Captive Insurance

Introduction:

Risk is managed by retention or by transfer. Retention of risk is insurance by self and transfer of risk is termed as commercial Insurance. An owner by not transferring risk bears with the unforeseen losses. These losses are often seen to be small in quantum, regular in nature and mostly manageable. Such losses are adjusted from the day to day income, contingency fund and are sometimes compensated by Governments under social responsibility, by family members out of family bond, by assistance from close associates, by employers as good will gesture, whose actions may be attributed to insurance or reinsurance sort of facility in a very narrower parlance.

The risk when found not to be manageable, the owner prefers to transfer the associated risk to a professional body at a cost with an assurance that the latter shall compensate the former if there happens to be a loss to the former. In simple terms this transfer of risk is called commercial insurance. In addition to self-insurance and commercial insurance, there lies another form of risk management which combines both.

To-day most of the insurable risks are seen to be mixed partly by retention and partly by insurance. In insurance understanding the former works like retention or deductible, and the insurer’s responsibility comes into the picture only when the loss is more than the deductibles. In some other times, the nature of risks is such that the insurer denies providing cover and the owner also fails to retain with him.

It leads to a situation of neither self insurance nor insurance. Such a situation creates tremendous concerns especially on the part of the big corporate, multinationals who think their business could be at stake. Necessity is the mother of inventions and every problem could have a logical solution. To overcome such a situation, the market found two other ways of risk management through i.e. ‘Surplus Lines Insurance’ and ‘Captive Insurance’. This Journal, in its April-June issue, had published an article on Surplus Lines Insurance under title “Selling insurance without Licence”. The present article confines only to ‘Captive Insurance’, most of the contents of which are related to the American Captives.

Definitions:

There are many legal definitions that apply in various jurisdictions. Some common definitions are:

• The insurance subsidiary of a non-insurance parent writing all or part of the insurable risks of the parent, or
• A limited purpose wholly owned insurance subsidiary of an organization not in the insurance business, which has as its primary function the insuring of some of the exposures and risks of its parent or parent’s affiliates, or
• A captive insurance company is a special purpose insurance entity designed to underwrite the risks of parent corporation, or
• A closely held insurance company, whose insurance business is supplied and controlled by its owner and the original insureds are the principal beneficiaries and the shareholders- insureds actively participate in decisions influencing underwriting, operations and investments.

The definitions mean Captives are essentially a form of self-insurance whereby the insurer is owned wholly by the insured. They are typically established to meet the risk-management needs of the owners or members. In other words, it is a subsidiary of a parent company created to work as insurance company but to write the risks of the parent company or the affiliates of the parent company. Captive insurance arrangement is different from commercial insurance as the former’s area of operation is limited to its parent company or companies or the company’s associates.

Captive insurance company is also different from surplus lines insurance company, since the former needs to be registered with the insurance supervisors/ regulators but the later does not. Although commercial insurance is available in almost all countries, Captive or Surplus lines insurance are seen in limited countries. Nonetheless, the use and need for such insurance are increasing gradually and steadily. As far as India is concerned, though there is no captive insurance system.

 

 History:

To give a bit of history, the captive concept has been found to be around for a long time. In the early 1500s, ship owners met in London coffee houses, where they retained, shared and transferred the cost of risk associated with their ships, akin to to-day’s captives. During the 1700s and 1800s, there were instances of mutual insurance companies being formed by members of a particular industry to provide insurance coverage.

In the 1800s, New England textile manufacturers formed a group to share risks due to high fire insurance rates. In the early 1900s, the Episcopal Church formed the Church Insurance Company to cover risks associated with member churches. At the end of World War II, the use of captives expanded with the industrial boom. The captive insurance industry in an informal manner took its origins in the formation of mutual and co-insurance companies in the 1920s and 1930s. However, the start of the real growth of the captive industry can be traced to the early 1950s.

 

Frederick M Reiss (1924-1993), a property engineer who became an insurance broker in Youngstown, Ohio, coined the term “Captive Insurer” and became the first person to invent the modern captive insurance. He ensured that the concept became an established practice in the industry. He also put Bermuda, the center for captive domiciles, on the map of major international financial centers today. During this time, American regulations made it prohibitively expensive to form and operate captives in the United States, leading Reiss to seek out other jurisdictions to allow his captive ideas to flourish.

