Although captive insurance has been an accepted risk management tool for over 70 years, it remains criminally underutilized for a number of reasons. The fact that insurance is one of the most dreaded business purchases doesn't help, nor does the industry's negative image. But the biggest obstacle remains the insurance business' opaque and complex nature.
Insurers are financial intermediaries whose operations involve actuarial analysis, complex accounting machinations, obscure tax code provisions, and, to avoid the pitfalls, a knowledge of antiavoidance law. This is not a recipe for widespread use.
But the benefits can be substantial for one reason—managing and mitigating risk can be financially rewarding. The reason is simple: the greater the risk inherent in a company, then the more an insurer will charge for coverage. When a company implements a captive and risk mitigation program, it lowers the frequency and number of claims, which eventually lowers the cost of insurance.
The purpose of this article is to help individuals gain a better understanding of the captive insurance transaction so that they are able to recommend or implement it at the appropriate time. The first section identifies factors that should be present in a captive candidate. The second section explains how a captive insurance company fits into a broader alternative risk transfer (ART) program, while the third section explains at a high level the parties involved in putting together a program.
What Is a Captive and Why Did Companies Start Forming Them?
A captive insurance company is nothing more than an insurance subsidiary of a larger parent company. For example, Acme Manufacturing forms Acme Assurance, which is a wholly-owned subsidiary of Acme Manufacturing. Acme Assurance only sells insurance to Acme Manufacturing. That's it.
Companies started to form captives in the 1950s because the insurance market either didn't provide insurance or only sold very expensive policies, forcing insureds to consider nontraditional options. This has happened to varying degrees during the last 70 years. For example, large jury awards from the tort litigation explosion in the 1970s led to a very difficult market in the 1980s. The problem became so pronounced that Time Magazine's cover on March 24, 1986, said, "Sorry America, Your Insurance Has Been Canceled." Currently, the trucking market is experiencing a similarly difficult environment due to large claims.
Who Should Form a Captive Insurance Program?
Ultimately, this is mostly a larger company transaction. While there are no bright-line rules, a good rule of thumb is that the insured has at least a combined $1.5 million of current ground-up insurance premiums. (Ground-up is an insurance term that refers to coverage for a loss that includes the entire amount of an insurance loss, including deductibles, before application of any retention or reinsurance.)
A negative experience with an insurance company is an excellent reason to form a captive. A complete denial of a claim—especially when the insured was confident in his coverage—is sufficient to consider a captive option. Difficulty in settling a claim can also provide the factual precursor, as can a single large premium increase or a series of hikes that eventually make the cost of insurance nearly prohibitive.1
The parent company's corporate culture should also be considered. A company that already has a risk mitigation culture in place is a superior candidate. So is a strong entrepreneurial spirit, as this indicates management has the required attitude to learn a complex and difficult-to-understand business. It's also helpful if the perspective parent company has a person completely devoted to managing insurance purchases or who is at least actively involved with the process, to the point where they regularly interact with an insurance broker or claims service.
Alternative Risk Transfer Explained
A captive insurance program is only a piece of an ART program. To explain how this works, it's best to start with a "nonalternative" insurance program that has two components: traditional third-party insurance and self-insured retentions (SIRs), either in the form of large deductibles or no coverage.
Traditional risk transfer has three main benefits.
Trading a predictable cash flow for a nonpredictable cash flow. This benefit is best explained by the following hypothetical fact pattern. Assume an insured owns $1 million of commercial real estate that can be completely insured for $100,000. Should they go without insurance, their potential cost of risk could be anywhere between $0 and $1 million. The variability in potential outcomes greatly complicates financial planning. In comparison, the $100,000 insurance premium provides certainty, allowing the insured to better project finances.
Well-known policy provisions. US insurance policies are form-based. For example, the commercial general liability (CGL) policy was first issued in 1954. While it's been revised several times, most of its core terms and definitions have remained the same. As a result, there is a tremendous amount of case law fleshing out the policy. This gives lawyers a tremendous advantage in understanding the policy's terms and conditions.
Efficient pricing. Most large and established insurers issue such common policies as CGL, commercial property, and excess/umbrella coverage. These companies aggressively compete for these premium dollars, usually offering a potential insured many affordable options.
There are, however, three drawbacks to this method of underwriting risk.
The morale hazard. This occurs when the existence of insurance causes the insured to have a lackadaisical attitude about risk management. A well-insured company is less likely to implement a risk management program because it knows that, should a risk occur, a third-party will pay for it.
