Is a Captive Right for Your Organization?

The insurance marketplace has a long history of cycles – i.e., periods of “hard” markets where commercial coverage is more expensive and becomes more difficult to buy and other (more pleasant!) periods when coverage becomes available at a more reasonable price. Risk managers are currently experiencing a hard market, particularly for property insurance. During hard markets, the prospect of self-insurance becomes more appealing for many organizations. One of the most common ways organizations can self-insure and stabilize their risk transfer costs is to form a captive.

Understanding captives

A captive is a licensed and regulated insurance entity (a subsidiary of an otherwise non-insurance parent company) that typically underwrites the risks of its sponsor or parent organization. Over the past several decades, captives have evolved and taken on different structures to meet the risk-financing needs of their owners. Today, there are about 7,000 captives based in 75 domiciles around the world.  

Here are the different kinds of captives that risk managers can consider forming in 2023: 

Single-parent captive

A single-parent captive is a stand-alone legal entity that insures the risks of its parent, affiliates, and/or third parties. Also known as a “pure” captive, this has been a traditional structure since the first one was formed early in the 20th century.

Cell captive

A cell captive describes several different variations on a simple concept: cells are part of a larger entity providing licensing and operating infrastructure, but each cell is separately capitalized and segregated from the liabilities of other cells. It’s similar to condominium units, with individual owners and their assets residing in the same building. Other types of cell captives are segregated portfolio companies, protected cell companies, and segregated account companies.

Group captive

A group captive operates like a pure captive, except it has multiple owners. Owners may be in the same or adjacent industries or in different industries. Group captive members typically share in the profits and losses of the group captive, in effect subsidizing each other’s risks.

Risk-retention group (RRG)

RRGs were first authorized in 1981 for product liability risks but became numerous after the Liability Risk Retention Act in 1986, which Congress enacted in response to a liability insurance crisis in the mid-1980s. RRGs are similar to group captives and, by law, are allowed to write liability risks nationwide – but not property risks – as long as they meet the regulations of their state of domicile. RRG members must be in the same industries or have substantially similar liability exposures.

Special-purpose vehicle (SPV)

SPVs are widely used in risk securitization or insurance-linked securities, which finance risk through the capital markets instead of traditional insurance. Examples are catastrophe bonds and longevity swaps. Captives can be authorized as SPVs for owners that wish to engage in risk securitization.

Efficiencies gained in a captive

Captives offer several advantages in risk financing. These include: 

Financial flexibility

Captives enable their owners to better control premiums and monitor loss development, enabling organizations to pre-fund losses. Captive owners also serve third parties, potentially making the captive a profit center by offering coverages such as warranties and liability protection.  Additionally, when a captive is able to offer coverage to entities other than just their corporate parent, they may be able to qualify for some tax efficiencies and deferrals.    

Customized coverage

Captives, for the most part, can underwrite any line of property or casualty insurance. It can offer customized coverages that are unavailable or excluded by commercial sources. Additionally, there are some great advantages to adding employee benefits, health, and pension-related coverages into a captive.

Stable source of capacity

Pre-loss funding through a captive provides a stable source of capacity for its owner’s risks. Commercial insurers may expand or withdraw capacity for certain risks based on financial performance. A captive, therefore, can be an important source of risk financing independent of market dynamics.

Potentially reduced cost of risk transfer

Commercial insurance companies price risks to account for administrative overhead and profit to meet internal financial goals. These items often do not apply to a captive. With effective loss control and even more motivation to reduce losses (since the captive subsidiary will ultimately be responsible for those losses), a captive’s underwriting results can surpass those of a commercial insurer.

These efficiencies and benefits continue to attract attention from organizations large and small. During 2022 and 2023, captive formations have increased around the world. 

Important considerations 

Before jumping into the deep end of the pool, risk professionals should know that forming a captive carries several important considerations. Firstly, a captive is not a short-term solution to address risk transfer expenses. It requires not only a sustained commitment of capital but also a long-term approach to risk management and loss mitigation. In addition, the captive’s objectives should be closely aligned with corporate objectives so it can support the business strategy. Additional professional services are needed to run a captive, including actuarial, claims, accounting, and legal support.

Partners needed for collaboration

Another element to consider is captives are, by their nature, collaborative ventures. A variety of partners with specialized skills and knowledge is necessary to effectively run a captive. Captives must comply with licensing and insurance regulations in their domicile, which may or may not be the same location as the owner’s headquarters. Domiciles typically require captives to have a full-time administrator.

Running an insurance entity has some practical requirements, including local banking and legal services and experienced underwriting and claims staff. In some jurisdictions, captives writing certain coverages, such as automobile liability or workers’ compensation, may require fronting insurance partners. The risk may be 100% reinsured by the captive, but a fronting relationship may be needed so that a licensed and admitted insurer can issue the necessary policies. There is some complexity to the network of partnerships that captives entail.

How to make it happen

To explore whether a captive makes sense for your organization, consider your organization’s risk profile, financial ability, and willingness to retain risk. Talk with your broker or risk advisor. Good sources of information and guides on captives are available from leading captive management companies.

An initial step in the process is conducting a captive feasibility study to examine your organization’s risk tolerance and financial needs. Working with experts in captive insurance, your organization can better understand and choose from the options that make financial sense.

LineSlip Solutions offers risk professionals one-click access to their risk management program details, including some key captive data. To learn more, visit https://www.lineslipsolutions.com/risk-manager.