Definition Of Captive Insurance

If you feel powerless against the rising costs and inflexibility of commercial insurance, you’re not alone. That’s why forward-thinking business owners are turning to an alternative risk management strategy known as captive insurance. Essentially, a captive insurance company is a wholly owned subsidiary that provides risk mitigation services specifically tailored for its parent company. While captive insurance companies have been around since the 1960’s, they’ve gained immense popularity over the last decade as a smart way for mid-size and large companies to take control over their insurance costs and coverage.

Key Benefits of Captive Insurance Companies

With customized coverage, increased control, and significant tax incentives, setting up a captive insurance company could be a total game-changer for your business’s risk management and long-term success.

A captive insurance company offers an affordable, customized insurance solution that finally puts you in control of protecting your assets without compromising profits. Key benefits you can expect include:

• Tailored coverage for your specific risks
• Stable, long-term pricing independent of market fluctuations
• Underwriting profits retained rather than paid to commercial insurers
• Tax advantages and incentives can further reduce costs
• Greater control over your risk management and claims handling

The Evolution of Captive Insurance

Captive insurance companies emerged as a creative alternative in response to challenges with traditional commercial insurance. A captive insurer is a legally licensed insurance company that is formed primarily to insure the risks of its parent corporation and affiliated companies. It essentially allows a business to “self-insure” by creating a separate entity to underwrite risks and process claims. Captive insurance companies are typically wholly owned subsidiaries of the parent company, which has full control over the captive insurance company's operations and underwriting decisions. Currently, over 90% of Fortune 500 companies utilize captive insurance.

Commercial Insurance vs. Captive Insurance

One of the key distinctions between commercial insurance and captive insurance boils down to motivation. Commercial insurers are ultimately driven by profit motives and answers to shareholders. As a result, they seek to limit policyholder payouts wherever possible to boost profits. Captive insurers, on the other hand, are driven by the risk management priorities of their parent companies. Their incentives are aligned with their owners’ goals of protecting assets cost-effectively rather than generating shareholder returns. This difference in underlying motivation is why captive insurance can provide specialized coverage often unavailable in the commercial market.

5 Steps to Forming a Captive Insurance Company

Forming your own captive insurance company is a complex, multi-step process that requires working with experienced captive insurance professionals. The 5 key steps are:

1. Conduct a feasibility study - Analyze your risks, required coverage, and premium costs to determine if a captive insurance company makes financial sense for your company.
2. Select domicile and captive insurance manager - Work with a consultant to select the optimal captive insurance domicile based on regulations, taxes, and incorporation costs. Also, choose a reputable captive insurance management company.
3. Develop a business plan and capitalization model - create a detailed business plan for your captive insurance company, including proformas, capital requirements, and reinsurance needs.
4. Incorporate the captive insurance company - Work with local counsel and regulators to legally form the captive insurance company in your selected domicile.
5. Implement operations - Develop insurance policies, underwriting guidelines, and claims handling procedures. Capitalize the captive insurance company and begin underwriting risks.

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How much does it cost to set up a captive insurance company?

The upfront costs vary based on factors like the scale/complexity of the captive structure as well as capital requirements. Typically, it takes $50,000 - $75,000 in expenses to set up a single parent captive depending on complexity. The regulators require initial capital and surplus that will depend on the captive program. However, most domestic jurisdictions have a minimum capital and surplus of  $250,000 for a single parent captive. The ongoing administrative costs are also important to factor in when conducting a feasibility analysis.

Once your captive insurance company is established, you must manage ongoing operations prudently to realize the benefits while avoiding pitfalls:

1. Implement strong underwriting discipline: Work closely with your actuary to develop smart underwriting guidelines for the risks you insure through your captive. Always follow sound actuarial principles.
2. Buy adequate reinsurance if needed: Transfer catastrophic or excess risks to reinsurers so your captive’s capital is not overexposed. Reinsurance adds stability and expands your capacity.  
3. Invest premiums wisely: Develop a conservative investment strategy that prioritizes principal protection and liquidity over returns. Never expose your captive’s reserves to undue investment risk.
4. Hire experienced staff: Managing the complex operations of a captive insurance company is not a DIY endeavor. Hiring skilled and trustworthy managers is a must.
5. Get annual audits: Maintain rigorous financial controls and undergo regular independent audits to prove the captive’s sound financial standing to regulators.

What are the main risks associated with running a captive improperly?

The top risks are...

1. Insolvency due to poor underwriting or investments
2. Failing to comply with regulations resulting in sanctions or license revocation and
3. IRS scrutiny of improper tax treatment or suspicious transactions.

A key benefit of owning a captive insurance company is the ability to insure risks that are prohibitively expensive or hard to place in the commercial market. Here are 3 meaningful risks that captive insurance companies are uniquely positioned to cover:

1. Cyber risk: Captive insurance can offer specialized cyber insurance tailored to their parent company’s specific data assets and security protocols. Pricing is based on individual exposure rather than market-wide severity trends.
2. Reputational risk: Commercial policies rarely cover reputational harm from scandals, recalls, etc. However, captive insurance companies can create customized reputational damage coverage calibrated to potential loss scenarios.
3. Supply chain risk: Commercial policies provide limited coverage for supply chain disruptions. Captive insurance companies enable parent companies to insure this complex exposure based on their unique vendor network vulnerabilities.

Forward-thinking companies will embrace the captive opportunity to gain customized coverage, stable pricing, improved cash flow, and greater control over their risk management. The potential rewards are well worth the time and effort required.