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Captives 101: What Are They, and Why Do I Want One?

Michael Mead , Joe McDonald | July 1, 2021

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The cyclical nature of insurance, coupled with both changing and emerging risks, will always influence the insurance and financial industries. New alternatives are being sought to address both unmet needs and a lack of capacity. Alongside these new alternatives are creative ways to employ more mature solutions. In the wake of the challenges caused by the hard market and the uncertainties and questions resulting from the experience of the COVID-19 pandemic, one solution that many companies are turning to or returning to—and expanding upon—is captive insurance.

This article will explain some of the elementary aspects of captives and highlight reasons as to why this solution is receiving renewed attention. The views here are simply meant to add a few points on the map, as it were, for inquiring minds who hope to better understand and navigate the captive landscape.

What Is a Captive

To begin with, it is essential to define terms. What is a captive insurance company? In the most simplistic terms, a captive insurance company is an insurance subsidiary of a noninsurance entity or parent and is owned by the insured.

The Purpose of a Captive

While it is true that a purpose of a captive insurance company is to generate revenue, this is not the fundamental reason, nor can it justify, absolutely to all parties, the existence of formation and ongoing operations of a bona fide insurance company.

To be very clear, the purpose of an insurance company and, therefore, a captive is to pay losses (your own losses) and to afford you (the owner) more control over your risk and any losses that do occur.

Put another way, captives are an alternative risk transfer mechanism used to finance risk. They are neither inherently mysterious nor illegal, but neither are they 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

Traditional insurance transactions begin by providing an insurance company information used for underwriting and determining premiums, which are paid as consideration in a contract (policy) issued by the insurance company that obligates the company to repay losses of the policyholder under the specified conditions of the contract. However, if circumstances warrant, as they often do, other options may be sought where alternative risk financing and transfer mechanisms may prove quite useful in addressing the unmet needs of companies from traditional insurance. One of these options is captive insurance.

The best captive insurance companies are those created and utilized by companies that understand their risk profile better than the traditional market does, having superior loss histories and more robust risk management in place. These captives are run and operated by sophisticated companies looking for greater control over their risk and their risk financing.

When premiums are due, components of the premium can be "unbundled" so that the captive owner can see rates and pricing on a granular level. This gives underwriting access that can be leveraged in a way that is more consistent with risk data and risk experience. This unbundling helps to control costs and gives direct insight into how ongoing risk management techniques and practices are directly affecting premiums.

While there are numerous differences between traditional insurance companies and captives, it is important to state that alternative risk financing is not opposed to traditional insurance. Many traditional insurers own or work very closely with captives and the alternative risk financing market. Traditional insurance companies, possessing significant financial strength, will often be needed to reimburse claims resulting from large or even catastrophic losses, while they usually prefer insureds to retain costs associated with less severe risks. In this case, a captive can be used to shift costs to the insured. Other cost-shifting techniques are deductibles, retentions, and coinsurance. All these options, including a captive, provide a mutually beneficial situation offering more control to the insured and eliminating certain costs for the insurer.

The Captive Option

One of the many reasons to choose the "captive option" is because of accounting and tax rules, which allow for the deduction of insurance premiums by insurance companies. Again, as a captive is an insurance company, reserve funds held for the payment of future losses are deductible. If a company simply increases its retention, the funds held in reserve do not constitute an insurance premium, and, therefore, the tax benefit is not realized. As for the self-insurance option, it is possible, of course, but as a legal form, it is often difficult, complex, and usually used for only very large risks or risks that the market has no appetite for.

It is important to consider a captive as a cost-effective solution and structure it in such a way as to participate in the profits of your own risk and not just accept the additional costs without the added benefits. To achieve real cost-savings, you must structure the captive so that you finance more than simply small risks.

