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Captive Resource Center
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Captives: Why or Why Not?
[Editor's Note: In response to an Ask the Expert request
asking for some of the advantages and disadvantages of captive ownership,
Karin Landry has graciously shared this white paper that formed the basis
for a CICA Conference
presentation. We think you will find most helpful.]
REASONS TO FORM A CAPTIVE
- Reduced Reliance on Commercial Insurance
As the captive matures, its surplus grows, giving it greater capacity
to retain risk. Increased surplus also creates new opportunities for
accessing reinsurers and entering pooling arrangements, which further
increase available capacity.
- Reduction of the Costs of Risk Management
The price of insurance coverage purchased in the conventional market
typically reflects a significant markup to pay for the insurer's acquisition
costs (including marketing and broker commissions), administration,
and overhead as well as profit to the insurer. The fact that premiums
are paid in advance represents a lost opportunity to earn investment
income.
Establishment of a captive cannot eliminate these costs, but it can
reduce them. The extent of the reductions will depend on the captive's
own loss experience, the claims handling costs and the degree to which
the captive promotes cost consciousness and efficiency in the parent.
- Stabilization of Pricing
Where the insured enjoys a stable and reasonable loss experience from
year to year, a captive affords the ability to price insurance coverage
accordingly. By contrast, the conventional insurance market will often
set prices in relation to broad industry classifications, and thereby
fail to reflect key differences in loss experience among individual
insureds. The result is price volatility based on general market conditions
and the actions of other insureds. In addition to the stabilization
of pricing over time, there are also advantages to be realized in terms
of the organization's financial planning and control functions.
- Provision of Cover Where Otherwise Unavailable
From time to time, the conventional market is unwilling or unable to
provide cover for certain risks, especially for liability and casualty
loss. The establishment of a captive (or group captive) to write such
lines or to provide additional capacity can be an answer to these market
problems. Coverage, which have at times been unavailable or difficult
to obtain on satisfactory terms, include product liability, professional
liability, and oil pollution, hazardous waste and labor strike insurance.
Whenever insurance cover is unavailable or overpriced, the feasibility
of a captive is enhanced.
- Access to Reinsurance Markets
Because reinsurers generally deal with insurance companies, a captive
affords direct access to the international reinsurance markets. In bypassing
conventional insurers, the insured is spared markup costs. The savings
associated with eliminating these costs will frequently outweigh the
incorporation and other startup costs of a captive.
- Improved Cash Flow Benefits
The ability of a captive to generate investment income from unearned
premiums received is often a critical advantage in forming a captive.
This is especially so where premiums are paid in advance and losses
are paid out over a lengthy period of time (which, in turn, depends
on the kinds of risks insured). To the extent investment income can
accumulate in a tax-free domicile, there will be additional funds available
to pay losses and a corresponding reduction for further funding of the
captive.
- Reduction of Government Regulations and Interference
By contrast to the rigorous insurance regulation in most industrialized
countries, a domicile can provide a less onerous, yet responsible, regulatory
framework. This has been described as a system of shared regulation,
whereby the regulated cooperate with a view to achieving the most appropriate
level of policyholder protection while at the same time permitting the
captive to grow and prosper.
- Ability to Customize Insurance Programs
A captive has complete freedom to insure any risk it chooses and to
customize the terms and conditions of its policies. This can lead to
improved loss control efficiency and promote greater awareness of the
factors that commonly give rise to losses.
- Formalize the Allocation of Deductibles for
Self-Insurance Retention within a Corporation
A medical facility may want to allocate costs to locations by loss ratios
while a real estate partnership may need to bill each partner its respective
cost (rather than an arbitrary allocation). With a captive, it is easier
for the smaller entities to justify these expenses.
- Underwriting Advantages
Inherent in Captives
A key advantage of a captive is its ability to provide management information
across a spectrum of disciplines. Among these is an ability to analyze
historical claims information. When feasibility studies are undertaken,
it is not uncommon to find that pre-captive loss experience is unreliable.
Depending on the risk involved, a wide range of sophisticated, analytical
tools can be employed to help calculate IBNR (Incurred But Not Reported)
losses. On a day-to-day basis, simple spreadsheets can be maintained
and used.
