Why Form a Captive

A captive insurance company lies somewhere between self-insurance and guaranteed cost insurance on a continuum of available risk financing techniques. To assess whether a captive is the right risk financing technique for a given situation, the potential benefits of a captive have to be compared to both self-insurance and traditional insurance. The following ten benefits are most often cited as the reason for forming a captive.

1. Insulation from market swings

A captive has the advantage of being able to charge consistent premiums and build surplus to insulate its owners from market swings associated with commercial insurance. A captive is able to do this in a more segregated and formalized environment than self-insurance mechanisms.

2. Internal smoothing of deductibles

For companies that operate on a decentralized basis, there is usually a significant difference between the amount of risk that can be comfortably retained at the corporate level and the subsidiary level. To enable these corporations to benefit from their overall financial strength and reduce the amount of external premium expenditure, an internal financing mechanism needs to be created to protect subsidiaries within the corporate retentions. A captive can be an ideal vehicle for this use and provides a formalized program to transfer the fluctuation of corporate deductibles to a captive subsidiary via the issuance of formal insurance contracts.

3. Focal point for risk management activities

A captive can be used to increase the visibility of a corporation’s risk management program. With senior managers and even operating managers participating on their Boards, captives can raise the level of awareness of risk management at these levels and help create ownership of the risk management program. A captive can also play a central role in the gathering of risk and insurance information for a decentralized organization. This is particularly true for international or decentralized programs where the captive’s participation in the insurance program may allow corporate involvement without disrupting local autonomy. These strategic benefits are difficult to reproduce in traditional insurance and self-insurance programs.

4. Coverage

Captives have more flexibility in tailoring coverage to the needs of their owners and providing coverage that is unavailable or prohibitively expensive in the commercial market. Self-funding these risks can also provide a financial buffer to protect an organization, although the greater structure of a captive may be more beneficial in creating segregated reserves and securing reinsurance support.

5. Profit

Many captives have a strong profit motive seeking to underwrite customer or related party business. The captive can often be an opportunity to sell a new service to an existing customer base, for example extended warranty insurance. Group captives often have a goal of extending beyond their initial owners to use the expertise they have developed within the captive and apply it to other peer organizations. Agency captives are primarily motivated by profit and seek to share in the successful underwriting of the risks the agency places.

6. Access to risk transfer capacity (reinsurance)

As a licensed insurer, a captive has the advantage of being able to access the reinsurance markets. This can increase the potential sources of risk transfer capacity and reduce the cost. Direct access to reinsurance can reduce the frictional costs, allow for payment of ceding commissions to the captive and lower federal excise taxes paid on the transaction.

7. Tax advantages

A captive has a potential tax advantage over self-insurance in its ability to deduct premiums paid to the captive. The tax treatment of captive premiums is an uncertain and fluid area. Any captive owner should seek advice from an insurance tax expert on the appropriate structuring of captive arrangements and the likelihood of tax deductibility before relying too heavily on this potential advantage.

8. Control over claims handling

Both captive and self-insurance programs have the potential to unbundle claims handling services with the owner/insureds having control over the TPA contracts. For liability claims the ability to have more control over claims handling is attractive to many insureds. The extent to which this can be achieved will depend to a large degree on the fronting and excess insurance or reinsurance arrangements supporting the program.

9. Risk control incentives

Being financially responsible for paying losses under captive or self-insurance programs can provide a greater incentive to prevent losses than under guaranteed cost insurance. The strength of the incentive depends on the degree to which the financial responsibility is felt by those most able to prevent the losses.

10. Cost

A captive is often seen as being able to lower frictional costs and charge stable costs independent of the commercial market. However the need for fronting and the opportunity cost associated with the capital investment and collateral requirements sometimes negate this advantage. Self-insurance mechanisms should have a cost advantage over captives, due to the management costs and capital investment associated with captives. As a result captives are rarely the optimal solution on cost alone. A combination of a captive program with self-insurance can help mitigate frictional costs while proving additional benefits.

The SRS Guide to Captives contains historical information that may no longer be accurate. It is for informational purposes only and does not constitute advice. No reliance should be placed on the information contained within this portion of the site and guidance should be sought from SRS regarding captives and alternative risk solutions. No information contained in the SRS Guide to Captives may be reproduced or copied in any format without the express permission of SRS.