Expert Commentary

The Greatest Captive Benefit

There is a raft of important benefits of captive ownership, but here I want to discuss the greatest benefit that any captive insurance company can bestow on its owner—a long-term, risk-taking, accretive asset.


Captives
August 2016

Instead of relying on the insurance industry, with a captive, you grow your own successful insurance company. Insurance companies make money partially because they know that many of their customers are irrationally risk averse. (Small businesses do not fall into this category, of course, as they have no choice but to buy insurance.) But, do risk managers of large companies actually understand (and act on) the actuarial and probabilistic dynamics of assuming and managing risk, or do they instead focus on low deductibles and self-insured retentions, purchasing excess coverage for risk that probably should be retained?

The risk you insure is but a drop in the proverbial bucket compared to the business and investment risks (BIR) your company takes every year. BIRs are almost entirely retained and managed, but you spend untold time and resources trying to figure out the most efficient (read low) insurable loss retentions while insuring what you think is catastrophic risk. No, friends, the majority of what you insure is not catastrophic risk. You insure this risk because you’re convinced that the cost of risk transfer is very low, so why not pay someone else to take the risk? This is not sound logic. No matter the state of the insurance markets (hard, soft, or otherwise), your risk profile does not change!

Regardless of a company's risk financing program, it ends up paying for its own losses. Think about it. If you buy insurance, and your loss ratio is 90 percent, next year’s premium will not allow that loss ratio to stand. And you cannot escape this fact.

Consider a Captive

Now let’s talk about creating a long-term, risk-taking, accretive asset, with meaningful loss retentions. If you fund a captive with expected losses based on meaningful, yet sensible, retentions and purchase a truly catastrophic loss coverage, you’ll begin to control your risk management destiny. I’m talking about retentions of between two and five times your current limit, depending on your unique circumstances. The goal is for you (the parent company) to retain the majority of losses, leaving shock losses insured in the world’s reinsurance markets or your friendly neighborhood multiline insurance company.

The definition of shock loss differs by the company, of course. As for taxes, the captive must qualify to use insurance accounting. Contrary to popular belief, this isn’t some special benefit, it’s simply the way insurance companies work.

Let’s assume you’re a property developer and have a self-insured retention (SIR) under your general liability insurance placement. The SIR is $25,000 per occurrence. However, only about half of your total losses are contained within the SIR. This means that the insurer pays the remainder, for which you pay guaranteed cost premiums.

Let’s assume that your company’s expected losses within the $25,000 SIR are about $800,000. In the following chart, expected losses correspond to three layers excess of the $25,000 SIR.

One-Year Projection

SIRs Expected Losses1 Expenses Total Premium After-Tax Premium2
25,001 to 100,000 222,000 55,000 277,500 180,375
100,001 to 250,000 170,000 42,500 212,500 138,125
250,001 to 500,000 21,000 5,250 26,250 17,063
413,000 103,250 516,250 335,563

Instead of paying the premium to a commercial insurer, it’s paid to your captive. Now expand this to reflect multiple consecutive policy years with funding (as above) each year. If ultimate losses settle less than expected, the captive retains these funds, plus investment income on all funds until they are paid as losses. Neither of these benefits is available from the commercial insurance markets.

The above premiums are estimates of what the commercial insurers would charge, but the chances are that the captive wouldn’t require the additional expenses, just the expected losses—significant cost savings as compared to the commercial insurers right from the get-go.

Conclusion

This is the greatest benefit of a captive—a bona fide (per the Internal Revenue Service) insurance company capable of paying all but the most catastrophic of losses while building a valuable corporate asset over time.


1 Actually determined

2 35 percent income tax rate


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.

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