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The Essential Guide To Captive Insurance

Captive insurance empowers companies to craft their own strategic insurance solutions, potentially saving money and gaining greater control of their risk. This guide provides the roadmap to navigate this powerful tool. It will walk you through the basics, ensuring a solid grounding in the concept and practice of captive insurance.
Sam Espinosa
|
February 5, 2024

Introduction

Captive insurance empowers companies to craft their own strategic insurance solutions, potentially saving money and gaining greater control of their risk.

This guide provides the roadmap to navigate this powerful tool. It will walk you through the basics, ensuring a solid grounding in the concept and practice of captive insurance.

A Review of Traditional Insurance

Just like health or home insurance for an individual, when a business buys insurance, it pays an insurance company a fee (called a premium) in exchange for protection against certain types of losses.

When such a loss occurs, the business must file a claim. If the loss is determined to be covered by the insurance policy, the insurer issues a reimbursement. However, if the loss is not expressly covered by the policy, the claim is denied and no reimbursement is issued.

This traditional insurance system is a good deal for a business so long as the costs of their actual losses are more than the cost of the coverage.

But, the opposite is true for the insurance company, where the system only works if the amount they collect in premium is more than they pay out in claims. The relationship between premiums collected and claims paid is called the 'Loss Ratio.'  The 'Combined Ratio' (premiums collected vs. claims paid + operational expenses) is the ultimate indicator of profitability for an insurance company.

For an insurer, a combined ratio below 100% reveals the extent to which they are profitable. The lower the percentage, the bigger their profit.

Traditional Insurance vs. The Modern World

Today’s world of risk is increasingly dynamic and unpredictable. To remain operational amidst such uncertainty, insurance companies have dramatically increased premiums (particularly for certain types of insurance) to preemptively insulate their loss ratios. That is, they charge more for coverage to make sure there is money left over after paying out claims.

For businesses that routinely experience losses that still exceed the rising cost of their premium, the arrangement is well suited. But, for all of the other businesses that find themselves paying more for coverage (and often, a lot more) than their actual losses, something has got to give.

A New Approach: Captive Insurance

Captive insurance is a different way to protect a business against its risks, while using the same concepts of traditional insurance to build value. Here’s how it works:

First, the business designs the ideal insurance policy to cover their unique risks. Then, it determines the amount of premium needed to support that policy. But, instead of paying the premium to a traditional insurance company, the business creates a new company, its own insurance company, and pays the premium to it, instead.

Now, anytime there is a loss, it can be instantly reimbursed. No more claims hassle. And, because any unclaimed premium becomes profit for the captive insurance company (see: loss ratio above), the business actually retains the earnings instead of giving them away to an outside insurer.

In a way, captive insurance vs. traditional insurance could be understood through an analogy as the choice between renting and owning a home:

  • Traditional insurance is like renting. The rent (premium) can increase annually, and the lease (policy) may not be renewed by the landlord (insurer). But, there are no upfront costs beyond rent, and the cost of any major repairs are usually not the renter's responsibility.
  • A captive is like buying a home. There are upfront costs like a down payment (captive formation costs), and there are still mortgage payments (premium). But, the homeowner has more control; the home can be customized in any way. Over time, a homeowner also builds tangible equity.

The Benefits of a Captive

Consider this simple example:

Over time, and with good a combined ratio, the profits held by the captive insurance company become a formidable capital fund that can support the parent business in many ways.

The profits can be invested in the stock market, loaned back to the business, returned as dividends to shareholders or policyholders, and much more.

The Worst Case Scenario

But if a captive is so valuable, why doesn’t every business have one?

In truth, going captive is a complex, often complicated process. Over 10 professional services are needed throughout the process. Quite simply, most businesses outside of the Fortune 500 do not have the internal resources to confidently select the right vendors and make the right decisions based on their advice to successfully navigate the process.

However, for those who have decided a captive is a good fit, one specific concern looms large.

The most commonly expressed concern when considering a captive is:  “What if I experience losses that exceed the amount in my captive?”

The good news is that most captives incorporate Reinsurance to protect against this exact scenario. Reinsurance limits the financial exposure of a captive, and protects its surplus.

Reinsurance works a lot like regular insurance. You pay for reinsurance in the form of a premium, the price of which depends on the type and amount of coverage you need.

The captive uses its own funds to pay for losses up to a certain point, beyond which reinsurance steps in to cover the rest.

The threshold that triggers reinsurance is called the Attachment Point. Determining the proper attachment point is a vital part of captive program design, as it impacts not only the cost and availability of reinsurance, but the potential exposure to catastrophic loss of the captive itself.

