5 Reasons Not To Form a Captive Insurer

An City Street Flanked by Skyscrapers Heads Toward an Orange Road Sign Illustrating Use Caution

September 29, 2023 |

An City Street Flanked by Skyscrapers Heads Toward an Orange Road Sign Illustrating Use Caution

When researching whether or not to start a captive insurer, one of the early questions an organization might ask is, "Why wouldn't we want to create our own insurance company?"

This is a pertinent question given that real and identified need should be the basis of captive insurance company formation for any organization. Below, we suggest five reasons why forming a captive insurance company may not always make sense. Key when considering the long-term success of a captive, these five areas are listed below in order of importance from highest to lowest. From our perspective, a positive response to the first two items is of vital importance before proceeding on to the last three.

1. Lack of Insurance Expertise

Those looking to own a captive insurer should ask themselves the following question, "Within our organization, do we possess a basic working knowledge of insurance, and if not, are we willing and able to undertake the education necessary to learn the business?"

For instance, captive owners could more than likely face a situation similar to the following scenario. A company's internal actuary and the external opining actuary undertake a routine discussion surrounding the divergence of the estimated loss reserves for the insurer. It would not be out of the ordinary for the actuaries to have differing opinions as to the total loss reserves. The internal actuary might find a reserve redundancy and the opining actuary might find a reserve deficiency. In this example, let's say the actual difference is about 5 percent of the total reserves.

Without a good knowledge of insurance, it would almost be impossible for captive owners to ask the requisite questions needed to determine how serious a problem the 5 percent difference noted above represents. And what, if anything, should management and/or the board do about it?

Hiring outside expertise does not absolve captive owners of their fiduciary obligation to know if the captive is safe and sound. Learning the rudiments of insurance is key for those thinking about forming a captive insurance company.

2. A Well-Defined Strategic Objective

Long-term strategic objectives are fundamental for considering whether or not to form a captive insurance company. Prior to scheduling a presentation with an outside professional about creating a captive, the owner and/or board members should ask, "What is the problem we are trying to solve?"

With this in mind, the organization will have a basis for evaluating whether a captive insurance company can offer some or all of the solution. Nonetheless, a well-defined strategic objective will be effective for answering whether or not to form a captive only when the owner or board members meet requirement No. 1: having a basic working knowledge of insurance.

3. Long-Term Commitment

In deciding to form a captive, or in using a sponsored cell of an existing captive, owners ought to view the decision as a long-term commitment. With the proliferation of both captive management firms and captive domiciles, the costs associated with creating a captive insurance company or captive cell have declined. Therefore, the natural inclination is to look at a captive and think, "Well, the up-front costs are not very much, so let's give this a try. If it doesn't work, we can always just put it into runoff or do a loss portfolio transfer and go back to what we were doing before."

However, the time and effort necessary for an organization to extricate itself from the decision to form a captive insurance company can be a lot more prohibitive than people might assume. If the organization has successfully navigated through requirement No. 2 and has defined a true strategic need, then it should be prepared to give the captive time to grow and fulfill the objective(s) it has identified.

4. Prudent Funding

Captives cost money. This is the money used as the initial surplus to form and operate the captive and money to adequately support the risks the captive assumes. Prospective captive owners should avoid making the mistake of assuming they can underwrite a given risk any less expensively than the traditional property-casualty markets.

While it is true a captive's administrative costs should be lower than the primary insurer's costs, don't assume that a risk profile is made immediately better simply by forming a captive. The best money spent when looking at whether or not to move forward with forming a captive insurance company is hiring a qualified actuary. An actuary can provide both an optimal retention analysis and forecast loss estimates under various retentions and conditions. Prudently funding a captive is committing to the long term.

5. Commitment to Good Governance

Assuming you have cleared all of the above four aspects, the final challenge is learning to practice good governance and implement sound governance policies. Doing this creates the required foundation upon which a captive can be built. Good governance requires time, effort, and money (see No. 4).

Sound governance will not stop a captive from facing setbacks and unforeseen problems, but when these do occur, the organization and its captive insurance company will be in a position to objectively analyze and respond to any issues.

For more on the fundamentals of captive insurance, subscribe to one of IRMI's Essential Captive and Risk Financing References.

September 29, 2023