DOCTRINA

Captive Insurance Companies: the "pros and cons" of their use

Por Rodrigo Amengual  (*) 

Risk can be defined in many ways.  It can be though of as “the possibility of loss”; the “uncertainty concerning the occurrence of a loss”; the “relative variation of the actual from the expected outcome”; the “unlooked for, unwanted event in the future”, and so on.  All of these definitions encompass a basic idea: there is a possibility that something bad may happen in the future, and such event is unpredictable. 

However, risk must be taken, and managed, in order to facilitate commerce.  Risk must also be controlled and directed to reduce its financial impact and increase the value of an organization.  Risk management is the discipline that, through an integrated approach towards risk, enables people to identify, analyze and address it.  Once risks are identified and analyzed, a decision must be made in terms of what to do with them.  Some risks can be reduced, by loss prevention and/or loss control, while others cannot.  For these later risks the company will more likely than not end-up paying.  The question is: where will the money come from? Or in other words: who will pay for those risks that cannot be reduced or controlled?  The answer lies in what is commonly known as risk financing, which is basically the funding for the payment of risks.  Risk financing can be implemented in two broad ways: a company can retain those risks (which means it pays for them), or it can transfer them to another party which becomes responsible for the loss.  Typically, a company will retain those risks that: a) will not threaten or seriously compromise its earning capacity or structure as a whole; or b) are too expensive to be transferred.  If a company chooses to transfer some of its risks, the most common way of doing this is through insurance, which is referred to as the “traditional” way of risk transferring.     

The study of captive insurance begins with an understanding of the purpose of alternative risk transfer, which is simply to find more efficient ways of financing risk.  As previously mentioned, risk financing is the process of providing funds or capital for the payment of losses. 

The purpose of this paper is to discuss some of the major advantages and disadvantages of captives, focusing on the U.S. environment, and to frame their boundaries within the insurance and risk management world.  An in depth analysis of the captive system is beyond the scope of this paper.

The captive mechanism is part of what is generally called alternative risk transfer (“ART”), as opposed to “traditional risk transfer” (“TRT”), typically provided by commercial insurers. 

As will be later explained, ART (and captives within it) is a response to TRT, which sometimes, either for regulatory constraints, business reasons or particular situations does not respond quickly and efficiently to the ever-changing risk environment of commercial and non-profit enterprises.  Captives, unlike traditional commercial insurers, are not subject to the constraints of an extensive regulatory system, which allows them to respond quickly and efficiently to the ever-changing risk environment.

A captive is a wholly owned insurance subsidiary of an organization not in the insurance business, whose primary purpose is to underwrite some of the risks of its owner/s or parent affiliates, which at the same time are the original insureds and the captive’s principal beneficiaries.[1]

The captive’s insureds have direct involvement and influence over its operations, including underwriting, claims and investments.[2]

Captives have grown to become a significant market force since the 1970’s.  However, the idea of a company structure where a parent owned a subsidiary for insurance benefits purposes dates back to the mid-19^th century, with the first captives of the modern era emerging in the 1920’s and 1930’s.[3]  By the end of 2003, there were in excess of 4000 captives, the majority of them domiciled in Bermuda, the Cayman Islands and Vermont.[4]  Not only these captive domiciles, or off-shore locations bring lower rates of corporate tax, but also have less stringent regulatory environments, where captives can be set-up faster.  The vast majority of captives have U.S. parentage.[5] 

Although a substantial number of reasons exist for forming a captive, they can be usually reduced to: a) dissatisfaction with conventional insurance markets[6]; and b) the “advantages” of a captive.  Captives –as many other commercial institutions, are the response from businesses and corporations to the ever changing commercial environment.[7]  More specifically, they comprise a movement that seeks more efficient means of financing the risks in nowadays marketplace.  In many cases, the amount of risk faced by the larger multinational companies is simply more than the amount that the conventional insurance market is willing to assume.  Sometimes, the increasing instability and volatility of conventional insurance have lead companies to seek new ways of funding for the unexpected.  In the end, the principal motivation for forming a captive is the parent’s need or desire to self insure.[8] 

A captive requires the insured to be both willing and able to contribute risk capital.  This is the first essential element of captive insurance.  Those companies who form or use a captive have made a choice, have analyzed their risk financing options, and they have the financial ability and desire to invest their own resources to benefit from this type of risk financing program, since ultimately, a captive is a risk financing mechanism.  The basic objective when using a captive is to maximize the financial benefits of the risk financing program.

