Captive Insurance: 7 Questions for Understanding What It Is and If It’s Right for Your Business
While commercial insurers struggle keeping up with the changing risk needs of companies, the captive insurance industry grows in popularity. Nearly all Fortune 500 companies and thousands of small and mid-sized businesses operate captive insurance companies instead of or in addition to holding traditional insurance.
But what is a captive and is it right for your business? The myCOI team answered some common questions for understanding captives and assessing their benefits as a risk management strategy.
1. What is a captive?
A captive is an insurance company wholly owned and controlled by its insureds. Its purpose is to insure against owner risk while reducing the overall cost of that risk. Captives are licensed insurance or reinsurance companies. However, they often have a more limited scope of coverages and less stringent regulations than traditional insurance companies.
Captives represent a type of self-insurance. Rather than paying to use a commercial insurer’s money, the owners invest their own capital and resources. This means higher risk when large claims arise, but also higher financial rewards for minimal losses because companies retain the money otherwise given to traditional insurers through premiums.
2. What benefits does a captive provide?
Companies form captives for several reasons, but the most common fall into the “three C’s”:
- Coverage – companies operating high-risk ventures or those with unfavorable loss histories often cannot obtain coverage on the open market. Traditional insurance also is slow to keep pace with new threats, leaving businesses with exposed risks. Captives solve both problems with tailored insurance unique to the business that relies on the self-funded capital of the insured.
- Control – captive owners have more control over safety, losses, and claims administration. The model incentivizes safer workplaces and behaviors because the capital is the company’s. The captive dictates guidelines for its self-interest rather than the interests of a commercial insurer, which improves claims processing and speed.
- Capital – with commercial insurance, a company with a clean loss history for the year may still experience increased premiums because of a poor investment market or the overall volume of claims processed by the insurer. Captives offer improved pricing stability over time as capital is accumulated. Underwriting profits from invested premiums stay with the captive. Plus, captives carry less expenses than traditional insurance companies and gain tax benefits. Estimates show that for every $10 million in net premiums, a captive can save insureds $1-2.5 million in expenses. Well-operated captives can become profit centers while insulating against business risk.
3. How does captive insurance differ from traditional commercial insurance?
With traditional insurance, a company provides underwriting information to an insurer which determines a rate for coverage. The two parties form a contract through which the insurance company agrees to repay covered losses. Captives are considered alternative risk finance. The insured contributes to the components of the coverage, its price, and how it gets delivered.
Think of insurance like a piggy bank. Money goes into the bank until it is needed. With commercial insurance, the insurer owns the bank. The insured contributes in the form of premiums, which are set by the insurer. When the insured files a claim, the insurer determines if and how much money comes out. Whatever money is left in the bank stays with the insurer. With a captive, the insured still contributes to the piggy bank, but they have a say in setting the amount of the contribution and determining claims payments along with the insurer. The insured also gets to keep the money in the piggy bank. The bank can handle additional risk over time without higher premiums as it accrues more money every year.
It is important to note that insureds are not limited to one piggy bank. Often companies use commercial insurance for larger risks together with captive insurance for smaller, more manageable risks.
4. Are self-insurance and captive insurance the same thing?
With self-insurance, a company sets aside money to fund future losses similar to a savings account. Business owners save money by eliminating the added costs charged by commercial insurers but assume the risk of using their own money to cover catastrophic losses.
Captives are self-insurance with added benefits. The creation of the insurance company formalizes the self-funding arrangement. The insuring entity offers unique coverage for specific risks. Funds accumulate for future claims by leveraging pretax premium payments and underwriting investments. Captives also can purchase reinsurance, which adds protection by reinsuring losses above a determined threshold.
5. What types of risk can captives insure?
Captives can cover any type of risk except Directors’ and Officers’ liability. They are ideal for insuring risks not covered in the commercial market. Captives also are good for adding large risk capacity that exceeds what a traditional insurer is willing to underwrite.
6. Which companies benefit most from captives?
The first captive launched in 1953 and today there are more than 7,000 in existence. Companies of all different sizes and industries can benefit. However, captives typically have several common factors:
- Annual premium payments large enough to justify the overhead of running a captive.
- Corporations willing to increase their financial investment to capture underwriting profits.
- Companies wanting to improve their risk profile by creating a long-term insurance partner.
- Corporations with multiple locations looking to consolidate risk and leverage data to minimize future exposures.
- Businesses with risks that are uninsurable or difficult to insure with products currently in the marketplace.
- Entities with a loss history better than the market and a propensity for low-impact, high-frequency claims.
7. When might a captive not be an ideal choice?
Captives provide great financial benefits, but not without substantial resource investment including staff and capital. The owner funds all upfront costs. They also require significant leadership resources and top talent in risk mitigation and insurance management. With traditional insurance, companies can shop around annually. The same is not true for captives. Their risk protections improve over time. When they go into run-off mode before dissolution, they drive limited to no economic benefit.
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