Some businesses have found they can benefit from creating a “captive” insurance company — one they own and fund.
Potential benefits include stabilizing premium fluctuations, recouping underwriting profits, increasing bargaining power with commercial insurers and realizing income tax benefits. It’s different than self-insurance in that the owner of a captive insurance company has “stop-loss” provisions that limit what they are liable for.
Captive insurance companies long have been a risk management tool for large corporations. Increasingly, small- to medium-size firms are realizing the benefits of small captives to fund their insurable risks, while seeking the potential economic benefits available to qualifying structures. A captive insurer is a legal entity formed primarily to insure the risks of one corporate parent company, or a number of affiliates, thereby reducing the parent company’s total cost of risk. The advantage of a captive is not being subjected to changes in the insurance marketplace
Companies in the middle market space ($250,000-$1 million in annual premiums) typically will look at what’s called a group captive. In that arrangement, the insurance company that is formed by the captive is owned by its members — your company as well as other companies like yours. It’s a risk-sharing group.
The process of insuring your risks through a captive works similarly to the traditional insurance market. The company still pays a premium into the captive, and an insurance policy still is issued. A third-party captive manager will be in place to help run the program, and an independent actuary calculates the premium. If your company continues to see favorable loss history in the coming years through the captive, instead of allowing surplus underwriting profits to go to an insurance company, the money can come back to you.
Before considering a captive, companies should carefully evaluate if their loss history and risk management programs would allow them to bet on themselves financially. They also must decide if they’re willing to invest more into risk management with their broker partner or internally, and whether they have the capital — which can be tens of thousands of dollars in a group captive setting — to invest into the captive initially.
It will be a long-term financial commitment and one not easily broken in most cases. Careful consideration and time should be spent as you explore your options and find out if a group captive might be the best fit for your company. It is recommended you allow at least six to eight months for you, your broker and the captive to perform all the due diligence necessary. A great time to start the process of selecting a broker actually can be immediately after your last renewal. You will have fresh full-policy-year information as well as the latest guaranteed cost rates to work with — and plenty of time to make the best decision for your business.
The parent company must contribute the capital required to support the captive’s business plan, as determined by the insurance regulator in the captive’s chosen domicile — generally a minimum of $250,000. While these funds remain within the parent group, they might not realize the same return as they would if invested in the parent organization’s operations. The captive’s capital could be eroded by adverse operating results. While underwriting gains may not be subject to federal income tax, underwriting losses may not be used to offset other gains or carried forward. The formation and operation of a captive will incur various expenses and vary by domicile. The benefits outlined previously need to outweigh the associated costs.
There are many benefits in forming a small captive, but clients should keep in mind that a captive is a long-term commitment and a fully functioning insurance company. As such, prior to establishing a captive, prospective owners should consider capital commitments, risk of adverse results and operating costs.