5 Reasons Not To Form a Captive Insurer

Over the last month, I have held discussions with an organization that was researching whether or not to start a captive insurer. One of the early questions I got was, "Why wouldn't we want to create our own insurance company?"

The question caused me to pause because, more often than not, it's outside consultants instead of a real and identified need that seem to be pushing management to form a captive insurance company. Therefore, I thought an article on five reasons not to form a captive insurer would be beneficial to individuals looking for ways to question the given notion that a captive always makes sense.

The five reasons I cite below are based on my opinion, and I am sure there is a much larger list than mine for why a given company would not want to choose to form or join a captive. However, from my perspective, these are the five that I consider to be the most critical to the long-term success of this venture. Readers may disagree, and we are always open to publishing critiques and/or rebuttals to articles we have printed. If so, me your thoughts.

I have deliberately listed these reasons in order of importance from highest to lowest. If you can't positively answer the first two questions, then there is no need to proceed further down the list.

1. Lack of Insurance Expertise

Within this reason, I include two items: lack of current insurance expertise among the owners and, if this is true, unwillingness on behalf of these owners to undertake the education necessary to learn the business. For example, I recently sat in on a presentation concerning loss reserve development. The individuals involved in the presentation were the company's internal actuary and the external opining actuary.

The issue under discussion was the divergence of the estimated loss reserves for the insurer. The internal actuary indicated the company had a reserve redundancy, while the opining actuary felt the company had a reserve deficiency. The actual difference was about 5 percent of total reserves.

Captive owners are more than likely to face this type of situation. Without a good knowledge of insurance, it would be almost impossible for the owners to ask the requisite questions needed to determine how serious a problem the difference noted above represents. And secondly, what, if anything, should management and/or the board be doing about it?

Hiring outside expertise does not absolve the owners of a captive from their fiduciary obligation to know if the captive is safe and sound. If you are not willing to learn the rudiments of insurance, don't think about forming a captive insurance company.

2. A Well-Defined Strategic Objective

As our attention spans and time frames continue to condense, it seems we are losing our ability to focus on long-term strategic objectives. Forming a captive insurer is not like the flavor of the month. Before even hearing a presentation from 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 that thought in mind, you then have a basis for beginning to evaluate the potential solution of whether a captive insurer can offer some or all of the solution. But this only works correctly when the owner or board members have fulfilled requirement No. 1: having a basic working knowledge of insurance.

3. Long-Term Commitment

Similar to our attention spans, it sometimes seems like our relationships have become shorter as well. In deciding to form a captive, or in using a sponsored cell of an existing captive, owners need 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 to extricate yourself from the decision to form a captive can be a lot more prohibitive than people assume. If you have successfully navigated through question No. 2 and have defined a true strategic need, then be prepared to give the captive time to grow and fulfill the objective(s) you have 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. As a prospective captive owner, don't make the mistake of assuming you can underwrite a given risk any less expensively than the traditional property-casualty markets do.

While it is true your captive's administrative costs should be lower than the primary insurer's costs, don't think you can somehow make your risk profile immediately better simply by forming a captive. The best money spent when looking at whether to move forward or not is hiring a qualified actuary. He or she can provide both an optimal retention analysis and a forecast of loss estimates under various retentions and conditions. By prudently funding your captive, you are committing to the long term.

5. Commitment to Good Governance

Assuming you have cleared all of the four impediments listed above, the final hurdle is the need to practice good governance and implement sound governance policies. By doing so, you create the required foundation on which your captive will be built. Good governance requires time, effort, and money (see No. 4).

Sound governance will not stop your captive from facing setbacks and unforeseen problems, but when these do occur, you will be in a position to objectively analyze and respond to the problems.

Captives can be wonderful risk mitigation vehicles if created and used properly.