Captive insurance is structured in a way where the insurance company which issues policies is wholly-owned and controlled by those it insures. The goal of this type of insurance is that it insures the risks of the owners. Those who are insured are able to benefit from the underwriting profits that are collected.
It is different from a mutual insurance company, which is also wholly-owned and controlled by policy holders, because votes are often used to determine a course of action instead of having a policy holder actually exercise control of the company itself.
The primary advantage of captive insurance is that it keeps costs centralized. It provides an option for corporations, groups, and individuals to manage risks by underwriting their own insurance. That reduces the number of premiums that must be sent out to third-party insurers, providing more overall control for the insurance experience.
The key disadvantage of captive insurance is that it places the capital of those who are insured at risk. Anyone who purchases captive insurance must be able and willing to invest their own resources into the policy. That is because they have control and ownership of the company and earn benefits from its overall profitability.
Additional Pros of Captive Insurance
1. It provides an opportunity to achieve an underwriting profit.
A captive insurance structure is considered a “single parent” structure. Think of underwriting profit not as an actual profit, but as less of a loss that would be experienced by obtaining a similar product from someone else. Imagine that you’re spending $10 per month on Netflix. Then you get the opportunity to stream your own movies for $3 per month instead. You’re still spending $3 each month, but it’s for a similar service and you’re spending $7 less than before. That is what captive insurance is like.
2. There is access to the reinsurance market.
Although access to reinsurance has been increasing since the 1990s, reducing the benefits of captive insurance in some ways, there is still an advantage here. The total number of advantages that can be obtained is dependent upon the formal risk financing program that is being created. The parent company, group, or individual can purchase excess insurance that is placed into the captive, then the captive can purchase reinsurance when needed.
3. It can be a vehicle for investment income.
Because captive insurance is wholly owned, the policy holders control how loss funds are dispositioned until they are paid out. The same applies to investment income that comes from loss reserves. Some cell captives may even provide a guaranteed rate of return to its policy holders. There are guarantees that involve a range of return rates as well. That makes it possible for a certain level of diversification to occur.
4. There are high levels of flexibility.
Although this benefit is usually reserved for non-fronted captive insurance, it does apply to the industry as a whole. That means the form of the insurance and the rates involved are much more flexible during the underwriting process. Although rates are usually dictated by the market, especially during the start of a formalized risk finance program, changes can be made as policy holders generate a specific loss experience. Over time, non-fronted captives provide opportunities to create their own rates and forms. Some fronting insurers may provide the same benefit.
5. It creates more predictability.
Insurance usually revolves around the concept of control. It is one of the most important benefits of holding a policy. If you’re in an accident with your vehicle, you still have control over your budget because you know what your costs will be, based on the type of accident you have and who may be at fault. Captives make it possible for organizations, groups, and individuals to have a more active role in how primary losses are paid. Control grows based on assets instead of starting over each year, as it would if there was a large deductible in place.
6. There are still tax advantages that can be found.
Although the IRS has been changing how captives are taxed over the years, it is still an insurance company. That means the loss reserves of the captive are allowed to accumulate untaxed until they are taken as earnings. If they are paid out as losses, then it doesn’t count toward the income and is not generally taxed. This structure permits the parent company to pay a premium to its captive and, in return, receive what is essentially an accelerated tax deduction if everything comes together correctly.
7. It offers a dividend guarantee.
Captive insurance provides claims management and enhanced loss prevention activities. No form of risk financing would be able to succeed if these activities were absent. Every type of active that establishes, and then maintains, claims management and high levels of loss prevention through its standards and protocols will always pay dividends to policy holders over time. The amount of time it takes to achieve those dividends varies based on the circumstances experienced by the policy holders.
8. It can be used as a defensive strategy.
Not every captive insurance policy is formed to take advantage of the financial gains and dividends that are possible. Captives can also be created to create a defensive strategy around a specific pool of funds that is designated to pay for specific claim types. An organization could employ captives as a way to protect themselves against product liabilities and the legal claims that arise from it, for example.
