There are many good reasons to form a captive, and there are just as many good reasons not to form a captive.
Here are five of the most prevalent reasons many companies use to eschew the formation of a captive.
I Don't Want To Be in the Insurance Business
Once the C-suite understands that owning a captive means having to manage a bona fide insurance company, sometimes it does not approve the project (much to the consternation of the risk manager and his or her broker/consultant). Sometimes the promise of a profitable third-party business might persuade senior management to consider the captive, but it usually doesn't if they're intent on staying out of the insurance business.
Captives Are Expensive To Form and Operate
Typical single-parent captives are nothing more than formalized self-insurance. The company already self-insures the majority of its risks through large deductibles and self-insured retentions; it sees no extraordinary value in adding additional costs to a perfectly good self-insurance program. Senior management understands the value of accelerating the tax deduction for self-insured losses, but the additional costs, along with the loss of the cash flow benefits of pure self-insurance, don't make it a worthwhile endeavor.
The Internal Revenue Service (IRS)
The IRS is scrutinizing certain captives for malfeasance. The C-suite isn't interested in the details of the IRS tax evasion investigations; all they see is a potential for an audit. The risk manager may try to explain that the captive they'd form is not one that the IRS considers a tax dodge, to no avail.
Captives Are a Poor Use of Capital
The risk manager and the chief financial officer (CFO) have diametrically opposing arguments when it comes to capital management. The risk manager's position is "the more, the better" in order to satisfy solvency requirements and perhaps write additional lines of insurance. The CFO, on the other hand, wants as little capital as possible devoted to a captive in order to meet the company's hurdle rate (the rate of return in excess of the company's cost of capital). While these are not entirely mutually exclusive positions, the fact remains that a captive often does not meet the company's capital management targets.
I Have a Low Appetite for Risk
Companies that are risk-averse rarely form captives. Many of these companies must self-insure some or most of their loss exposures, only because the alternative, transferring the risk into the insurance markets, is usually way too expensive.
So, there you have it—five good reasons not to form a captive. Numbers one and five are tough to overcome, but the others may be with a deeper dive into the individual circumstances.
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