A “captive insurer” is generally defined as an insurance company that is wholly owned and controlled by its insureds; its primary purpose is to insure the risks of its owners, and its insureds benefit from the captive insurer’s underwriting profits. It may also be defined as another version of self-insurance for companies as a company can directly own and operate their own insurance companies/risks to their own needs.
For many years, large corporations have enjoyed many benefits from operating their own captive insurance companies. Most were established to provide coverage where insurance was unavailable or unreasonably priced. These insurance subsidiaries or affiliates were often domiciled offshore, especially in Bermuda or the Cayman Islands. The risk management benefits of these captives were primary, but their tax advantages were also important.
In recent years, a handful of US states have allowed more domestic captives to operate, this has opened the door for smaller closely held businesses that have learned that the captive insurance entities can provide them significant benefits. These include the attractive risk management elements long appreciated by the larger companies, as well as some attractive tax planning opportunities.
A properly structured and managed captive insurance company could potentially provide the following tax and nontax benefits:
- Tax deduction for the parent company for the insurance premium paid to the captive;
- Greater transparency in annual premium dollars that reflect the insured’s experience and not an array of external, market-driven factors out of the insured’s control;
- Opportunity to accumulate business wealth in a tax-advantageous vehicle;
- Asset protection from the claims of business;
- Reduction in the amount of insurance premiums presently paid by the operating company;
- Use profits generated by good loss experience to offset new premium requirements in future policy years, allowing a multi-year strategy that can simplify budgeting
- Letter of Credit replacement strategy for the collateral requirements of the deductible, potentially eliminating the impact on a client’s working capital
IDEAL CANDIDATES FOR CAPTIVES (Worker Compensation)
The use of a captive should be considered for entities that meet the following criteria:
- Profitable business entities seeking substantial annual adjustable tax deductions.
- Businesses with multiple entities or those that can create multiple operating subsidiaries or affiliates.
- Businesses with $500,000 or more in sustainable operating profits.
- Business with $375,000 or more in insurance premiums costs per year
- Businesses with requisite risk currently uninsured or underinsured.
- Businesses where owners and or shareholders are looking for asset protection.
To Achieve Risk Financing Objectives
When the products offered by insurers do not meet an insured’s risk financing needs, the best option might be to form a captive insurer. The main reasons why organizations wish to better control their risk management programs are excessive pricing, limited capacity, coverage that is unavailable in the “traditional” insurance market, or the desire for a more cost-efficient risk financing mechanism. Other reasons for utilizing captive insurance include
- Broader coverage,
- Stability in pricing and availability,
- Improved cash flow, and
- Increased control over the program.
Many captives are established because insurance in the commercial market is prohibitively expensive, poorly matched to the insured’s needs, or not available at all. A captive insurer can successfully provide coverage for difficult risks that is tailored to fit the exact needs of the insured(s)—as long as the captive operates within sound underwriting, actuarial, and regulatory guidelines.
Stability in Pricing and Availability
Pricing stability is achieved over time as a captive matures and expands its own risk retention capability. The more capital that is accumulated, the greater the captive insurer’s ability to retain risk and insulate itself from changes in the commercial insurance market. A captive insurer can also provide stability in the availability of coverage.
Improved Cash Flow
Cash flow improvements are achieved in a number of ways. Losses retained through a captive reduce or eliminate underwriting profits; reduced losses increase them. Because captive insurance inherently offers financial rewards for effectively controlling losses, safety and loss control get a higher level of attention.
The underwriting profits and gains from the invested premiums that would otherwise be held by a conventional insurer are retained by the captive. Even with conservative investment portfolios, the dollar amounts are substantial due to the high levels of capital and surplus typically held.
Finally, cash flow is improved by reducing the expense factors associated with commercial insurance. Generally, insurers allot 60 percent or more of premiums taken into loss payments, while the other 40 percent or so covers expenses and profits. Captives have far fewer expense components than do commercial insurers. Estimates for the expense components of captives typically fall in the 15 percent to 30 percent range. This means that for every $10 million in net written premium, a successful operating captive can save insureds $1 million to $2.5 million in expenses alone.
Increased Control over the Program
Ownership and control by its insureds distinguish a captive insurer from a commercial insurer. This is not the type of ownership or control evidenced by a nominal percentage share in the company’s surplus. It means ownership in the company’s strategic business purpose.
Captive insurers offer increased control in a number of other ways as well. For one, captive owners have more control over insurance-related services such as safety and loss control, and claims administration. Safety and loss control services established by a captive can be tailored to each participant’s individual needs, resulting in safer workplaces and more favorable loss experience. Claims handling services are unbundled and separately arranged. Strict guidelines can be drafted and enforced by the captive. This is preferable to allowing a commercial insurer, whose interests might be more self-serving than an insured desires, to dictate how claims are handled.
In some ways, a captive insurance company resembles a form of self-insurance. However, the owner(s) of a captive place their own capital at risk, and they directly control their insurer (the captive). Captive insurance company owners are willing to risk their own capital in anticipation of the financial rewards associated with better control over their insurance program. These include broader coverage, stabilized pricing and availability of insurance, and improved cash flow. The planning, formation, and management of a captive can be complex undertakings, and compliance with the formalities of running a true insurance company is mandatory. The use of a Captive Manager, such as Phoenix Captive Solutions, that is more familiar with the ins and outs of the captive world is crucial to establishing a captive insurance company that is feasible. Where captives are appropriate, they can provide substantial tax and nontax benefits to successful shareholders with the right kinds of insurance risks.
This article was written by Phoenix Captive Solutions C.F.O Blake Coats.
To learn more, write to Blake at firstname.lastname@example.org