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An Education In Captive Insurance–Part One

As many know I was in the Insurance Business from November 1976 to June 1999. I taught Insurance for 19 years. Some have asked for help as I do consulting work

I am no longer licensed  but still receive Insurance publications and read them monthly.

A funding source of ours has asked me to consider running a captive Insurance Company for them. That’s what prompted this article.

I wrote an Ebook on Project Funding which examines funding from a risk management perspective. You may want to acquire a copy.

At some point in the development and growth of a business, most owners eventually recognize the need to focus a great deal more resources on managing risk.

As business owners realize greater returns in varying market cycles, they also begin to identify greater inherent risks to their assets and the ultimate viability of their business.

Risk Management Defined:

The concept of risk management can be defined as the identification, evaluation and prioritization of risks or hazards followed up by an organized and economical deployment of resources to reduce, monitor and control the probability and ultimate impact of any number of unfavorable events with respect to a business.

Risks can be realized in numerous areas including but not limited to: financial markets, credit and liquidity risk, technological obsolescence, project failures, legal liabilities, accidents, natural causes and disasters as well as overt market attacks from competitors.

Some risks are insured through third party commercially oriented insurance resources, while most others are self-insured by the business owner.

What is a Captive Insurance Company?

A Captive Insurance Company is an insurance company established primarily to insure the risks of a business, which is related to it through some form of common ownership.

More specifically, the owner of a business can form a wholly owned licensed captive insurance company for the purpose of insuring his or her related company’s risks.

The insured business pays premiums to the Captive in exchange for insurance coverage.

A compliant Captive can be owned by the business owner, his children and/or spouse, other relatives, a Trust or another related company.

Captives that are owned by United States citizens account for approximately 4,000 of the nearly 6,000 Captives that are currently in operation globally.

Captives can be domiciled and licensed in numerous jurisdictions, both foreign and in the United States.

There are now at least 36 countries and 24 U.S. States with captive insurance legislation that serve as captive insurance domiciles.

Captive insurance companies that are formed outside the United States can make an Internal Revenue Code Section 953(d) election to be taxed as a Domestic U.S. corporation for U.S. Tax purposes.

This may allow a foreign based captive insurance company to receive much the same U.S. Tax treatment and benefits as a Captive formed in the United States.

Generally, the biggest difference is that a foreign based Captive has a lower cost of structuring and ownership. For this reason many small captive insurance companies with annual premiums below $1.2 million are formed and licensed in a foreign jurisdiction. Otherwise, the upfront and ongoing costs could prove to be prohibitive.

In the last 30 years there has been enormous growth in the number of captive insurance companies globally. As a result, there are currently upwards of 6,000 captives worldwide writing nearly $25 billion in premium. These companies have capital and surplus estimated in excess of some $50 billion.

The captive insurance industry built its foundation on the formation of mutual and co-insurance companies some 80 plus years ago. As you may know, Allstate Insurance Co. was founded in 1931 and underwrote some of the risks of its parent company, Sears, Roebuck & Co.

The greatest motivation for the development of captives has been the volatility, expense and lack of availability of certain types of insurance coverage in the third-party commercial market. However, even when commercial premium rates are available and economically viable, the interest in captives by risk managers and business owners continues to be extraordinarily strong.

Evidence of this demand is provided not only by the sheer number of captives being formed but also by the increasing number of jurisdictions available for their incorporation through new legislation.

Long-standing jurisdictions, such as Bermuda, Cayman Islands, Guernsey, the Isle of Man and Luxembourg have been joined in recent years by the likes of Anguilla, Barbados, British Virgin Islands, Dublin, Gibraltar, Kentucky, Montana, South Carolina and Vermont.

In Vermont alone, there are now nearly 600 Captive Insurance Companies.

There is no greater evidence of captives entering the risk management and insurance mainstream, then the Council of Lloyd’s passing a bylaw 11 years ago, permitting the establishment of captive operations at Lloyd’s of London.

There is demand by business owners large and small to take back control and management of their cash flow and risks.

