There are many reasons an organization chooses to form a captive. The best way to fully understand the specific opportunities and benefits for your particular organization is to consult with a risk management advisor who has expertise in the captive, traditional, and the alternative risk transfer insurance markets. Such a professional would likely gather some initial information, evaluate the organization’s risk-management goals and then, if it appears a captive insurance strategy is at least a realistic possibility, recommend conducting a formal feasibility study. This process is an essential component of determining the projected return on the investment made to establish and manage a captive. After all, forming a captive is a risk-financing strategy. If the benefits are strong enough to meet or exceed the organization’s internal ROI requirements, then captive formation warrants serious consideration. Although the package of benefits behind each captive will be unique to the particular organization it serves, there are certain benefits that are relatively universal.
The greatest benefit a captive offers companies is significantly greater control over their risk-management program. This occurs in many ways and will be evident in the following discussion of just a few of the specific benefits of captive formation.
Improved cash flow
Beyond achieving lower premium costs, the use of captives can benefit organizations by improving cash flow. This can be achieved through developing precisely tailored coverages, improving claims handling and stabilizing insurance budgets.
Earlier, we compared buying insurance to buying clothing. In our highly simplified analogy, we said buying from a commercial carrier is like buying clothes off the rack and having the choice of small, medium or large; whereas, buying through a captive is like buying clothes through a tailor who custom makes the clothes for one individual to achieve a perfect fit. A captive simply provides an organization with more risk financing options to create the best fit.
A good example of how this works is found in how small claims are handled. In the commercial insurance industry, a significant percentage of total expense is generated by what are characterized as high-frequency, low-severity claims. These are the claims that individually are de minimis, but collectively, they can account for a significant portion of an insured’s total premium. A company that operates a captive can take a higher deductible to cover these small claims and purchase coverage from the captive to cover larger claims. The captive could then go to the reinsurance market to secure appropriate coverage for higher claim amounts. This saves the commercial insurer from shouldering the cost of such claims and results in a lower premium for the insured.
Improved claims handling and reporting
The premiums a company pays to a commercial insurer are based in large measure on industry-average claim-processing costs. The claims your company incurs are handled by the insurance company’s claim administrators. This will be either the insurer’s own administrators or more often, a contracted third-party administrator (or “TPA”). How well the TPA performs in terms of the time and cost to resolve claims will be a key factor in determining your premium costs. The challenge for you is that although there may be steps you could take to have a positive impact on those costs, you have no control over the TPA. Caseloads for claim managers are notoriously well in excess of anything they could effectively handle on a consistent basis. Decisions that could expedite claim resolution are routinely delayed. Claim settlement strategies that might be appropriate for your organization are ignored in favor of traditional routine. Opportunities to provide input in any meaningful way on important claim-management decisions are effectively nonexistent. In the end, you get results that are often not based on your needs, but rather, results based on the insurer’s or TPA’s needs. As a consequence, there is no real opportunity to impact the cost allocated to you for managing your claims.
Contrast this scenario with one that puts you in charge of setting claim-management policy, influencing claim-management strategy and ultimately having a direct impact on claim-management costs. This is the opportunity that a captive presents because it takes away the commercial-insurer layer between you and the claim manager (whether that manager is in-house or contracted).
One of the primary goals of our consulting practice is helping clients develop a strategy that allows them to take a measured approach to understanding and insuring their risks. Chief among those risks for many of our clients is financial risk; that is, risk of the unexpected interruption of cash flow, decrease in stock price or loss of earnings. Just as there are many types of financial risk, there are a variety of ways to manage them. The methods fall within three primary categories: avoid the risk, retain the risk or transfer the risk. Avoiding the risk through business-process or business-structure measures is always a preferable strategy whenever it is possible. But to the extent that it is not possible to avoid risk altogether, a company must decide whether it will retain the risk or transfer it.
If a company chooses to retain the risk, it should do so only after complete evaluation of the alternatives. A competent actuary should be retained to perform an analysis of level of risk and potential losses, as defined by potential frequency and severity of the insured-against event.
If a company chooses to transfer the risk to a traditional, commercial-insurance carrier, that company will be among many others who are insured by the same carrier. These other companies will represent a wide variety of industries and will present loss profiles that vary widely in type, frequency and severity. Despite this non-homogeneous pooling of risk, premiums may be uniformly imposed without reflecting the diversity in level of risk. This means companies with excellent safety records, great training and loss ratios far below the average in their industry will pay the same premium as companies with much higher loss histories. If, on the other hand, a company chooses to retain its risk inside a captive, the premiums will be based exclusively on that company’s unique loss profile.