These tables can be enhanced to show numbers of claims and differentiate
between paid and outstanding amounts so that the cash flow effect may
be monitored. It’s simple and effective when its limitations are
understood:
- The composition of the portfolio may have changed
over the years.
- The method of reserving may have altered over
time, especially because it is often based on human, not scientific,
judgment.
- Deductibles may vary year to year, distorting
the information.
- A yearly security loading variable that tries
to track judicial inflation, currency movements, and the unexpected
may have been added.
A significant advantage in maintaining this type of record is its
appeal in explaining to non-insurance people the method of determining
IBNR levels.
Because of the uncertainty associated with tail business and risk
of a catastrophe, it may be appropriate for a captive to purchase
aggregate excess of loss or stop-loss protection. In some cases,
it may be necessary to engage the professional services of a qualified
actuary. In either event, be aware of and monitor what is happening
to the captive in order to maximize its value to the parent and
to support a prudent assessment of future premium requirements.
- Opportunities for Improved Claims Handling
and Control
A captive is also free to establish its own claims handling policies
and procedures. This has obvious advantages such as the reduction of
the time taken to process and pay claims.
- Creation of a Profit Center
To the extent a captive might offer insurance coverage to unrelated
customers (sometimes in response to tax planning objectives of the captive),
it will have diversified into open market operations not unlike conventional
insurers. Although there are special risks and capital requirements
associated with engaging in such business, doing so will have the potential
to generate additional profits.
- Tax Advantages
While professional tax advice should be sought before making the decision
to form a captive, there may be certain tax advantages associated with
such a decision. These might include the tax-favored accumulation of
underwriting and investment income (which may depend on, among other
factors, the domicile of the captive, the residence or citizenship of
the captive’s owners or the source of its income). Another advantage
may be the deductibility of premiums paid for by the insured for tax
purposes (as premium expense of the insured).
Also, if a captive qualifies as a true insurance company for tax purposes,
then unlike other corporations it can deduct currently a “reasonable
and fair” loss reserve for unpaid actual losses incurred. Finally,
state premium taxes otherwise payable in a commercial insurance program
may be reduced. Although tax advantages may be of significance in the
decision to form a captive, they should never be the prime-motivating
factor.
- Ability to Direct Investment
Options
Generally when you purchase commercial insurance you do not control
the investment of the premiums. A captive can afford the opportunity
to direct these investment choices.
SOME POSSIBLE DRAWBACKS
- Administration
Increased Administration Burden:
The captive owner(s) will be ultimately responsible for such items as
claim administration, loss control and underwriting. Additional time,
money, personnel and management commitment is required for these services.
Such costs may be offset by contracting out administration to captive
management companies. However, these costs will reduce the premium savings
expected in comparison to conventional insurance companies.
Delegation: Where a captive
management company is engaged, a high degree of delegation and partnership
is required. A significant management time commitment is involved, but
if the parent company already employs a risk manager, this time commitment
should be within the normal arena of such a manager's duties.
Acquisition of Expertise:
A parent company must acquire relevant expertise for all the insurance
related disciplines. This could be offset by the engagement of captive
management services, although it would be prudent to have a least some
expertise residing in the parent company.
Merger or Acquisition:
A captive’s existence may complicate merger or acquisition activity.
- Financial
Volatility of Reinsurance Market:
Generally speaking, the reinsurance market acts more swiftly than the
primary insurance market in the event of adverse experience. Since the
reinsurance market tends to be experience rated (premiums closely reflect
the loss history of the insured) a reinsured risk of a captive might
face premium increases sooner than a commercially insured risk.
Capital Commitment: At
least during the initial stages of a captive formation there will be
a burden on the parent's financial resources to fund the initial set-up
costs and the capitalization required by the domicile's regulatory body.
Run-Off: A change in the
parent company’s business plan or a merger might result in the
captive being placed in a run-off mode. Expenses of a run-off produce
no current economic benefit.
For more information, visit the information-rich Spring
Consulting Group website or contact Karin Landry directly:
Phone: 617-589-0930
Fax: 617-589-0931
E-mail: captive@springgroup.com
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