Reasons for Establishing a Captive

Probably the most common reason for establishing a captive is to minimize overall costs of risk and risk management. Insurance purchased in the conventional market includes an allocation for the insurer’s overheads and profits, which is expected on average to be about 30% of the premium. Many insurers purchase coverage through the traditional distribution system, which often includes significant friction costs. For example, the premiums paid to the insurance broker can be subject to a commission of 10% before being passed to the insurer. The latter will assume some, often a small portion, of the risk, then purchase reinsurance coverage. The premium for this is paid to a reinsurance broker who takes a commission of 15%-20%. Many reinsurers will seek retrocession protection again through a broker. Establishing a captive often eliminates at least one layer of friction costs at material savings.

Other cost reduction opportunities include:

• Establishing the captive as the insurer or direct writer. This reduces the commission costs associated with commercial insurance companies.
• Incurring the costs of its affiliated risks without sharing the poor experience of other insurers. Commercial insurers have to factor their overall pool of risk into the premiums charged to any one insured.

Some captives have been formed because coverage – for example for a new or potentially hazardous product – is either unavailable in the conventional market or is only available at an unacceptably high price. Other examples include inadequate conventional coverage availability for environmental pollution, medical malpractice and natural catastrophes.

The insurance industry is subject to considerable cyclical changes in which excess capacity leads to competition resulting in decreased premium rates and subsequently high loss ratios. This results in increased rates and reduced capacity, which may cause some types of coverage to be unavailable until increased capacity re-establishes a market. This sudden unavailability or excessive cost of the required coverage may cause insureds to contemplate the establishment of a captive. A captive can create a stable base from which the insured can be confident in obtaining coverage, irrespective of the commercial market offerings, and pricing control.

The assumption or retention of its own risk within certain limits is attractive to a company with a better loss history than its industry’s average. The existence of good risk management capabilities and the use of risk management tools, such as intensive claims analysis, related loss prevention and other control methods, can maintain and improve loss profiles and cost.

The insurance industry has traditionally relied upon investment income to supplement its often negative or modest underwriting results. Investment income is generated primarily from funds held as unearned premiums and reserved but unpaid losses. Premiums are usually paid in advance, often annually, while claims tend to be paid out over a period of time, the length of which depends on the type of business.

Another benefit resulting from establishing a captive is its ability to gain access to the international reinsurance market – the wholesale market for insurance. As well as avoiding possibly one layer of friction costs and commercial insurance company costs, the insured is able to present its case face to face with the main risk taker. The reinsurance markets are generally financially stronger and more sophisticated than the primary market. These presentations allow the insurers to better understand the nature of the insured risks. This has proved to be one of the most significant benefits of captive insurance.

Another reason for establishing a captive is to diversify into open market insurance services and operate as a separate commercial profit centre. Although the primary reason for forming a parent-only captive is usually to reduce insurance costs, an ancillary benefit may be the generation of profits from unrelated business. However, the underwriting of such business also exposes the company to less controllable underwriting losses. Successful examples of such captives indicate that some underwriting control by the parent, including a professional selection of business underwritten, is desirable.

The subject of tax planning in connection with the use of captives is a complex one and anti-avoidance tax legislation now exists in many countries. Consequently, expert legal and tax advice must always be sought in advance of establishing a captive insurance subsidiary. As indicated above, the establishment of a captive insurance company should always be determined by its viability as an insurance operation, independent of any tax consideration, which should be viewed as incidental.

A captive may be used to centrally retain risk at a level that a group as a whole can afford, while allowing operating units to retain only those levels which they can individually afford.