Incentive to control losses
While no one who is trying to run a profitable business begrudges a commercial carrier’s profit motives, everyone wants to be treated fairly. This is certainly true for any company working to lower costs through careful risk-management planning and practice. If those efforts do not result in lower premium rates, then the insured believes there may be no economic reason to control losses. Conversely, when premiums are established based exclusively on one organization’s loss experience, and that experience is better than the average experience in the market, the company will realize lower-than-average premium costs.
A captive insurer does not have the same operating expense structure, overhead, or profit requirements of a commercial carrier. Moreover, a captive does not have to maintain higher average rates to ensure it can cover the losses associated with the high-risk members of its pool of insured. A captive’s concern is sharply focused on one company as opposed to the entire industry, thereby allowing it to directly reflect that company’s efforts to lower insurance costs through better risk-management. Through a captive strategy, improving risk management practices will directly impact the insured’s cost of insurance.
Direct access to wholesale reinsurance markets
Reinsurance is coverage purchased by commercial insurance companies. When an insurance company assumes its insureds’ risks, it often does not retain those risks for itself—at least not completely. Instead, it obtains its own insurance to compensate it for the claims it may have to pay on behalf of its insureds.
Reinsurance is purchased by insurance companies at what amounts to wholesale rates. When a company’s insurance program requires reinsurance, that coverage must be secured through a commercial insurance company who buys it at wholesale and sells it to the company at retail. Because a captive is an insurance company, it can go directly to the reinsurance market and purchase coverage at the wholesale rates. The captive eliminates the commercial insurer as the middleman and allows a business direct access to global reinsurance markets. For many companies, the savings can be substantial. The direct access to reinsurers saves all of the fees paid to agents, wholesalers, and brokers, as well as the profit markup that the first-level insurer would normally earn. In addition to the favorable pricing, the company (through its captive) will also retain much more control over the choice of the most appropriate reinsurance partner.
Positive tax benefits
As pointed out in the first chapter, the deductibility of premiums is a very important benefit of establishing and running a captive. Companies who have been self-insuring at least a portion of their risk will understand the benefits immediately.
With traditional self-insurance, companies only get a deduction for claims paid. This is very important when looking at the overall cost of a self-insurance program, since most companies fund future liabilities using today’s dollars. For example, if a client pays $50,000 per month into the fund and uses only $200,000 for claims, at the end of the year, it has $400,000 ($50,000*12 =$600,000-$200,000=$400,000) in a trust that cannot be deducted and would be treated as earnings. The trust would ultimately be used to pay claims and reduce premiums in the future. Nevertheless, after having to fund the trust in the first place, the business then has to pay taxes on the $400,000.00 remaining in the fund at the end of the year. This means that a company may end up incurring more expense because it had fewer claims! It’s counter-intuitive, but true. But the bleeding doesn’t stop here. There are other ancillary costs of self-insured programs that must be considered.
Let’s say a company creates a partially self-insured medical program. It incurs two additional costs, the premium for the excess policy, and the cost of creating and administering the ERISA fund that is used to “warehouse” the retention funds until they are required. These consequential expenses, coupled with the tax limitations, can add hundreds of thousands of dollars to the cost of running a good self-insurance program.
Now let’s assume we have a captive in place. The captive gets a current deduction to fund reserves for future liabilities. When a captive is utilized to pre-fund a business’ high-frequency, low-severity claims, the business takes a current deduction for this pre-funding. In addition, the captive gets to deduct the cost of covering these claims if it has reinsured them. If the business had instead used some form of traditional self-insurance such as an equity fund to cover catastrophic losses, it would have had to reserve a significant dollar amount which would not be tax-deductible until losses occurred and were paid.
The tax impact of operating a captive is very complex and should be considered only with the advice of a competent accountant with a background in captive insurance.
There are many other benefits to including a captive insurance company in an overall risk-management strategy. Some of these include:
- Increased insurance coverage as well as capacity
- Flexibility with funding and underwriting
- Reduced deductible levels for operating units
- Better allocation capabilities
- Additional negotiating leverage for underwriters
- Creation of a market (such as pollution liability) where there is no established market;
- Additional investment income to help fund losses
- Greater stability in coverage and pricing
- Reduction in the cost of insuring certain high-quality risks
- Reduction in expenses associated with transferring risk
- Enhanced asset protection/estate-planning/wealth transfer