Faced with an increasingly challenging insurance marketplace and unpredictability of where a company’s next large loss may come from, some companies are seeking alternatives other than traditional insurance to transfer risk.
“Captive insurance companies (“captives”) are one of the current trends suggested as an option to provide insurance coverage in these situations,” says Michael J. Perry, vice president of DLD Insurance Brokers Inc.
Smart Business talked with Perry for more information on captives and the advantages and disadvantages companies should consider.
What is a captive?
A captive is a specific-purpose entity set up to operate as an insurance company. The form of the captive is generally classified by its ownership; it may be owned and controlled by a single parent, by a group of companies or by an association. Captives are seen as an alternative to buying insurance from a traditional insurance company.
Why do companies purchase insurance through a captive?
For the most part, captives become more popular when traditional insurance is either too cost-prohibitive or entirely unavailable. Some companies use the captive to purchase reinsurance directly so they may obtain additional savings on their premium, while others use it to accelerate the tax deductibility of their retained losses. The decision to set up or participate in a captive should be considered long term and not taken lightly.
What types of insurance are commonly purchased through captives?
Captives were originally used to insure tough-to-place product liability insurance. Over the years, this has evolved into a creative vehicle for providing insurance covering most types of insurance, including but not limited to workers’ compensation, general liability, auto liability, employee benefits, property, earthquake, flood, warehouse, legal, and even warranties.
What determines the structure of a captive?
There are many variables that go into the ways a captive is structured. Many homogeneous groups — for example, manufacturers of a similar product — may gather to share in the purchase of insurance to obtain competitive rates through greater economies of scale. These are called group captives. Some companies do not want to share the risk of others, so they may set up a single-parent captive or a segregated-cell captive.
How do companies determine if a captive is the right decision?
The first thing you should do is speak with your insurance broker about your motivations for considering a captive. In most situations, captives are not a tool for immediate savings due to the up-front costs associated with setting up the captive.
Once your broker has done this ‘sanity check’ and detailed the future costs associated with setting up a captive, he or she should be able to assist you in hiring an independent consultant to do a feasibility study. That will help you to determine the return on investment of a captive versus other risk transfer mechanisms, taking into account various factors such as captive structure, domicile, and your own internal rate of return.
Why, in past years, are so many captives set up outside the continental United States?
When captives were initially introduced as an accepted financial mechanism for insurance, the ‘inventors’ were utilizing the relaxed insurance regulations and tax advantages of some offshore domiciles. Domestic captives popularity rose since the passage of the 1986 Tax Reform Act eliminated the ability to shelter off-shore income until it was repatriated on shore. In addition, insurance and accounting regulations were tightened requiring the increase for the credibility of the risk transfer. However, it should be noted that the support from the IRS has accelerated clarifying tax deductibility based upon the brother/sister structures. Recently, many states in the U.S. began adopting captive domicile status to be able to regain some of the lost premium tax income.
What warnings would you give to people considering a captive as an alternative to traditional insurance?
Do not take this step without reviewing it seriously. Many people think that captives will automatically help them save money due to the acceleration of tax deductibility or that they can charge themselves less premium than the traditional marketplace. Tax deductibility should only be determined after tax counsel advice. The underwriting of the risks should be actuarially determined and premiums should be set to reflect the retained exposure.
It is critical that premiums paid in the early years of the captive adequately fund losses. Savings of premiums may occur over a five- to 10-year period as earnings are built up. More important than savings is the fact that a risk management tool is in place to be used to address cycles of the insurance markets and potentially to insure risks that are traditionally uninsurable.
MICHAEL J. PERRY, CPCU, ARM, is vice president of DLD Insurance Brokers Inc. Reach him at (949) 553-5686 of [email protected].