9. Secured loans become a possibility.
In the United States, under section 831(b), one of the financial benefits of captive insurance is the possibility of a secured loan. The captive business can provide a secured loan to the operating company without the same profit motive of other third-party providers. Businesses can be denied insurance from a commercial standpoint. Even if a claim is approved, the process may take several weeks (if not several months) to complete. Because of the structures involved, business owners have control over their claims process, which eliminates the chances of a denial. Fraud is eliminated because one cannot commit fraud against themselves. That means the captive benefits, the policy holders benefit, and everyone can become financially secure.
10. It creates an additional chance for investment.
There is an underwriting profit that comes from the issuance of a policy. Premiums on that policy are paid in advance, then claims are paid out over the long run. Until a claim becomes payable, the available premiums become available for investing. With captive insurance, the investment income and the premiums are retained by the owner. If the captive is offshore, then there is a possibility that the income could be untaxed.
11. It can provide insurance for typically uninsurable activities.
One of the best advantages of captive insurance is that it eliminates the problem of coverage unavailability in the market. Commercial insurers may be unwilling or unable to cover certain risks. Some companies, groups, or individuals may not find the premium price quoted to them to be a reasonable offer. By working with captive insurance instead, the needed insurance can be provided, albeit at the cost of retaining more of the individualized risk.
Additional Cons of Captive Insurance
1. Raising capital is mandatory.
Captive insurance is basically a self-insurance policy. That means there must be capital available in reserve if there are claims that must be paid. Should the captive insurer underestimate their protection level, there may not be enough funds available to provide an adequate level of protection. Raising capital to support this reserve is almost always mandatory. Otherwise, there could be a need to draw from company assets and that could put the future of everyone at risk.
2. There can be quality of service issues.
Because captive insurance is a self-based product, the quality of service is often dependent upon the insurer’s personal efforts. Some may attempt to select third-party vendors or service providers that offer discounted pricing compared to a more traditional product. That action may save some cash for the insurers, but it can also cause services to be inadequate or inconsistent.
3. Captive insurance offers no tax benefits.
Although captive insurance offered a number of tax benefits in the United States in the past, the benefits have been going away over time. Some of those benefits, such as low taxes on plan profits, have made this type of insurance cost-prohibitive for some groups. Many of the tax advantages that used to be associated with “going captive” for insurance have been reduced or eliminated.
4. There is no way to spread out the risk.
Insurance is based on a principle of risk. To keep costs down, the available risk is spread out through large groups of people so that an adequate level of protection can be achieved. Under captive insurance arrangements, the pools that are available to insured individuals are often very small. That means total costs can vary greatly each year, making it difficult to budget for actual insurance needs. Many who use captive insurance find a need to have a secondary policy that can cover unanticipated expenses.
5. It requires additional management.
Captive insurance requires more resources and time, which contributes to its higher overall cost. Insurance groups often need to bring in people to handle the daily operations and responsibilities of policy administration.
6. There can be barriers to entry and exit.
Captive insurance policies can be difficult to purchase. There can be several barriers to entry compared to what is available from policies that are on the open market. For those seeking to leave captive insurance, the same barriers to exit are in place to prevent unwanted changes to the insured pool. That is why this type of insurance must be fully thought out before seeking to obtain it because many policy holders find that it can be difficult to change one’s mind after they get involved.
Captive Insurance: Which Side is Right?
Captive insurance is not for everyone. It is a policy that makes sense for organizations, groups, or high wealth individuals that must protect themselves from risk while managing their budget in a predictable way. The pros and cons of captive insurance are more than a means to eliminate third-party premiums and other insurance costs. It is also a chance to earn profits, grow assets, and eventually take on more risks if desired.
In a perfect world, “going captive” provides a path of growth for entities that has reduced costs and risks compared to insuring actions through third-party providers. At the same time, losses are still covered, dividends can be declared, and surplus positions can create real profits that still grow in a tax advantaged way.
The environment around captive insurance is changing. The benefits of this type of policy are not what they once were. Under the correct conditions, however, it can still be an effective way to diversify and manage risk.