Starting in 1958, he developed a firm called American Risk Management, and toured the world to seek an ideal offshore jurisdiction. Youngstown Sheet & Tube Company, in Ohio became his first client, which had a series of mining operations and were used solely as captive mines. In 1962, he founded International Risk Management Ltd, in Bermuda and in 1972; he formed the “captive of captives” facility known as ‘Hopewell International’, which is said to be the first established captive management organization.

Between 1970-1976, his firm could play dominant in the Bermuda captive insurance scene and was considered well ahead of its time. The concept took a while to catch on. It gained momentum in the mid-to-late 1980s during the hard commercial insurance market, when liability coverage was either unavailable or unaffordable for many buyers.

 

Why Captives:

Through the years, traditional insurance has been the primary method for organizations to deal with the financial effects of hazard risk. The simple pooling mechanism of traditional insurance remains one of the most efficient methods of reducing the effects of risk on an organization. However, simple pooling often becomes costly for organizations with good claims history, many times is not available to cover all types of risks, usually excludes coverage under many conditions, and does not allow true customization of policies to meet an organization’s specific and unique needs.

Importantly, the owner also loses 100% control of his “risk capital” up front when buying traditional commercial insurance. The administrative costs and profits of traditional insurance is also found to be comparatively high for companies with well managed risk.

The captive insurance industry emerged to address deficiencies and inefficiencies of traditional pooled insurance programs. Captives also work in sophisticated ways to build asset reserves with pre-tax assessment value to cover self-insured risks whether market policy deductibles and exclusions or any of the many varieties of risk knowingly or unknowingly self insured.

The greatest stimulus to the development of captives has been the expense or lack of availability of certain types of insurance coverage in the commercial market. These have become so important in the minds of risk managers and finance directors that, even when commercial premium rates have been extraordinarily low, the interest in captives has been seen to be greater than ever.

In recent years, captives have become a significant part of the global insurance landscape primarily due to insurance industry experts creating service provider firms that help organizations form and operate their own private insurance company.

 

 Business of Captives:

Captives are formed to cover a wide range of risks. Practically every risk underwritten by a commercial insurer can be provided by a captive. The type of entity forming a captive varies from a major multinational corporation to a nonprofit organization. Majority of Fortune 500 companies have captive subsidiaries. Once established the captive operates like any commercial insurance company except serving to the parent company and are subject to state regulatory requirements including reporting, capital and reserve.

In the last 20 to 30 years there has been phenomenal growth in the number of captive insurance companies.  In 1980, there were around 1000 captives. Today there are well over 5,000 captives worldwide writing more than $20 billion in premium. These companies have capital and surplus estimated at over $50 billion.

Captives that are owned by US citizens account for approximately 3,500 which is around 70% of those currently in operation worldwide. Captives can be domiciled and licensed in a wide number of domiciles both in the US and off-shore.  There are now approximately 24 US States and well over 35 countries with Captive nsurance legislation that serve as excellent Captive Insurance domiciles.

Van Fossen discussed the development of offshore captive centers and quoted the following data: In 2000, even before the recent hard market began, Bermuda’s captives had capital and surplus of $44.7b, investments of $107.6b and $23.9b of premiums. Bermuda has added reinsurance and many other risk management services (particularly in property, catastrophe and excess liability) to its original base in captive insurance.

These non-captive offshore insurers now account for about one-third of the premiums, capital, investment and assets of Bermuda’s insurance center- which is the world’s third most important, after New York and London. In 2000, the last year of the soft market, other prominent offshore risk havens were Ireland (with 163 captives, receiving $7.6b in premiums), Barbados (199 captives; $4.9b in estimated premiums), the Cayman Islands (517 captives, $3.2b in premiums), Guernsey (375 captives; $3.0b in premiums), Luxermburg (264 captives; $2.6b in premiums) and the Isle of Man (168 captives, $1.5 b in premiums). The deregulated onshore centers of Vermont and Hawali had 361 and 74 companies, receiving $2.8b and $0.3b in premiums respectively.

Interestingly, the concept of Captive is now not limited to the US alone but has expanded internationally to countries and places like Australia, New Zealand, British Columbia, Denmark, Hongkong, Singapore, Switzerland, Sweden, Turks & Caicos Islands, West Indies, London,Mauritius (South Africa) etc.

Cobb (2001) researched the growth in the financial services industry in a number of offshore financial centers and noted that, in the Isle of Man, the financial services companies had wide international linkages and that the mix of companies included: ….. banks, building societies, life and captive insurance companies, fund management companies, law, accountancy and ship management companies.

