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Who Should Form a Captive?

Hale Stewart | February 15, 2019

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Everybody in the captive insurance business has a set of boilerplate criteria to determine who should form a captive. The list of factors is usually so broad that any company could qualify. Universally overlooked is this key fact: the decision to form a risk financing facility is unlike every other decision the proposed parent company makes.

Forming an insurance subsidiary—or captive—is far outside the business experience of company executives, and there is a steep learning curve to understand the inner-workings of an insurance company. This makes it vitally important for the parent company's culture to have the right attitude to form and run the captive.

Knowledgeable Insurance Purchasers Form Captives

How do we ascertain if the right mindset exists? The first step is to determine if the company is a "perfunctory" or "knowledgeable" insurance purchaser. The former describes the vast majority of insureds who don't want to buy insurance but understand its importance. They begrudgingly pay a premium but take no initiative to understand the policy. The only time they read the policy is after an accident to see if they have coverage.

A "knowledgeable" purchaser is someone who actively participates in the sales process, asking meaningful and probing questions—or attentively listening to the sales presentation and then interacting with the agent in a thoughtful manner to better understand policy nuances. This is a person who has the right attitude to form a risk financing facility.

How does someone become a "knowledgeable" purchaser? There are a number of common precursor events. Two require no explanation: the insurer denies a claim outright or offers the insured pennies on the dollar for a claim. Either result forces the insured to become more involved with the insurance process for obvious reasons.

Two others require more discussion. Some insureds can't find coverage, meaning they not only know they have a risk but also have a good idea for their specific coverage requirements. For example, it should come as no surprise that no insurer wants to underwrite nuclear power risk, forcing the industry to form Nuclear Electric Insurance Limited (NEIL). But this process also made individual nuclear providers analyze their risk needs, which are then developed in partnership with NEIL. This has also created a stronger risk management culture within nuclear power companies.

Finally, despite being a good risk, some companies face rising premiums, forcing them to seek alternatives. Ever-rising health insurance costs are the best example of this, especially in white-collar industries where the population is more health conscious.

Other Reasons for Forming a Captive

While some companies may not be "knowledgeable" purchasers, they may already be engaged in activities that could be described as "captive light." The two most common are reserving and financing warranties.

A reserve is an account on the liability side of the balance sheet earmarked for a specific cost. For example, a retailer may allocate a set percentage of sales to pay for the return of merchandise. A reserve has all the hallmarks of insurance, save for one key difference: payments into a reserve are not deductible as a business expense.

A warranty, on the other hand, is typically embedded in a contract as an express or implied promise. The most common examples involve a contract for the sale of goods in which a seller specifically states that merchandise will perform as advertised. If it doesn't, the seller replaces the good at no additional cost. This expense can be converted into an insurance premium and insured through a risk financing facility.

There are several types of companies that are more likely to have the requisite culture to form a captive. Companies of a certain size and larger are more to be attuned to risk mitigation. I use $10 million in gross revenue or 25 employees as a minimum, although opinions on these factors understandably vary.

Finally, some industries have more risk and are, therefore, more attuned to risk management and mitigation. For example, I recently visited a Houston sports doctor for joint pain. His office had numerous posters and flyers on the wall focusing on risk management and mitigation. I asked the doctor about this, and he mentioned the staff is routinely trained and evaluated on risk mitigation techniques as a way to contain insurance costs. The reason for this is simple: as a medical practice, the group faces continuing premium pressures, forcing them to engage in risk management to contain costs.

Why is the right attitude so important? Because an insurance company is unlike any other business that the parent company will undertake. Instead of selling a product or providing a service, it mitigates risk. Its internal operations are completely different. The parent company needs to develop a knowledge of reserves, claims, and asset/liability management. This takes time and effort; the parent company has to want to understand its new subsidiary, which is why it must have the right attitude.

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