Working outside of the commercial insurance marketplace is the second essential element of captive insurance.  The fundamental distinction between the traditional and the alternative marketplace is that the traditional market focus is on the pooling of similar risks from a large number of insureds in the same underwriting class.  Insureds access alternative markets for two distinctly different reasons.  Either their risks are so unique, with an underwriting class composed of so few insureds, that traditional underwriting methods will not be acceptable to the insurer; or the risks are so numerous that the owner of those risks (the insured) can by itself form a single underwriting class.  Inevitably, insureds that wish to improve control over the way that insurance is used to finance their risks seek to increase their control over the insurer.  This explains why the second element of captive insurance involves financing risks using special purpose insurers.  It is in the world of captive insurance that one most clearly understands the reason for the more equal relationship between the insurer and its insureds and the corresponding lack of the need for regulatory protection of the captive’s insureds.[9]

The third essential element of captive insurance is that it is used by insureds to achieve their risk financing objectives.  The captive’s purpose is to insure the risk of its owners.  Ownership does not mean ownership of nominal percentage share; it means ownership in the company’s strategic business purpose: the dominant factor that motivates insureds to finance their risks outside the commercial marketplace is clear.  It is done to improve the insured’s control over the purchase of insurance. 

With all of the aforementioned as background, the following are some of the most commonly recognized “pros and cons” of using the captive insurance system.  It is useful to bear in mind that these “pros and cons” are not being displayed using a “most to less important” pattern, but rather discussing first the ones that appear to be related to the advantages of the captives with regards to a traditional insurer; and then outlining the benefits of a captive to the overall risk management process.   

By establishing a captive, the parent can achieve substantial premiums savings, which is accomplished in more than one way.  First, a captive enables its parent to pay for insurance based on their own loss experience.[10]  Second, some of the rate components that exist in the premiums charged in the traditional insurance market are eliminated from the picture, i.e.: since the main purpose of a captive is to insure the exposures of its parent, there is no “profit” component in the premiums paid by parents to their captives.  Likewise, the parent avoids contributing to some of the costs inherent to the insurer’s organization: accordingly, those costs usually encompassed under the “other expenses” loading of the rates (e.g.: policy acquisition costs, general overhead, licenses and broker fees, marketing, etc), or “loss prevention expenses” (often called “safety” in workers compensation, or “engineering” in property insurance) are not part of a captive insurance premium.  Further, in some countries like the U.S., some states make assessments to the commercial insurers for “guaranty funds”, which are programs designed to ensure that losses will be paid if an insurer becomes insolvent.  As previously mentioned, captives work outside of the commercial insurance marketplace: therefore they do not participate in state guaranty funds, nor do captive insureds receive any protection from such funds.  Accordingly, the captive premiums can be lower simply by virtue of not having to cover the “residual” costs of contributing to state funds. 

Further, captives enable their parents to have access to coverage in hard markets.  Being statistically predictable is not a condition of insurability for a risk in the alternative market.  All risks facing an organization can be insured by a captive, whether or not the traditional commercial insurance marketplace has yet found a way to finance them.  On the other hand, finance for high frequency/low severity losses can be uneconomic to insure in the traditional marketplace. 

On another note, traditional market insurance operations generate large amounts of funds that can be invested, primarily from loss reserves, loss adjustment expense reserves and unearned premium reserves.  The long delay inherent in the loss adjustment process (specifically in the liability side) generates very large loss reserves.  Insurers are allowed and usually do invest part of these reserves to benefit from them.  This is called investment income, and consists of interest, dividends, rents, and similar regular income received from the invested assets held by the insurer.  Investment income is the most stable source of income for most insurance companies.[11]  A captive retains 100% of the investment income on the portion of loss reserves held on its books.  This is investment income that would otherwise be earned by or split with a commercial insurer; therefore, a captive allows its parent to re-capture investment income.

Captives also provide some value to the overall risk management process.  Risk quantification is another very important advantage provided by a captive, particularly for those risks deemed uninsurable by commercial insurers.  Uninsured risks are frequently nonquantified.  The captive provides the mechanism for collecting loss data on an ongoing basis and becomes the underpinning for the risk qualification initiative.  Of course this is also possible without a captive, but a captive facilitates this process.  The aforementioned advantage leads to another one: risk control motivation.  Retaining risk means that the impact of loss is felt immediately.  By externalizing and isolating the cost of the organization’s pure risk in this manner, the risk manager may also be able to use the captive to enforce and demonstrate the benefits of loss control.  This can also provide motivation for the pursuit of the benefits to be derived from a full risk management policy. 

