An entire generation of investors has grown up on Wall Street and on Main Street and never faced a bear market or a year of declines. A new generation of risk managers has never seen rate increases and never faced a hard market. Based on these circumstances, why would a risk manager consider increasing corporate retentions, creating new companies in an already crowded corporate structure, and overseeing insurance company operations? Why dream of creating a captive?

Responsible risk managers periodically think about all methods of risk financing, including forming a captive insurance company. More than 3,900 companies have decided to become captive owners. Why did they dream of creating a captive? Their common goal was to protect all assets, tangible and intangible. All causes of loss need to be managed at the lowest possible cost to the company, regardless of the point in the underwriting cycle.

There are various types of captive structures, including single parent or equity captives, group captives, association captives, risk retention groups, and rent a captive arrangements. The most dramatic benefits can be realized by the simplest captive structure-the single parent or equity captive. A wholly owned equity captive is an insurance company that primarily insures only exposures from its parent company.

According to the January 1998 issue of Captive Insurance Company Reports, at the end of 1997, there were more than 3,900 captives operating worldwide, of which 3,077 were single parent captives. During the past year, 310 new captives were formed, and 139 were in some stage of winding down. (See Chart 1)

The decision to form a captive requires a long-term view and commitment from management. Captives are typically formed to finance loss. Claims are either serviced by the parent or through a third-party administrator. There are many reasons to form a captive, which range from hard dollars-and-cents issues to softer organizational behavioral concerns.

Perhaps the primary benefit of owning a captive is the flexibility to handle changing risk financing needs. In an underwriting cycle, various coverages alternate between expensive and affordable, when they can be purchased at all. Hard to insure exposures in a soft market become impossible to insure exposures in a hard market.

Ownership of a captive changes that equation-a captive is always available to finance risk. Captives, however, are not always the right vehicle. In a soft market, risk transfer costs can be far too good to pass up. But, the presence of a captive ensures that those same exposures, when overpriced, have a home.

Growing companies face changing and unpredictable exposures to loss. The term "Employment Practices Liability" did not even enter the insurance lexicon until ten years ago and still remains hard to quantify and transfer even in the current soft market. Management may not wish to share with its insurers a history of prior employment practices actions or current human resources policies. Nevertheless, the exposure is real and can be properly funded.

A captive gives the parent organization a place to store funds for future liabilities without paying for risk transfer. The reserve funds need not be earmarked for a particular coverage; a pool of funds is created. This pool can be helpful in funding any difficult to insure exposures, including employment practices, environmental impairment, political risk, currency fluctuations, interest rate fluctuations, directors and officers, or punitive damages.

Many large organizations today face business planning and cost allocation challenges. Multifaceted companies with diverse operating units may encounter an interesting dilemma-the parent organization has the risk appetite and wherewithal to maintain high retentions, but the operating units prefer lower retentions to limit the financial impact of large losses. A captive can be quite effective in this situation. The captive itself takes a high retention and sells lower retention policies to its insureds-the local operating units.

For example, a French division wishes only a $25,000 general liability deductible but the U.S. parent has a $1 million per occurrence risk appetite. The French division purchases a $25,000 deductible policy from the captive, who then aggregates worldwide general liability exposures into a single excess contract with a $1 million retention with the reinsurer of its choice. The captive retains the risk in the excess layer and receives the premium to fund this layer from the French division's policy. The French unit is happy, and the overall corporate insurance program costs are minimized because fewer premium dollars are transferred to an outside insurer.

Clear measurement of a risk management program is also provided by a captive. The captive is a separate corporate entity with its own balance sheet. The financial benefits of an well tuned loss control program are highlighted on the captive's individual profit and loss statements. Assets held by the captive can be invested to maximize the use of corporate funds as well as to meet the long-term loss payment obligations.

Because a captive is an actual insurance company, it may purchase protection directly from professional reinsurers. Unlike the insurance market, the reinsurance market is largely unregulated concerning forms, rules, and rates. Unique exposures can be handled with customized policy language, and prices may be lower because of the greater depth of the reinsurance market. Professional reinsurers may also offer a useful twist-an all lines stop loss program. This product would limit, in absolute terms, the total potential liability of the captive.

A captive potentially offers one unique avenue of savings-the early recognition of losses for federal income tax purposes. Income tax deductibility is a complicated subject, however, and not all premiums may be tax deductible. The IRS will require a captive to act like an insurance company by insuring exposures belonging to companies other than its parent. In the 12 years since the Tax Reform Act of 1986, there have been many rulings regarding the deductibility of premiums paid to captives. Whether premiums will be deductible when paid needs to be addressed by any corporation while deciding if a captive makes sense for them.

Managing a captive creates other financial advantages. A captive insurance company creates a mechanism for a company to set reserves for the loss exposures it insures. The reserve level can be monitored through hard and soft markets and good and bad experience. This has the overall effect of smoothing surplus levels throughout a complete cycle.

A captive yields corporate control over investment income. The assets that support loss reserves and captive surplus must be invested to gain a reasonable return. Profits for an insurance company are largely created by careful, prudent investing. By segregating loss funds, a captive's cash can be invested to reap greater returns than insurance companies will provide while helping to immunize the loss portfolio against unexpected inflation.

Dynamic companies that actively manage both loss activity and costs consider all alternatives in the marketplace before making any risk financing decision. The best risk management program must achieve overall cost savings compared to its alternatives. Captives, like every other alternative, offer advantages and disadvantages that risk managers must carefully weigh and analyze.

The decision to create and manage a captive must recognize the up-front costs and administrative burdens associated with operating an insurance company. The formal business planning process begins with a feasibility study. A feasibility study is a report generally prepared by a consulting firm which details expected premium and loss payments based on the parent's risk profile. Upon formation, the parent must provide funds to capitalize the captive in accordance with regulatory requirements. Depending on the location of the captive and the lines of business it underwrites, a captive can cost $50,000 or more annually just to operate. Fronting fees, taxes, reinsurance costs, and other items create additional frictional expenses. Insuring a large volume of losses can make these costs small by comparison.

All of the items discussed here need to be considered in depth prior to forming a captive insurance company. Each corporation's structure and unique set of risk management and financial objectives, based on past, present, and future exposures to loss, will determine whether a captive is an attractive option. The next step would be to start the process of making that captive dream become a reality.