The "boilerplate" problem. US insurance is conducted on forms that are written by the Insurance Services Offices, Inc. The organization broadly drafts policies in order to get them approved in a majority of states. While this method of "drafting" contracts lowers the transaction cost, it also invites litigation due to the breadth of the forms.
The more obscure and expensive a risk, the less likely a major insurance company will underwrite it. CGL and commercial property insurance provide broad coverage for well-known risks. Compare that to pollution insurance, where payouts are usually larger and litigation is far more complex. This leads to the following rule of thumb: the more specific and obscure a risk, then the more expensive the premium and the greater the difficulty in finding adequate coverage.
In addition to third-party insurance, a traditional risk transfer program has either a deductible or SIR. Both terms mean the amount of risk paid by the insured. The former is usually used for a small amount, while the latter is used for larger retentions. For example, a deductible might be $5,000, whereas an SIR might be $100,000.
Now that we've described a traditional risk transfer program, we can move on to an ART program, which has four components: third-party insurance, an SIR, a comprehensive company-wide risk management program, and a captive insurance company (optional).
All captive programs utilize third-party insurance for the benefits outlined above: competitive pricing, well-known policy provisions, and the trading of a nonpredictable cash flow for a predictable one. But an ART program should underwrite a larger deductible for its third-party insurance. For example, while most policies have low deductibles (such as $5,000), an ART program's deductible would be $100,000. Because the insured is now responsible for the first layer of risk, it is now incentivized to lower its cost.
It's imperative for the company to either bolster an existing risk management program or create one. The entire company must buy into this program, from the highest executive to the lowliest employee. Management must actively promote it, fund it, measure it, and make adjustments after implementation. The purpose of this program is to create a risk-sensitive culture in the company leading to lower claims, which eventually lowers the cost of insurance.
Finally, an insured may form a captive insurance company to fund some of its risk. As noted above, this is nothing more than an insurance company owned by the insured that underwrites the insured's risks.
Parties Involved in Developing an Alternative Risk Program
When captive insurance first started in the 1950s and 1960s, it was unknown whether or not a captive insurance program would be beneficial to the parent company. Hence, the report's primary purpose was to determine if the program was "feasible." This is the origin of the phrase "feasibility study," which is the name of the report that outlines the parameters of the captive insurance program. While in modern practice—people involved with a program's design have a good idea of a program's viability early in the process—the name lives on.
Before looking at the legal side of the formation ledger, let's briefly discuss the role accountants and actuaries play in the formation process. As the insured will be financially responsible for some or all of its risk, it needs to know how much it can afford to pay. This means accountants are needed to analyze previous years' cash flows as well as projecting the parent company's future cash-generation capabilities.
An actuary's main job is to price risk. The actuary determines the amount of premium for the policies the captive will issue. But their responsibilities don't stop there. They'll also project losses, help in the reserving process, and identify risks to underwrite.
Lawyers have several responsibilities during the captive formation process. The first is to analyze the insured's currently in-force insurance policies to determine the exact risks covered, along with exclusions, limitations, and extensions of coverages. The second is to look at the legal risks that the insured currently faces to see the extent of the insured's potential exposure. This involves linking potential risks imposed via statute2 along with other potential risks and coverages. For example, a company with a large number of employees should analyze the entire employment cycle from the initial contact with a prospective employee to the exit interview to determine potential weaknesses in the employment process. Lawyers also draft insurance policies and corporate documents and help to fold the captive into a larger corporate structure.
These pieces are assembled in the feasibility study that outlines the insurance program. This is then submitted to the insurance regulator to gain approval to form a captive insurer.
It can't be stressed enough that an ART program is not for everybody. As noted above, only companies of a certain size and larger should consider one. And the prospective parent company should also have a more-than-average amount of risk or hard-to-insure exposures. It's also imperative that the prospect either have a risk management program in place or be willing to implement a broad and well-funded program. But, if some of these criteria exist, the rewards can be profound in the form of lower insurance premiums and a build-up of savings in the captive program.
If you'd like to learn more, please see my books: Captive Insurance in Plain English and U.S.Captive Insurance Law.
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1 All of these events are more likely to encourage the candidate to initiate a risk management program to lower the cost of their risk.
2 These include federal and state employment law, environmental law, and intellectual property issues along with other risks.