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How does captive insurance work

how does captive insurance work

How does Captive Insurance Work?

Captive Insurance Company ("Captive")

Captive insurance companies are used predominantly to underwrite the business risk of other subsidiaries of the parent company or owner. The word "captive" is insurance slang used to describe an insurance company fulfilling the described role.

Benefits and Responsibilities

Insurance is the most basic risk management tool. Its purpose is to transfer certain risks at a fixed cost. When commercial insurance costs outweigh the benefits of transferring certain risks to a third party, self-insurance is an option.

When commercial insurance for certain risks is simply unavailable, self-insurance is a necessity. If the costs of commercial insurance outweigh the benefits because the potential insured's loss history and risk profile is better than others in the pool of insureds, there is pricing inefficiency which benefits the insurance company, and usually not the insured.

However, where the insurance company is owned by the insured or the owners of the insured (i.e. it is a "captive" insurance company), the insured and the insured's owners can benefit from the insureds favorable loss history. Why not retain those potentially large underwriting profits?

Captive insurance companies often are established as a sister company to its insureds, usually as a subsidiary of the parent holding company that owns the insureds. While contract and insurance law determines the insurance relationship between the parties, tax law often determines the insurance relationship between the insureds and the captive.

For the captive insurance arrangement to be respected as insurance for tax purposes, the insurance arrangements must be bona fide, must shift and distribute risks adequately, and the parent, the captive and the insureds must be separate entities for legal and tax purposes. Treatment as insurance for tax purposes can be important so that premiums may be deductible by the insureds and so that the captive will be treated as an insurance company for tax purposes.

A captive insurance company allows a business to take on favorable layers of insurance risk, and to administer their own claims when they desire. They are such efficient risk management (i.e. insurance cost management) tools that many major corporations worldwide have their own captive insurance companies.

You Already Insure Yourself - Whether You Realise It Or Not.

If a liability claim arises for which you and not a third party insurance company will pay your litigation expenses - and damages if you lose - you're self-insuring. In other words, if you're "naked" with respect to a particular risk, you're self-insuring for that risk whether you realize it or not.

Self-insurance is often deliberate. If a particular type of insurance coverage is so expensive that it is economically unreasonable to purchase the coverage, the person or business exposed to that risk will take on the risk rather than pay an insurance company to assume it.

Often, however, people and businesses are exposed to risks which they unwittingly assume. For example, if you breezed past (or didn't read at all) the section of your business's general liability policy that excludes coverage for sexual harassment claims, you may not realize that your business bears the risk of sexual harassment claims against you and its other employees. You're self-insuring for sexual harassment claims whether you know it or not.

If a claim arises, the funds to defend - and potentially pay - the claim come out of your business's coffers. If you know you've assumed that risk and others, because you've decided that commercial insurance coverage is too expensive, perhaps you set aside a reserve of funds to cover these risks. Essentially, you're setting aside an insurance fund for yourself. Unfortunately, those funds are exposed to creditors and reserves set aside for such risks cannot be deducted from your business's taxable

income for tax purposes.

A captive insurance company helps you to formalize and tailor your risk management program, and may allow you to reserve for these self-insured risks in a tax-advantaged way.

Claims Resolution

The captive insurance arrangement allows you to resolve your own claims. This gives you the ability to settle claims early if you desire, or to refuse to settle if you think that is in your better long-term interests. It also gives you the ability to select your own lawyers - lawyers who will look out for your best interests as opposed to those of a commercial insurance company. This means that you will have substantial control over the litigation process, letting you dictate the course of the litigation rather than standing by feeling helpless.

Draft Your Own Policies

A considerable advantage of using a captive is that it allows the business owner to custom-tailor the insurance to fit the business's needs, and to include or exclude certain risks as desired. For example, a property insurance policy might be drafted to cover losses due to governmental action (such as changes in environmental laws).

Some smaller captives might issue policies that don't cover liability for damages to a third-party claimant, but rather provide coverage for litigation expenses (lawyers fees, expert witness expenses, discovery expenses, etc.). This may make particularly good sense for a business exposed to the risk of frivolous litigation, where the likelihood of a plaintiff prevailing is low, but defense costs are high. With a litigation expense policy, the business can create a "war chest" to fund future defense litigation.

The effect of these policies is psychological as well as practical. A litigation expense policy effectively tells a plaintiff's lawyer, "Our insurance policy will pay to fully litigate the claim, but won't provide anything for you to collect." Facing a fully-funded legal battle without the easy pickings of insurance funds is attractive to few plaintiffs and, more importantly perhaps, few plaintiffs' lawyers.

Reducing Overall Cost of Insurance

Another potentially useful function of a captive is to cover large commercial insurance deductibles. In that case, the business is retaining the risk - in the captive - of small claims and the first layer of larger claims, while shifting the "worst-case scenario" risk to a commercial insurer. Significantly increasing a deductible in a commercial policy will lower the cost of the commercial policy, so that a business with good risk management practices and few claims can capture the cost benefits by paying premiums for that first layer of risk to the captive, and retaining underwriting profits in the captive.

That leads to another benefit of captives. Captive insurance arrangements often are attractive because of pricing inefficiencies in the commercial insurance markets. If a business's loss histories have established that the anticipated cost of claims will be less than annual premiums in the long run, then moving to a captive insurance arrangement often makes sense. Likewise, where a business is unfavorably underwritten because it is grouped into a category of business with a bad loss history, the cost of a captive insurance program may beat the cost of a commercial insurance program.

A captive can also function as a reinsurance company - that is, as an insurance company for insurance companies. This is common where the insurance in the captive program is of a type that requires that the direct insurer be admitted (licensed, essentially) to issue insurance policies in the insured's home jurisdiction. In a so-called (and perfectly legal) "fronting" arrangement, an admitted carrier will issue the policy to the insured, and the insured's captive insurer will reinsure some (or all) of the risk of the "fronting" insurer. This allows the captive to assume most of the risk and to earn most of the premium, less a fronting fee charged by the fronting insurer.

Category: Insurance

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