For these costs-saving economic advantages, certain elements are required. In most cases, premiums paid must be sufficiently large (e.g., over $750,000 annually), and/or coverage necessary to the operation of the parent company or group must be unavailable in the traditional market. If it is your intention to establish a new profit center, the projections of the insurance business of others will further make a case for the captive option.

As an insurance company, you must be able to pay claims and secure future losses. Full projected amounts in pro formas are rarely required to be deposited in advance. However, the ability to ultimately pay claims arising from losses must be demonstrable. Again, as an insurance company, the ability to pay claims and remain solvent cannot be overemphasized.

It is necessary to recognize that a captive is a business separate and apart from your primary operating business, no matter what structure is ultimately selected. Close attention must be paid to the formation and operation of a captive, or the consequences will nullify the advantages.

Determining the Feasibility and Goals of a Captive

The process of forming a captive begins with an actuarial analysis or feasibility study of your loss history and past claims. This will determine the accepted loss level and level of claims for your business and gives clear trends and attachment points for premiums, costs, and reinsurance. It also helps determine if forming a captive is your best option. It is imperative to determine in the early stages of formation if the proposal of using a captive will result in any anticipated long-term solution.

Once the actuary has opined on the numbers, the next step should be to further develop the goal of the captive. The initial inquiry into forming a captive may have been caused by high insurance premiums or even a lack of insurance, but there are additional reasons to consider forming a captive. These additional reasons include increased control over premium fluctuations and changes in the market, more freedom of choice between vendors and service providers, reinsurance structure options, personal tax advantages (in specific situations), and possibly even creating a new profit center. While difficult to place an exact dollar amount value on these considerations, they can materially affect the view toward the cost-effectiveness of a captive.

Domicile Selection

With an actuarial/feasibility study complete and clear goals outlined, it is time to select a domicile. There are onshore domiciles (located within the United States) and offshore domiciles (located outside the United States, in the Caribbean, Europe, Asia, and Latin America). There are many reasons for making the decision on where to form the captive. Careful consideration must be given to the regulatory environment and how the goals of the captive align with that environment. That said, expenses and profits will likely be more affected by the structure and choice of service provider than whether you are onshore or offshore.

A key difference between onshore and offshore domiciles is the regulatory approach, how rigorous the regulators are, and how the regulations are applied. A distinction that is important to captive regulation, as opposed to the regulation of traditional insurers, is that the owner of the risk (the insured) is also the owner of the captive or insurer. When regulators acknowledge this, it creates a regulatory environment that is flexible, allowing for creative solutions while simultaneously applying regulations appropriately for the health and solvency of the captive.

The best regulators have a highly developed and nuanced sense of the "principle of proportionality," which states that regulation should be proportional to the risk. As long as you are well-informed, well-financed, and well-managed, you should have greater control and freedom to use the captive in unique ways with the full support of the domicile. The quality and quantity of regulation and support services should be seen to bring the best fit to the goals of the captive.

Visiting potential domiciles and meeting with regulators in the initial stages of formation can help in choosing a domicile. Many regulators want to have face-to-face meetings to get to know prospective captive owners. Maintaining a relationship with regulators is often important to the captive's success. Some domiciles do require annual meetings to be held on-site, which can be a great opportunity to solidify relationships with regulators and local service providers.

Service Provider Selection

Following domicile selection, additional service providers will need to be selected. Depending on the specifics of the captive in question, a captive manager, a reinsurance broker, a third-party administrator (TPA), an attorney, an accountant and tax adviser, a banker, and, of course, an actuary will need to be engaged and hired.

The manager or consultant will assist in the preparation of a business plan, which will be instrumental in gaining regulatory approval and risk-sharing support. The importance of the business plan for making a case for forming the captive cannot be overstated. A well-thought-out and presented business plan will support not only the formative period but also the captive company as it matures. It is also critical that all service providers have a level of expertise about captives and be knowledgeable and supportive of your goals and expectations for the captive.