Within many multinational corporations with decentralized structures, conflicts can arise between group and local management as to the amount of risk that should be retained, often resulting in worldwide insurance costs greater that it should be, or in retaining an amount or level of risk not related to the financial strength of the corporation.  The captive can play a significant role in centralizing a worldwide risk financing policy and can also provide a means of achieving greater control over a corporation’s overall risk financing strategy through the integration of local and group deductibles, the provision of wider coverage and the reduction of insurance expenditure; accordingly, captives may serve as a tool for achieving a global risk financing strategy.  In addition, a captive provides the parent with a funding vehicle with formalized reporting and accounting, which can be extremely important for captives whose parents have diverse accounting centers (multinationals).

Another advantage in using a captive is the improved cash flow.[12]  This can be achieved as the captive usually writes coverages and bills premiums directly to its parent at the inception of the underwriting period, but pays reinsurers as claims settle.[13]  When reinsurers make claim payments, the captive will typically pay its insureds immediately, rather than holding the cash to earn income, as a commercial insurer may.  This way, the insured benefits from a direct reduction in risk financing costs whether the captive holds on to claims settlements or pays them quickly.  In addition, by using a captive the insured can reduce its reliance on the fronting insurer to investigate and settle claims.  This is recommendable when the insured knows and understands its own risks, and therefore is in a better position than the fronting company to decide when to settle and when to defend a claim.  

And finally: tax deductibility.  This was intentionally left for the end since it is the most complex and sensitive issue of all discussed, and probably leads to the most frequently asked captive question of all time, the one about whether or not premiums paid to a captive are tax-deductible.  Back a few decades ago, tax deductibility used to be the sole purpose for forming a captive, but due to increasingly stringent requirements (especially in the U.S.) it is no longer the benefit it was.[14]  The tax deductibility issue can relate to whether the captive is an insurance company for corporate tax benefits, or to whether the premiums paid to a captive are deductible.  For the first issue, the Courts basically have required that: a) underwriting risk must be taken (there should not be any provisions that eliminate the risk of loss to the captive); and b) that the captive operates according to accepted insurance practices (rating filings, adequate regulatory surveillance for insolvency, etc). 

The second issue is even more sensitive, because the fact that the captive is considered an insurer for tax purposes does not necessarily mean that premiums paid to it are tax deductible.  In the U.S. the Financial Accounting Standard Board has developed Financial Accounting Standards (“FAS”) that address this matter.  According to these FAS, premiums paid to a captive will be deductible only if: a) the financial impact of a loss cannot be measured by the entity.  This means that if the amount of money paid in premium, plus investment income on reserves less policy expenses equals the expected losses, then the transaction will not be deemed insurance, and therefore premiums involved in it will not be deductible for tax purposes; and b) there is the possibility that the potential impact of the losses on the captive are significant.  Since this second “test” is obviously much more subjective than the first, there is not a rule of thumb to decide whether or not premiums paid to a captive are tax deductible, but rather an idea of how this matter should be approached.[15]        

Notwithstanding, as previously mentioned, the captive system is not flawless.  Captives have at least two significant disadvantages.  The first one relates to the costs of establishing and operating the captive.  The second one is the substantial amount of management time that is required to be devoted at the outset to the issues surrounding the establishment and operation of the captive, which may not be justified in relation to the return that the parent can expect from the captive. 

All of the above being said, captives are neither magic solutions, nor alternatives for every corporation.  First, captives appear to be more suitable for big companies.  Several reasons support this assertion.  Any discussion of risk evaluation should begin with the law of large numbers.  This mathematical principle simply means that the variation around the expected value (or average result) will be greater for low volumes of loss.  Further, usually the larger entities are the ones that have satisfactory loss control capability and sufficient premium volume.[16] 

In addition, the larger companies are the ones that not only have their own risk management departments, but also allocate more funds to them[17], which enable risk managers to become more sophisticated when dealing with alternative approaches towards risk. 

Risk managers are taking a more strategic position towards managing risks.  A minimum captive commitment of 5 years, and even 10 is not unrealistic.  The captive must be a vehicle for stability rather than an emergency measure for short-term problems.    

Accordingly, captives must be seen as a part of the overall (or holistic) approach to risk management; otherwise, the companies will find captive formation a short-live and expensive venture.  A captive is not an insurance company per se, but rather a loss-financing mechanism used to support the overall risk management objectives of a parent or parents, and this financing mechanism is not a transaction into itself: it must always be connected to the organizational strategy.