness.

Domicile Selection

With an actuarial study and clearly articulated goals in hand, it is time to select a domicile. Basically these are onshore, within the 50 United States, or offshore, outside the United States. There are many reasons for making the decision, and careful consideration should be given to the goals of the captive. Costs and profits can be materially affected more by structure and choice of vendors than whether you are in or outside of the United States.

The larger issues to be addressed as to selection of domicile relate to the goals of the captive. A principal difference between onshore and offshore is potential ease of regulation. Ease does not mean laxity, but rather is based on the fact that, while your captive may be sited outside the United States on an island, it is not covering risks of that island. Therefore, the regulators take the view that, as long as you are well informed, well financed and well managed, you have greater freedom to use your captive as you see fit.

Onshore regulators have other issues that become entwined with overall U.S. regulatory issues and can cause delay and expense. This is not true of every situation, and should not be the sole determinant. Rather, the quality and quantity of regulation and support services should be seen to bring the best fit to the goals of the captive.

A visit to the domicile that you have chosen may be in order. Many regulators want to have face-to-face knowledge of their owners. Maintaining a relationship with them is primarily the domicile manager's job, but the owner's attendance is important to success. Some venues require annual meetings to be held at their location, which can be an opportunity to solidify relationships with regulators.

Partner Selection

Following selection of a domicile, it is time to select partners. Depending on circumstances, you will need a U.S. consultant, a domicile manager, a risk-sharing entity, attorney, accountant, banker, and, of course, the actuary. Some of these may be vendor/partners that you are using currently.

The manager or consultant will prepare, or assist you in preparing, a business plan, which will be instrumental in receiving regulatory approval and risk-sharing support. It is critical that they be knowledgeable about captives, your goals, and your expectations.

A company must be formed. This calls for officers and directors. The domicile manager and/or attorney can handle this task. Depending on domicile, there can be extensive referencing required, which can be off-putting to some potential participants. New regulations on money laundering and transfer add materially to the time involved, so this activity should run concurrently with other tasks.

Critical to the success of the captive is selection of the risk-sharing partner. This is the entity that is on the line for the largest and most frequent claims. This is generally a U.S. licensed and admitted insurance company. It will often offer many necessary services, including underwriting, risk engineering, loss adjusting, claims reserving, litigation and regulatory support. You may need to issue certificates of insurance to third parties, assuring coverage. Generally, a certificate from the captive will not suffice.

This partner may be your current, traditional insurer. You may have to form a new relationship. In the current times, it is imperative that you begin exploring the dynamics of this relationship from the beginning of the captive process. The risk-sharing Partner will likely have strong opinions on your plan and your other partners. This partner will rely heavily on the work of the actuary.

This partner may have restrictions and requirements on practices, procedures, and vendors that will make or break your captive, so a solid relationship is essential. Management of this relationship should be conducted in such a manner that both sides are aware of all other arrangements and are fostering each other's profitability and growth in accordance with business plans.

Operating a Captive

With all of these elements completed, the captive is ready to begin operation. The captive will likely be a reinsurer to the risk-sharing partner, accepting a predetermined level of risk and the accompanying premiums. The captive is now a reinsurance company. It will also likely purchase reinsurance. It behooves the owners to set up appropriate committees, such as underwriting, claims, investment, and audit.

In the early stages, the most important of these is the Investment Committee. Funds will be received almost immediately and must be prudently invested so that they are available to pay claims. This is a major source of revenues for the captive, which previously went to the traditional, primary insurer. Earnings from these investments can, over time, be considerable and become the primary reason for the existence of the captive. Improperly managed, however, they can cost the owner substantial sums and even imperil the continuation of the captive. The domicile manager will do the actual investing and offer advice, but the manager will not decide what instruments to purchase.

If the captive is to entertain risks other than that of the owners, then an Underwriting Committee must be established along with underwriting standards, lines of authority, and procedures. This committee may also be responsible for arranging reinsurance. This is an opportunity to improve costs from pre-captive structures.

At some early stage, a Claims Committee must be in place. It will regularly review claims reports to determine trends, underwriting violations, and reserving practices. It may be involved in selection of adjusters, attorneys where appropriate, and reserve management. This is another area in which costs can be improved from the traditional placement.

Captive Advantages

There are many, many other considerations and structures to a captive. It can reinsure traditional lines such as workers compensation, general liability, auto liability, professional liability, and credit risk. This is due to the relative ease and certainty of projecting losses and revenues with coverages in which claim payments occur years after the incident of loss, known as long-tail losses. More and more captives are entering property fields, or short-tail losses. The traditional view of restricting captives to long-tail business has encountered the reality of escalating prices and lack of availability.

A captive can also be used to provide coverage and limits not available in the market, such as credit risk and terrorism. The captive can provide a tax-sheltered approach to large retentions. If no certificate is required, it can accept direct placements.

With considerable effort, there are occasional personal tax advantages that can be obtained with a captive, but these require a sophisticated, knowledgeable consultant, and there are the usual caveats about taxing bodies.

Some captives have performed so well for their owners that they have re-domesticated to the United States, filed for licensing as an admitted insurer, and offered primary coverage, replacing their risk-sharing partner.

If your approach is well thought, properly executed and diligently managed, a captive can be an ongoing source of profit for years to come.