Since a captive is a company or corporation, officers and directors are needed. The captive manager and/or the attorney can handle incorporation and drafting bylaws and other formal operating documents. Most domiciles require some referencing to ensure the directors and officers are in good standing. This should simply be seen as prudent caution by regulators and is often a background check or Internet and court searches. 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 the selection of the risk-sharing partner. This is usually the reinsurer, another insurer, or an entity that insures the largest and most frequent claims. Generally, this is a licensed US-admitted insurance company. It may also offer necessary additional services to the captive, including underwriting, risk engineering, loss adjusting, claims reserving, litigation, and regulatory support. If you need to issue certificates of insurance to third parties, assuring coverage, and enter into a fronting arrangement, these risk partners can help.

Risk-sharing partners can be your current, traditional insurer, or you may have to form a partnership. It is imperative that you begin exploring possible partners early in the captive formation process. The main risk-sharing partner will likely have strong opinions on your plan and service providers. This partner will rely heavily on the work of the actuary, so communication, professionalism, and responsiveness should not be overlooked.

Additionally, they may have restrictions and requirements on practices, procedures, and vendors that will impact the success of your captive, so solid relationships are, again, 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 operations. 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 acting as a reinsurance company. It will also likely purchase reinsurance itself. It behooves the owners to set up appropriate committees, such as underwriting, claims, investment, and audit.

In the early stages, one of the most important of these committees is the investment committee. Funds will be received almost immediately and must be prudently invested but also sufficiently liquid so that they are available to pay claims. This is a major source of revenue for any captive, which previously went to the traditional, primary insurer. Earnings from these investments can, over time, be considerable and are a major motivating factor in the continued existence of the captive. Improperly managed investments can cost the owner substantial sums and imperil the continuation of the captive and even hurt the parent.

Captive managers or investment firms will often do the actual investing and offer advice, with the owner ultimately deciding what instruments to invest in. Keep in mind any regulations in place that bear on investment activity. Abiding by all statutes and regulations is essential and not simply to maintain a good relationship with the regulatory authority in the domicile and to remain in good standing but also to ensure the ultimate health and continued existence of the captive.

As surplus accrues and the familiarity and experience of the owners increase, the captive can consider taking on additional risks other than that of the owners. When this takes place, an underwriting committee should further develop underwriting standards, lines of authority, and procedures. The underwriting committee may also be responsible for establishing and maintaining the reinsurance arrangement. All of these options create opportunities to costs from the structures and policies in place before the captive existed.

Among service providers, TPAs will often be engaged if claims handling is not done "in-house." If it is, a claims committee will be responsible for regularly reviewing claims reports and to determine trends, underwriting violations, and reserving practices. It may also be involved in the selection of adjusters, attorneys where appropriate, and reserve management. Again, this is another area in which control can increase and costs can be improved from traditional placement.

Captive Advantages

There are many, many other considerations and possible captive structures. It can reinsure traditional lines such as workers compensation, general liability, auto liability, and professional liability. A captive can also write coverage for third-party risk and employee benefits. 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 also entering property lines and other more "short-tail losses." The traditional view of restricting captives to long-tail business has encountered the reality of escalating prices and lack of availability in the traditional market.

A captive can also be used to provide coverage and limits not widely available or even not available at all in the market, such as credit risk, terrorism, and pandemic risk. As previously mentioned, captives can, when appropriate, provide a tax-sheltered approach to large retentions.

In addition to this, there are occasional personal tax advantages that can be obtained with a captive, but these require a sophisticated, knowledgeable consultant, and it is of the utmost importance to be intimately aware of the current positions of the Internal Revenue Service, tax courts, and any other tax authorities who may have an interest.

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

If your approach is well-thought-out, properly executed, and diligently managed, a captive can be an ongoing option to increase risk control, further focus on risk management, and further afford owners flexibility in their risk financing approach when the tides of the traditional market change, as they so often do. A captive can also become a source of profit that will support the primary operating company or group for years to come.

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