With the right reinsurance strategy, even the worst case loss scenario for a captive in any given year (you spend 100% of what you put into the captive) is the guaranteed outcome with traditional insurance every year (100% of your premium is kept by the insurer).

And since every year is typically not the worst case scenario, the more likely outcome is that profits grow in the captive year over year, eventually maturing into a significant financial stockpile.

The Early Years

Still, a new captive is more vulnerable in its infant years, where significant losses, combined with a suboptimal reinsurance program, could deplete or erase the available funds. In this scenario, additional capital investment may be needed to maintain regulatory requirements. A sophisticated captive manager can dramatically reduce the likelihood of this scenario through proper planning and program strategy.

As a captives’ operating balance grows from retained earnings year over year, it steadily insulates itself from the losses within any single year and gains the financial flexibility to reduce the scope and cost of reinsurance.

How Reinsurance Works

Reinsurance needs are considered when determining the total premium for a captive, as the payment for that reinsurance can be drawn directly from the premium once the captive is funded.

When shopping for reinsurance, the captive can decide the type and amount of coverage needed, as well as the attachment point.

A higher attachment point might lower the cost of reinsurance (the captive will pay more out-of-pocket before reinsurance kicks in). A lower attachment point might cost more in reinsurance premium, but the captive will have to pay less out-of-pocket for a loss.  In this way, a business can incorporate their own risk appetite into the reinsurance strategy.

However, the reinsurance market can also dictate the range of options for a captive. The type or amount of coverage needed, the desired attachment point, and the specific loss history of the business will influence a reinsurer's willingness to write the policy.  This is where an experienced captive manager can help to navigate the reinsurance market and secure the ideal coverage.

Fun Fact:

Insurance companies actually leverage the exact same reinsurance system for the traditional policies they sell, it just happens behind the scenes. The insurance company takes a portion of the premium they receive from a business and send it to perhaps many reinsurers, each responsible for covering losses within agreed-upon dollar thresholds. For example, Reinsurer #1 might cover losses between $1-5M, where Reinsurer #2 covers losses from $5M-$10M, and so on.

Insurance companies leverage reinsurance to de-risk their own exposure. In the event of a major claim, no single party wants to be 100% responsible for footing the bill.

Navigating the reinsurance landscape can be challenging and time consuming, but the right captive manager will know the ins and outs to make the process go smoothly.

For a more in depth review of Captive Reinsurance, visit our blog to read How Captive Reinsurance Works.

The Anatomy of Captive Insurance

Practically speaking, a captive insurance company is just a bank account with a pair of licenses. Often, the company must secure a license from the state’s Secretary of State in order to operate (just like any other business). Second, the company secures an insurance license from the state’s department of insurance (in order to legally accept premiums and pay claims). The issuance of the insurance license is conditioned upon the completion of an application, an actuarial study calculating the proper loss cost for the insured, collateralization of the company, and other fact-specific steps depending on the complexity of the program.

The Genesis of Captive Insurance

The concept of captive insurance emerged as a solution for businesses seeking customized risk management. It was born out of necessity when traditional insurance markets were either too costly or did not cover specific business risks.

Captive insurance lore generally agrees that captive insurance emerged in the mid-20th century as the brainchild of Fred Reiss. He leveraged a self-insurance model to provide coverage for a company’s various insurance issues for mining and heavy industrial activities.

The success of his concept slowly spread through the alternative risk transfer markets and ultimately achieved ubiquity in the wake of the Humana v Commissioner case resolved in favor of the taxpayer in the late 1980’s.

Fast forward to 2023, and the largest corporations now dominate the captive landscape. Over 90% of the Fortune 500 use one or more captives. And, 70% of all captives are managed by the 10 largest captive management firms.

Captivating Value

Captives allow a business’ insurance budget to work double time. First, to cover any losses. Then, to earn profit from the surplus. Captives instantly transform an insurance liability into an asset, giving the business:

Total Control of Insurance

  • Design an insurance plan that rewards risk management performance. Then, the ability to keep the profit, fund growth, and benefit from potential tax advantages.

Tailor-Fit Coverage

  • The flexibility to customize coverage to match any risks, and close coverage gaps that are created by typical policy exclusions through traditional markets.

Funding For Growth

  • Surplus that can be used to reimburse operations, reinvest in growth, or launch profitable insurance services (like launching an Embedded Insurance program).

Better Risk Management

  • Aligned incentives that drive improvement in risk management strategy. When the premium surplus can be kept as profit, the business has a vested interest in taking steps to limit losses.

