Is your company paying a considerable premium annually to your insurance carrier, but in most years claims payments are far less than the premium? If so, a captive may be a creative way to lower your cost of risk and gain better control of managing your exposures. In this blog, I provide you with three helpful steps to evaluate whether a captive insurance company can be a cost-effective alternative for your organization.
Definition of a captive
Most simply, a single parent captive is an insurance company that your organization owns to insure your risks. It is an alternative risk transfer (ART) vehicle separate from your core business that is managed by specialist service providers you outsource, and is overseen by you through the captive’s board of directors. When you have a loss, rather than submitting claims for payment to a national/regional carrier, you’ll pay claims from the funds in your captive.
Its advantages
Many companies find ART helpful because sometimes traditional insurance carriers don’t fully understand idiosyncrasies of a business, and as a result, calculate an inflated rate based on their inaccurate perception of the business’ exposures. Also, if your industry has a higher average risk profile (your peers experience significant and/or frequent losses) — even if it may not be reflective of your organization’s loss experience – your rates will be higher.
With a captive, you can bypass the traditional insurance market and obtain coverage from the reinsurance carriers directly, which is where insurance carriers submit their risks for insurance (a.k.a. re-insurance). This direct access can save you by avoiding paying a portion of the administrative/underwriting expenses associated with a traditional insurance carrier.
Perhaps most importantly, you can gain more control of your risk management program through a captive. You can hire or replace any service provider responsible for the daily operations of the captive, if necessary, to fit your company’s culture, goals and financial objectives. These include captive management firms, actuaries, banks, accountants, claims managers, loss control experts and legal professionals.
Under traditional insurance, the services are non-negotiable and bundled into the premium. Managing them separately is important because you may or may not be receiving the best service available.
Another significant benefit of having a captive is the ability to tailor policy language and coverage to specifically cover your company’s risks and even exposures for which coverage might not be available in the traditional insurance marketplace.
Its disadvantages
Forming and managing a captive requires significant time, financial commitment, and a long term strategy. These factors should be weighed against any potential savings and benefits before you decide to form a captive. To determine whether a captive would be beneficial for your business, you should start with a feasibility study.
Step 1: The feasibility study
I highly recommend consulting an ART or risk management advisor who can be invaluable in providing step-by-step guidance saving you time and effort. An experienced ART advisor can assist in forming a captive and conducting a feasibility study, which includes the following preliminary considerations:
- Gather information regarding your loss runs, current exposures and premiums. These are used to estimate your expected losses, also known as a “loss pick” and to determine the capital requirement for your captive. Your ART advisor should help you select a reputable actuary, who can perform the estimation.
- The captive assumes coverage up to a certain level of risk. Beyond that point, the re-insurance company will cover any losses. Your ART advisor/reinsurance broker should prepare a submission to and negotiate with reinsurance carriers to obtain proposals for reinsurance.
- It is also important to estimate the expenses associated with forming and running a captive. Beyond reinsurance, service providers represent the second largest portion of your expenses. To select the most cost-effective and qualified team, you should interview several potential candidates and obtain fee proposals.
The information provided by the feasibility study will reveal whether there are potential savings by having a captive insurance company, and whether these savings justify the time, effort and expense involved in forming and managing the entity.
The study may indicate that you do not need a captive. However, if you do, continue with steps two and three.
Step 2: The structure and domicile
These are some of the key questions you should consider when determining the structure and domicile (aka country or state where incorporated) of the captive insurance company:
Captive Structure
- What captive structures are allowed in the selected domicile?
- What structures would be most appropriate for your business? Some you could consider include single parent, group, protected cell, association, risk retention group.
- How will the structure benefit your company and perhaps your customers or other stakeholders? (Cost savings, flexibility, enhanced coverage, etc.)
Domicile
Different countries have widely varying laws and circumstances pertaining to captives. Consider the following questions when determining whether the captive’s domicile should be in the United States or in a foreign country:
- How will the captive laws and regulations of the selected domicile affect your customers or stakeholders?
- Are current laws and regulations of the domicile captive-friendly? Is there ongoing pro-captive legislation?
- Is the domicile’s Department of Insurance (regulative body) collaborative, welcoming and service-oriented?
- For regular board meetings, how convenient is travel to the selected domicile, and what are the recreational opportunities and accommodations available?
Step 3: Captive formation and ongoing management
After you have identified the most suitable captive structure and domicile for your needs, you should interview and finalize selection of the captive’s service providers. This team of professionals will help you form and manage the captive, which includes application submission to the domicile’s regulator for approval, incorporation of the captive, appointment of board members, capitalization of the captive, and obtaining reinsurance. Once formed, the captive can begin operation under the oversight of its board of directors.
If you have any questions regarding alternative risk transfer solutions or need assistance forming a captive, feel free to contact me at cmorsberger@psafinancial.com. Our risk solutions team is highly experienced in advising all types and sizes of businesses. We help you evaluate different options and implement optimal solutions whether that be alternative risk transfer or traditional insurance.
