Captive Insurance: Is it right for your business?

The use of captive insurance has grown dramatically in the past few years, but it has raised questions and remains somewhat mysterious to business owners. Clients often ask us if captive insurance makes sense for their companies. Many are interested in maximizing their value by using captives, while others merely want to understand the basics about captives.

What is a captive?

Let’s begin by exploring the basics about captive insurance companies. Just what is a captive?

A captive insurance company primarily insures the risk of its owners and sometimes affiliated firms. Towers Perrin’s definition of captive is “a closely held insurance company whose insurance business is primarily supplied by and controlled by its owners, and which the original insureds are the principal beneficiaries. A captive insurance company’s insureds have direct involvement and influence over the company’s major operations, including underwriting, claims management policy and investment.”

Captives are alternatives to traditional insurance products that have become prevalent with larger organizations. They now constitute about half of the United States insurance market. With the recent creation of new innovative captive structures, their use has migrated to many mid–sized and privately held businesses as solutions to insurance and risk problems.

Why form or join a captive program?

Reduction of risk management cost. The primary motivation for use of captives is to reduce insurance costs. We’ve all heard the horror stories about spiraling premium increases during hard market insurance cycles. By using captives, business owners achieve savings since they reduce conventional costs for insurer’s acquisition costs, administration and overhead. The captives’ loss experience, claims–handling costs and cost consciousness all determine the degree of savings.
Stabilized pricing. When a business consistently achieves stable and favorable claims experience, captives give them the ability to price insurance coverage accordingly. This is far different than in the conventional market where pricing often is subject to market cycles and broad industry classifications.
Access to coverage for difficult risks. We sometimes encounter businesses that are unable to obtain coverage in the conventional insurance market, mainly because of liability risks. Joining a group captive or establishing a captive can be a great solution to this problem. When insurance coverage is not available or prohibitively priced, captives may be an attractive option.
Improved cash flow. Captives offer owners the same advantage that traditional insurance companies enjoy — investment income from unearned premiums. This is particularly true when premiums are paid in advance and losses are paid over a long time period.
Customized insurance programs. Captives have the flexibility to provide coverage for any risk and can customize policy terms and conditions. This is far different than the traditional market, where insureds are limited to the offerings of insurers.
Improved claims handling and control. Captives design and manage their own claims handling policies, which presents clear advantages in claims processing and payment time.

What’s the possible downside of captives?

Additional administration. Since captives are owned by the insureds, owners are responsible for claims administration, loss control and underwriting. The added time, money and management commitment required for these services is sometimes a drawback for businesses. These services may be outsourced to captive management companies, but the cost to do so should be factored into any pricing analysis.
Financial burdens. During the initial phases of captive formation, there will be a significant burden financially on the owners due the set–up costs and capitalization requirements.

How about rent–a–captives?

Rent–a–captives are attractive alternatives for companies seeking the advantages of captive insurance, but that are reluctant to commit to the legal and administrative requirements of startup. In this arrangement, companies “rent” part of a rent–a–captive’s capacity and rely on their technical expertise. Rent–a–captives don’t usually share risks with each other and are accessible to companies of modest size. This arrangement can serve as a first step before joining a group captive or setting up an individual captive insurance company.

Who should consider a captive?

Here are a few rules of thumb that a prospective captive owner/renter should consider about captives:

Premium size. Premium should be large enough to achieve savings and cover expenses. Generally, $750,000 to $1,000,000 in annual premiums will overcome the start–up costs and operating expenses that are part of captive programs.
Initial capital investment. The parent should have adequate resources to exceed the minimum investment capital without draining corporate earnings. The minimum is about $100,000 but differs depending on where the captive is legally based and the type of business.
Willingness to make necessary commitments. Because of the time commitment and initial funding required when forming a captive, a business should evaluate its ability and commitment to these roles.
Good historical loss experience. Contrary to popular belief, insureds with poor loss experience are poor candidates for captive insurance arrangements. Those with good historical loss experience that are experiencing premiums increases because of market cycles are ideal candidates for captive programs.

In the right situation, captives can provide significant benefits to a parent organization. However, review and implementation shouldn’t be taken lightly with their complex structure and regulatory environments.

TriSure can help you explore the feasibility of this option and determine if it is right for your company. For more information, please contact us at 919.469.2473.