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What Is Captive Insurance?

August 30, 2023

Whether due to market pressures, adverse loss history or increased risk tolerance, companies have routinely evaluated the opportunity to take on more risk. Though the most common form of increased risk tolerance is through large deductibles, more advanced forms of risk retention have become common, including quota-share arrangements, self-insured retention models and full self-insurance.

Companies that want to assume more risk must determine how to account for and fund the risk appropriately. Since the early 1960s, captives have been one of the most valuable alternative risk management financing strategies companies can implement to formalize and fund self-insured risks.

What is captive insurance and how does an insurance captive work? Read on to learn more about these useful alternative risk solutions.

What Is a Captive Insurance Company?

A captive is a licensed insurance company owned and operated by those it insures. A single parent or a group can own a captive.

The captive is wholly funded, owned and controlled by the organization or organizations that benefit from its existence. Creating the captive gives them an alternative to purchasing insurance on the open market and allows them to tailor the coverage to the specific risks associated with their operations. The captive must abide by the regulations set forth by its captive domicile, which is the state, country or territory that licenses it.

What Is the Purpose of Captive Insurance?

Captive insurance companies enable organizations to enhance protection, customize policies and benefit from underwriting profits that generally go to a third-party insurance carrier. This type of alternative risk management carries more risk than a traditional, guaranteed cost insurance program but less risk than self-insuring.

Why Do Companies Form Captives?

Companies that have difficulty obtaining appropriate coverage for unique risks, feel insurance markets haven’t rewarded their excellent loss histories or want a more effective way to finance their risks may explore captive insurance programs. Under the right circumstances, captives can be an excellent insurance solution and cost-saving tool. Companies form captives to retain control of their destiny with their risk program. Companies should carefully consider the captive insurance pros and cons, however, as this may not be the right solution for every organization.

Related Reading: The Best Candidates for Captives.

Benefits of a Captive Insurance Company

  • A correctly structured and managed captive can provide coverage when traditional insurance carriers are unwilling to or are demanding exorbitant premiums.
  • Captive insurance company owners gain greater visibility and control over premiums and claims and direct access to additional insurance and reinsurance markets.
  • Companies gain greater access to and can tailor coverage types and limits that address their specific—and often unique or problematic—risks.
  • If the captive is structured correctly, captive owners may earn investment income on their premium reserves, enhancing cash flow.
  • Overall, captive owners can gain more control over their risks and potentially reduce insurance costs.

Potential Disadvantages of a Captive Insurance Company

  • Owners of captive insurance companies sometimes assume more risk. They must set aside enough reserve to pay any claims, which may be more than initially estimated, despite actuary reports and history.
  • Capitalization is required in the start-up phase and must remain captive for the entire life cycle.
  • Owners must actively manage the captive insurance company throughout its life, which means regularly interfacing with captive managers, insurers, regulators, tax specialists and lawyers to stay in compliance.
  • Closing a captive isn’t as simple as just shutting it down. It is a complex process that can be time-consuming and expensive. Therefore, captive formation is not a short-term strategy.

Who Should Consider Forming a Captive?

Ideal candidates for captive ownership share several characteristics:

  • They demonstrate effective risk management strategies and loss control practices.
  • They are eager to gain more visibility and control over their claims and insurance spending.
  • They are comfortable assuming more financial risk themselves.
  • They have the capital to fund the captive insurance company properly.
  • They want a long-term financial strategy for managing their risks.

Companies interested in exploring captive formation should work with a captive expert who can help them determine whether a captive would be in their best interest.

What Are the Different Types of Captives?

Captives can be structured in various ways to achieve the parent company’s key objectives. Each type of captive comes with benefits and considerations. A captive advisor can recommend the most appropriate type based on the organization’s coverage needs, available capital, risk appetite and legislative requirements.

Types of captive insurance include the following.

Single Parent Captive

Also known as a “pure” captive, a single parent captive is owned by one parent company. It insures or reinsures the risk of its parent, subsidiaries or chosen unaffiliated parties. There is no risk sharing or profit sharing with other companies.

The parent can underwrite any coverage that is an insurable risk, is actuarially determined and is approved by the domicile. The parent retains any underwriting profits but also assumes full risk for the captive.

