How to understand the different structures of captive insurance Featured

8:00pm EDT June 25, 2010

Many companies have bought traditional insurance for years and are tired of being at the mercy of the commercial insurance market. But, what other types of risk financing vehicles are there?

Perhaps you’ve heard about captive insurance, an alternative risk financing approach to the traditional commercial insurance market, but don’t really know how to begin the fact-finding process. When it comes to selecting the type of captive, there are a number of options available, including a wholly owned or ‘equity’ captive, a rent-a-captive, a segregated portfolio captive (SPC) or a group captive.

“No structure is inherently better than the next, but when it comes to selecting the right one for your business, it is possible to make the wrong choice,” says Scott N. Saunders, ARM, a vice president and senior account executive in the Pittsburgh office of Aon Risk Services Central, Inc. “Every structure has unique advantages and trade-offs.”

Smart Business spoke with Saunders about the different structures of captive insurance.

What are the differences between equity captives and non-owned captive structures?

An equity captive usually has only one shareholder, the parent company of the captive. That same parent provides the capital the captive needs and supplies the board of directors with the direction and governance of the captive. Such a structure provides the larger parent company with the control it requires over the operation of the captive, and the vast majority of the world’s 5,500 or so captives are formed in this manner.

While this format works well for the larger companies, for a smaller parent company or group of interested parties, the use of an equity captive — at least in the beginning — may pose too great of a financial burden.

As an alternative to the equity captive, a potential captive user may wish to look into the non-owned captive structures offered by rent-a-captives, SPCs or group captives. This is not just a question of the parent company’s size. When considering the various captive options, a company must weigh the opportunity cost of committing a significant amount of capital in an equity captive vehicle versus the relative ease of renting another’s capital in a non-owned captive vehicle.

The SPC or group captive may be limited by their charter, whereas an equity captive might have more flexibility to consider lines of business outside of the SPC’s underwriting reach. Similarly, many companies prefer to manage their own destiny and do not wish to participate in a collective captive option when they can afford the capital and time to establish their own. Also, the SPC can be formed more quickly (and less expensively) than an equity captive, and access to a rent-a-captive or group captive is normally not much longer than a regular insurance submission process.

Why would I join a captive in such a soft insurance market cycle?

If joining a captive was seen as a decision with a 12-month duration, captives would have a difficult time growing in the depths of this soft-market cycle. Most companies are taking a much longer-term approach to risk financing. Realizing that market cycles are just that — cycles — companies are putting greater emphasis on stabilizing their costs by managing their claims and controlling risk.

What benefits are there to joining a captive versus buying traditional insurance?

Captives are simply insurance companies that have been dismantled and their components made transparent to the buyer.

An insurance contract is the offer to accept and pool risks from a large group of participants and to follow the fortunes of that risk pool for a charge in the form of an annual premium. The insurance contract includes such services as claim adjudication, loss control, reinsurance and premium tax payments, and within the total cost is the insurance company’s profit margin. The fee for these bundled services is set in the annual premium whether the insured makes full use of them or not.

A captive, however, has the ability to pick and choose only those services it wishes to buy and carefully scrutinizes from whom they buy them. Most importantly, it self-selects the pool of risks. While the traditional insurance market has a larger risk pool to draw from, captives deal with smaller, likely cleaner risk pools and offer only those products and services that directly benefit the parent or group — with the underwriting profit of the insurance carrier mostly stripped out.

What are the trade-offs?

Captives require increased participation in their insurance programs more fully than traditional insurance risk transfer. Captives can expect positive peer pressure from their parent or other group captive members to control their losses and comply with loss control recommendations. Also, instead of a 30- to 60-day renewal cycle flurry of activity, captives require ongoing scrutiny of loss reserves, quarterly financials and an annual meeting. Most fundamentally, an insurance premium is a static cost negotiated annually. The cost of a captive is tied to the performance of the risk control and claim management of the company. While captives can return underwriting profit, they can also result in an assessment in response to poor results. To secure this potential assessment, captives often require some amount of additional collateral.

Why would I want to get into the insurance business when that isn’t even close to my company’s mission?

Every company needs to stick with their strengths, but participating in the active management of your retained risk via the use of a captive falls within your core competency.

Some companies are better than others when it comes to safety. Your captive manager will run the day-to-day operation of the captive, but as a captive participant, your job is to do what you are already doing: controlling costs and keeping your employees and the public safe from harm.

Scott N. Saunders, ARM, is a vice president and senior account executive in the Pittsburgh office of Aon Risk Services Central, Inc. Reach him at (412) 594-7583 or Scott.N.Saunders@aon.com.