Captive insurance companies: an alternative risk transfer vehicle
March 2016 | SPECIAL REPORT: INSURANCE COVERAGE
Financier Worldwide Magazine
Any commercial organisation that is large enough to utilise a holding company structure for its subsidiaries and operations should seriously consider creating and utilising an alternative risk transfer (ART) vehicle or structure for its insurance needs rather than purchasing insurance from the commercial insurance market.
Considering the amount of insurance that most sophisticated organisations need for their operations and the total amount of premiums that they pay to commercial insurers for such coverage, it is worth considering whether they would save money through the use of an ART structure. Such a structure, which can (and should) be designed for the specific needs of each organisation, would allow them to bank premium dollars and establish reserves for their particular exposures, calculated by an actuary and based primarily upon their prior loss experience.
If the organisation does not experience losses, it can later recover a significant portion of those premium dollars. And an ART vehicle can purchase reinsurance for its risks, which can be much less expensive than traditional commercial insurance. Moreover, reinsurance premiums are typically paid in arrears, which is an additional benefit from a cash flow perspective.
There are a number of ART structures that can be utilised, but the following is a brief summary of captive insurance companies, which is an ART vehicle that offers a substantial degree of flexibility for most organisations. The creation and use of captive insurance companies has become more popular over recent years for a number of reasons, including: (i) volatile premium costs in nearly every line of insurance; (ii) limited capacity in the market for certain types of risks; (iii) differences in coverage in various parts of the world; (iv) inflexible credit rating structures that reflect market trends rather than individual loss experience; and (v) insufficient credit for deductibles, or loss control efforts, or both.
Captive insurance companies
A company may form its own insurance company subsidiary, known as a captive insurance company, to finance its retained losses in a formal structure. A captive insurance company is established for the specific purpose of financing risks arising from its parent company’s (or its parent company’s group). A captive insurer, however, may at times also insure the risks of its parent company’s customers.
A captive insurer may insure nearly every type of risk that a traditional commercial insurer may underwrite, including liability and first party risks (e.g., property, first party auto, employee benefit plans, and supplemental life insurance plans). Many captive insurance companies are created to insure working layers of high risk categories (e.g., general liability, professional liability, directors and officers liability, product liability) in order to access the reinsurance market, including Lloyd’s syndicates, for excess protection that may be unavailable or cost-prohibitive at the primary insurance level. Captive insurers are often created, for example, to provide auto insurance, both property damage and liability, for corporate fleets.
There are a number of advantages offered by captive insurance companies. One is cost. Premiums charged by traditional commercial insurers include amounts to cover the insurer’s profit margin and overheads. Such costs can be significant with large insurers that have complex structures to maintain. These additional costs can be substantially reduced utilising a captive.
A second benefit is flexibility. Organisations can ‘insure’, or build budgets, for risks that are not otherwise insurable in the market. When the market is soft, the captive insurer can also take advantage of low rates by reinsuring a large portion of its risks. The low cost of reinsurance in a soft market allows the captive to build its reserve base. If and when the market hardens, the captive insurer is then able to retain a larger portion of its written risks as a result of its reserves and can maintain cover for its parent company even when capacity in the traditional market is unavailable or prohibitively expensive.
A third benefit is claims management. The process of submitting a claim and getting paid for a loss from a traditional commercial insurer can be long and expensive. When the insurer is a captive, the claims handling procedures can be dictated by management, significantly reducing the delays and costs that are common with traditional carriers.
There are also claims experience benefits. With respect to the risks retained by the captive, if the claims experience is better than expected, the excess of net premiums over claims is retained by the parent company and, if the reserves are sufficient, can be distributed in the form of dividends to its shareholders.
Additionally, captives can be designed to effectuate wealth distribution and estate planning goals. For instance, small to mid-sized companies can take advantage of Section 831(b) of the US federal tax code, which enables a captive company collecting premiums under $1.2m annually to incur taxes on investments only.
A significant issue for an organisation considering creating a captive is whether to create the captive within or outside of the US and, if within the US, which state to domicile it in. Considerations in this regard include tax, regulatory and capitalisation issues. Vermont is the most popular jurisdiction within the US to create a captive because of its favourable rules and regulations and knowledgeable insurance regulators.
Several types of captive insurers have been created. These include: (i) Single Parent Captive, where an insurance or reinsurance company is formed primarily to insure the risks of its non-insurance parent company or affiliates; (ii) Group Captive, which is an insurance or reinsurance company that is jointly owned by a number of companies and created to provide a vehicle to supply a common insurance need; and (iii) Rent-a-Captive, which is an insurance company that provides captive facilities to others for a fee, while protecting itself from losses under individual programmes that are also isolated from losses under other programmes within the same company. This facility is typically used for programmes that are too small to justify establishing their own captive.
Organisations that have experienced difficulty in obtaining coverage for their operations because of lack of capacity in the traditional marketplace, or are simply tired of paying substantial premiums each year to commercial insurance carriers despite having a relatively low prior loss experience (and, as a result, little prospect of benefitting in the future from those premium dollars), should consider utilising an ART structure rather than the traditional commercial insurance market. They should first speak with an insurance lawyer experienced in evaluating and creating such a structure, which would be particularised to the organisation’s specific needs.
James M. Westerlind is counsel at Arent Fox LLP. He can be contacted on +1 (212) 457 5462 or by email: firstname.lastname@example.org.
© Financier Worldwide
James M. Westerlind
Arent Fox LLP