U.S. Branch Captive

This type of single parent captive is usually formed in the U.S. as a branch of an off-shore captive. This captive type allows a company to access U.S.-only coverage, such as employee benefits and terrorism-related risks.

Group Captive or Association Captive

A group captive insurance company is owned by multiple organizations that share risks, liabilities and profits to insure or reinsure the risk of the entire group. A group captive can be homogeneous, meaning members are from the same industry, or heterogeneous, meaning members are from different industries.

Each member’s premium is based on its own loss experience, meaning it’s a controllable amount. Members of group captives make decisions for items like underwriting, loss control, operations, reinsurance coverage options, and even risk management service providers. Because the cost is shared among all group members, operating expenses for group captives are typically lower than other captive types. To learn more, read “Creating Captive Insurers Can Be an Affordable Solution for Affinity Groups and Associations.”

Risk Retention Group

A specific type of group captive, a risk retention group is regulated under U.S. federal legislation, is licensed in one state and can operate in all 50 states on an admitted basis. A risk retention group can only write liability lines of risk—not workers’ compensation or property coverage.

Cell Captive

A cell captive insurance company is formed by a third-party sponsor who “rents” cells to unrelated companies, like an apartment owner who rents apartments to individuals. Each cell’s assets and liabilities are segregated from those of other cells, with each cell owner capitalizing its own cell. Cell captives typically have lower start-up capital and ongoing frictional costs than single parent captives.

Micro Captive

Also commonly called an 831 (b) captive or small captive, a micro captive insurance company makes an IRS 831(b) election to be taxed on investment income only (not on premiums collected). Collected premium dollars must be below the threshold for the given tax year for a small captive to qualify. There are some complex rules by the IRS that must be met to make this tax election.

How Is a Captive Insurance Company Formed?

Captives are not a short-term solution to a company’s corporate risk challenges. If structured incorrectly or implemented for the wrong reasons, they can become a costly exercise in futility for the parent company.

Therefore, the first step is to work with a captive expert advisor who can help determine if a captive is a viable solution for the organization. This begins with a feasibility study.

Captive Feasibility Study

The feasibility analysis typically looks at the following:

  • Goals and objectives for the parent company
  • Exposures, coverage needs, cash flow requirements and current program evaluation
  • Domicile analysis
  • Ownership and structure analysis
  • Investment considerations
  • Regulatory and legal considerations
  • Federal and state tax considerations
  • Cost considerations
  • Implementation plan for execution

If, after careful consideration, a company determines that a captive will deliver the desired business outcomes, the captive advisor will structure and implement the captive-related insurance programs.

Captive Insurance Company Implementation

The captive advisor will lead the following captive implementation activities:

  • Business plan drafting
  • Policy drafting
  • Service provider selection
  • Domicile regulator meetings
  • Business plan submission

Once the captive is formed, it must be managed appropriately.

Captive Operation and Management

Managing and operating a captive is complex and time-consuming. While a company can possibly manage its own captive (read "Best Practices for Effective Captive Management"), in the majority of cases, they choose to let a qualified captive advisor do the following:

  • Coordinate all service providers
  • Liaise with domicile regulators
  • Coordinate and manage all board meetings
  • Coordinate renewal processes
  • Perform all financial, underwriting and corporate administration of the captive

Working with the Right Captive Insurance Team

Any organization asking "What is captive insurance?" or considering this complex risk-financing alternative should work with someone who has a vetted process for helping it understand whether forming a captive is in the company’s best interests. The advisor should have deep experience structuring and implementing these alternative risk financing solutions.

Award-winning Hylant Global Captive Solutions helps organizations that feel their better-than-average claim history isn’t being rewarded in the traditional market or have difficulty obtaining certain types of coverage explore alternative risk-financing solutions. If a captive is appropriate, the team customizes a structure, implements, operates and services the captive-related insurance program throughout its lifecycle. Executives and their stakeholders benefit by strengthening the organization’s financial performance while protecting its assets.

Learn more about Hylant Global Captive Solutions here.

The above information does not constitute advice. Always contact your insurance broker or trusted advisor for insurance-related questions.

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