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Ask the Right Questions To Determine Whether a Captive Is the Answer

Dark-Haired Businessman Wearing Suit Ponders Question Marks
June 10, 2020

As insurance markets continue to harden, many businesses are considering captive insurance companies as an option to address some of their risks. Before taking the step, however, it's important to consider whether a captive is the right fit and, if so, what sort of captive structure is most appropriate.

"Given the market conditions with an increased hardening market, clients are often looking for alternatives to traditional insurance, and a captive is a natural alternative to consider," said Michael O'Malley, managing director at Strategic Risk Solutions (SRS).

Mr. O'Malley and other panelists discussed "Is a Captive Right for You?" in a recent SRS webinar. Answering that question involves first answering a number of other questions, according to the panelists.

"A captive is a type of sophisticated risk financing structure," said Andy Hulme, executive vice president and director of underwriting at SRS. "So, the initial question you have to ask is, Is risk financing right for you? Inevitably, the answer to that is yes."

"Essentially, risk financing is about looking through effective, reliable strategies for managing risks and the periodic review of those strategies," Mr. Hulme said.

While captive insurance companies may be similar, each is essentially unique, Mr. Hulme said, designed to meet the specific circumstances of the company using it. "There's a saying in the industry that if you've seen one captive, you've seen one captive," he said. "Your potential captive is driven by your risk profile."

Not all risks should be treated equally, Mr. Hulme said. "Different loss characteristics can be approached in different ways," he said. "And each loss scenario can have its own solution." And, Mr. Hulme noted, organizations considering forming a captive should consider how their risks and risk appetite might change. "As risk and appetite change over time, what's suitable today may not be ideal in the coming years," he said.

As organizations consider whether to form a captive, the first question they should ask is, "Do you want to get into the insurance business?" said Mr. O'Malley. They also should consider the time frame they're considering for the risk financing solution they're looking for. There are complexity and cost involved in establishing a captive insurance company, Mr. O'Malley said, and from a time frame perspective forming a captive is a long-term strategy.

"The second question is, Is my program size large enough to consider this approach?" Mr. O'Malley said. If, for example, the organization's premiums for the lines of coverage to be placed in the captive aren't much greater than the cost of operating the captive, the benefit gained by forming the captive is reduced. "Program size is critical in these situations," he said.

Other questions to consider are how the captive might affect the organization's operations and compliance requirements, whether the prospective captive parent is comfortable with the underlying risk to be placed in the captive, and how much control the organization has over that risk.

An organization considering a captive insurance company also must consider how much capital it's willing to expose to finance the risk being placed in the captive. That includes considering the parent company's financial position and any possible collateral requirements for fronted programs.

Smaller insureds considering entering a group captive should consider whether they're willing to share risk with others in the group.

It's also important to think about the exit strategy for the captive insurance approach, Mr. O'Malley said.

Another question to consider is whether the captive insurer might qualify as an insurance company for federal tax purposes.

"One of the costs that often gets overlooked when considering the feasibility of a captive and also the overall ancillary benefits of a captive [is] taxes," said Eric Williams, director at Cover & Rossiter. If the captive qualifies as an insurance company for federal income tax purposes, the operating entity will be able to deduct premiums paid to the captive as a business expense, he said.

To qualify as an insurance company for tax treatment, a captive insurance company has to demonstrate sufficient risk distribution and risk shifting. Also, the captive must act like a "real" insurance company with valid and binding insurance policies, premiums determined under arm's-length underwriting standards, premium payments that are in accordance with policy terms, and claims-processing procedures.

Also, to qualify as an insurance company for tax purposes, the captive must operate in accordance with domicile regulations and meet the capital requirements of the domicile.

If organizations determine that a captive insurance company is the right alternative, there are choices about the type of captive that's most appropriate, Mr. O'Malley said.

Single-parent captives are wholly owned, completely controlled by the parent with no risk sharing.

While domiciles have different names for cell captives or rent-a-captives, though the names might differ, they generally function in a similar manner, Mr. O'Malley said. Participants' assets and liabilities are segregated in their cells. The structure can be considered as analogous to a condo versus a single-family home, Mr. O'Malley said. There is no risk-sharing within the cells, and the approach eliminates the need for regulatory capital.

Association or group captives involve multiple companies or organizations coming together to share risk and own a group captive. Risk is shared among the member participants in some form.

Risk retention groups (RRGs) are regulated under federal law. Policyholders must be shareholders and while RRGs are licensed in one state, the RRG registers in all the states where risk resides, so it can operate as an admitted insurer in each state where it's registered. By law, RRGs are limited to covering liability risks.

Even if an organization forms a captive insurer, it can still benefit from commercial market support for its risks, Mr. Hulme said. "The captive doesn't exist in isolation," he said. Captives can work with fronting insurers or as a tool to gain access to reinsurance markets.

Access to the reinsurance market can be particularly beneficial. "The more interesting aspect of this is segmenting risks and using global capacity as a key strategic advantage of running your own insurance company," Mr. Hulme said. That can be particularly timely as markets harden and capacity for some risks dries up. In such cases, the captive might provide a vehicle to gain access to capacity that isn't available in the local market.

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