Some considerations for forming a captive insurance company:

Captive Insurance Companies are formed for a number of economic reasons with the main incentive being risk financing and risk management. Consider the following:

Asset Protection considerations: Captive insurance companies may have considerable Asset Protection benefits for their owners and affiliated insured parties. With respect to Asset Protection, one should consult with a qualified professional advisor as this can be rather complex.

Lowering insurance costs considerations: Naturally, commercial market insurance premiums must be adequate to meet the cost of claims. Though like any commercial endeavor, insurance companies are in business to make money and will therefore include in the premium provisions for their operating costs, marketing costs and desired margin of profitability.

This portion of the premium can represent as much as 35% to 45% of the gross premium.

In the case of establishing a captive, the parent company seeks to retain any potential profit within the group rather than see it go to an outside third party.

A captive may also help reduce insurance costs by charging a premium that more accurately reflects the parent’s loss experience rather than the extremes represented in many lines of coverage.

Claims management considerations: The process of making a claim from a third party insurer can be an expensive, long and arduous process.

Through  a captive, the claims handling procedures can be directed by management, cutting down on the costs, delays and bureaucracy that are often a part of the claims handling procedures of commercial insurers.

Cash flow considerations: Aside from the pure underwriting profits, most insurers rely on investment returns and income. As you no doubt have realized insurance premiums are generally paid in advance while claims are paid out or realized over a much longer time period.

The time period leading up to the point when claims can become payable the premium is available for investment.

When operating a captive insurance company, premiums and investment income are retained within the group or company. Additionally, a captive insurance company may be able to offer a more variable or flexible premium payment schedule, often resulting in a direct cash flow advantage to the parent company over other market offerings or third party providers.

Risk retention considerations: In some cases, company’s become interested in retaining or taking more control of their own risk. Sometimes this is done by simply increasing third party insurance deductibles on various lines of coverage.

Interestingly, there is not always a direct correlation between increasing deductibles and lower premiums. Additionally, in this scenario there are obviously no reserves to pay future claims with respect to these coverage’s.

Unavailability of coverage considerations: Often the commercial insurance market is unwilling or simply unable to provide coverage for a variety of risks.

In other instances, the premium costs are clearly not economically viable either short or long term. In these cases, a captive insurance company may offer the necessary coverage with respect to these risks.

Risk management considerations: As is the case with many Fortune 500 companies, a Captive Insurance Company can be the cornerstone for the risk financing and risk management activities of its parent company.

Ultimately, a thoughtful and prudent risk management and financing plan should result in profits for the captive insurance company.

Furthermore, risk management can be viewed by a captive owner not as an expense, cost or drag but rather as a potentially robust channel for profitability over the long term.

Access to the reinsurance market considerations:

As you know, reinsurers are the international low cost provider or wholesalers for the insurance world.

While operating with a substantially lower cost structure than a direct insurance company, a reinsurer is often able to provide coverage at highly advantageous rates.

When using a captive insurance company to access the reinsurance market the buyer can more easily determine his own risk retention levels and ultimately structure his business affairs on a customized basis with greater flexibility.

Writing unrelated risks for profit considerations:

Aside from underwriting its parent companies risks, a captive insurance company may very well operate as a separate business channel by underwriting the risks of third party companies.

More specifically, a company or organization may be interested in selling insurance coverage to its existing customers with respect to its core operating business.

For example, a distributor of industrial pumps, furniture, recordable media, hurricane shutters or automobiles may compliantly sell extended warranty coverage to customers with the risk being carried by the distributor’s captive insurance company along with reinsurance.

The historical claims blueprint for this type of business model is generally highly predictable with a significant number of smaller events, resulting in a meaningful source of revenue to the distributor or parent company.

Tax considerations:

Captive insurers must meet certain compliance issues such as “transfer of risk and distribution of risk” in order to be treated as an insurance company.

Without exception, the tax considerations in forming a captive insurance company should be contemplated in the context of a comprehensive tax plan with qualified professional tax and legal advisors.

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