Instant, Easy Claims

  • No more frustration, delays, or denials from an insurance company when filing claims. Because a captive is designed by and for the business, there is no confusion surrounding which losses are covered under the policy.

Asset Protection

  • As a wholly-owned subsidiary, a captive insulates a business and its assets from its risks.

Examining captive insurance from a financial perspective, the structure allows for potential savings, direct access to reinsurance markets, and efficient use of capital.

Captives are long-term, strategic risk management vehicles. This is because each year, the surplus can be retained by the captive, and compounded the following year. Over time, the captive fund builds into a powerful financial resource that can be used to support the growth of the parent business. Consider the chart below that displays the performance of a captive after 5 years of operation:

Want to explore the various influences on Captive performance? Take The Quiz. Then, log into your account to gain access to the Captive Simulator. Adjust the annual premium or total claims to refine your results.

Types of Captives

There are many types of captive insurance companies. Single-parent captives, group captives, and micro-captives represent the most common. Each serves different business structures and risk profiles. The primary distinction between each type of captive is how the business entity is structured and governed.

Let’s use an analogy to explain the most common structure types, and why they are used:

Pretend that ACME Company is creating ACME Hotel (A Captive).

Single/Pure Captive: ACME company owns the entire hotel.

This arrangement provides ACME with the most control and 100% of risks and benefits. It is the most difficult and expensive to set up, and carries the most ongoing responsibilities.

Group Captive: ACME and a group of other companies join together to buy the hotel.

This arrangement spreads the costs across multiple owners, making it less expensive to start and operate. But, it can also increase risk. Something that happens on one floor can impact other floors.

Segregated Cells: ACME owns the hotel, but sells (or rents) an ownership stake in the rooms, to any number of other companies.

This arrangement makes it easier for ACME to profit from the hotel, and makes it much easier for other companies to join the venture and share in the benefits with far fewer requirements.

Setting Up a Captive

The process of setting up a captive involves several milestones, and a variety of professional services.

Milestones

  • Choosing a domicile
  • Meeting capital requirements
  • Feasibility study
  • Reinsurance / Fronting Needs
  • Regulator approval
  • Ongoing management
  • Annual compliance

Pro Services

  • Legal
  • Actuaries
  • Advisors
  • Regulators
  • Audit & Tax
  • Accountants
  • Investment
  • Reinsurance
  • Claims

To fully explore the process of planning, forming, and managing a captive, click here.

Tax Considerations

Captives can provide tax benefits under certain conditions, such as the ability to deduct premiums and the exclusion of income for small insurance carriers under specific premium thresholds. Unlike traditional insurance premiums, which are considered expenses, premiums paid to a qualified captive are deductible as business expenses for the insured entity. This reduces taxable income, potentially leading to significant tax savings. Investment income within the captive can grow tax-deferred until distributed, offering a potential growth advantage. Captives established in certain jurisdictions or domiciles with favorable tax laws can offer additional tax advantages.

Small captives meeting specific premium thresholds can enjoy tax-exempt status on underwriting profits, further boosting their financial attractiveness. For instance, the IRC 831(b) election provides the opportunity for a captive insurance company to elect not to be taxed on underwriting profit earned within a calendar year. This election is open to captives writing less than $2.8 million in premium (as of 2024, indexed to inflation). However, it should be noted that these captives are often frequent targets of IRS litigation and can be seen as aggressive tax avoidance strategies if not complaint and properly managed by professionals.

Challenges and Considerations

While captives offer numerous benefits, they also come with a few challenges.

Orchestrating the cooperation of nearly a dozen professional services and meeting potentially high capital requirements can certainly complicate and prolong captive formation. Then, once operational, managing the day-to-day operations, regulatory scrutiny, unpredictable reinsurance markets, and emerging risks may also test viability. Businesses should be aware of these challenges and have a plan in place to address them before getting started.

Conclusion

Captive insurance is a strategic choice for companies looking to take control of their risks and potentially improve their related financial outcomes. With the right approach and expert guidance, a captive can be a powerful tool for business resilience, innovation, and growth.

If you are considering a captive, ask yourself this single question:

Does our business pay more for insurance premiums than we claim in losses?  If the answer is yes, a captive might be the best way to solve your insurance problem.

Want to know for sure? Take Our Quiz.

In just 5 minutes, you will receive an instant XN Captive Star Rating to indicate how well-suited your business is for a captive.

By creating an free account, you'll also gain access to in-depth analysis that includes:

5 years of simulated financial data, including your captive’s potential:
  • Premium level
  • Expected losses
  • Administration fees
  • Operational expenses
  • Reinsurance pricing
  • Annual surplus
  • Cumulative earnings
  • Investment income

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