Although the term “captive” originally referred to subsidiaries set up by non-insurance companies to insure the company’s own risk, the use and definition of “captive” has broadened over time, as insurance companies are also now creating captives. Notably, some life insurers have entered the market, utilizing captives to form captive reinsurance subsidiaries and insurance securitizations. This development has also led to questions regarding whether third-party insurance risk should be a risk undertaken by a captive.

 

Forming a Captive:

The formation of a captive insurance company is a lengthy process including feasibility studies, financial projections, determining domicile, and, finally, preparing and submitting the application for an insurance license. The need for a qualified insurance manager on the planning team is very important, particularly in the formative stages.

The requirement for adequate initial capitalization of the captive is dependent in part on the level of risk projected to be assumed by the captive and the requirements of the particular domicile chosen. In some cases, this initial capitalization can be accomplished through the use of irrevocable letters of credit. The irrevocable letter of credit would be obtained by the sponsor applying to the bank. This will involve a fee for the issuance of such a credit facility and may restrict the sponsor’s other borrowing capability.

One critical function to be performed during the formative stages is the identification of the risks to be insured by the captive. The operating company is presently paying premiums to one or more commercial insurance companies to protect it from specific risks, some of which could be catastrophic if they were to occur without such insurance. The goal of smaller captives would be to maintain the transfer of the catastrophic risks to the commercial carriers, but to assume the underwriting associated with more standard risks.

The policies that are written need to be for “real” insurance risks but with low probability of occurrence. Should the captive see a need to protect itself in the case of a higher-risk policy, it may be able to buy reinsurance at premiums that are less than the premiums that it has charged the parent company. On an annual basis, the premiums paid to the captive in excess of its claims and operating expenses will transfer to the earned surplus account and be available for more aggressive investment activities.

Care should be taken in the process of selecting “risks” for the captive to insure because true insurance requires a certain amount of fortuity. Any “risk”, that is assured of occurring, even if the amount of the risk is not clearly determinable, is not a true insurable risk. In that case, payments into the captive would take on the aspects of deposits into a sinking fund to help liquidate an existing liability.

One of the risk management benefits that the captive may provide is the flexibility to opt for higher deductible levels on the existing property and casualty insurance policies. In keeping with the above desire to minimize, but not eliminate, claims experience, the selection of the risks that the captive is willing to assume should be prudent. Moreover, the Governments provide tax incentives, which can be best availed through proper planning of Captives.

Types of Captives:

There are various types of captive structures. The vast majority of captives insure only the risk of its parent (single parent or ‘pure’ captive). In addition to single-parent captives, there are group/association captives, rent-a-captive, risk retention groups, agency captives, branch captives, senior or diversified captive, protected cell captive and producer owned reinsurance companies (PORCs). The list is not exhaustive; variations continue to flourish as companies come up with more sophisticated and innovative ways to use captives.

• Single Parent Captive– is an insurance or reinsurance company formed primarily to insure the risks of its non-insurance parent or affiliates.
• Association Captive– is a company owned by a trade, industry or service group for the benefit of its members.
• Group Captive– is a company, jointly owned by a number of companies, created to provide a vehicle to meet a common insurance need.
• Agency Captive– is a company owned by an insurance agency or brokerage firm so they may reinsure a portion of their clients risks through that company.
• Rent-a-Captive– is a company that provides ‘captive’ facilities to others for a fee, while protecting itself from losses under individual programs, which are also isolated from losses under other programs within the same company. This facility is often used for programs that are too small to justify establishing their own captive.

Two other types of insurance company which have developed recently are special purpose vehicles (SPV) and segregated portfolio companies (SPC):

• SPV– Although used extensively in the past for various financing arrangements, recently they have been used for catastrophe bonds and reinsurance sidecars.
• SPC– SPCs can be formed as a rent-a-captive facility to enable those companies who lack sufficient insurance premium volume, or who are averse to establishing their own insurance subsidiary, access to many of the benefits associated with an offshore captive.

Benefits of Captives:

The main objectives of Captives are for –

-reducing the cost of insurance to the parent

-providing coverage for risks that are otherwise difficult to place

-reserving for future liabilities.

 

The benefits of Captives can be summarized as follows-

1. 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. By the process it reduces too much reliance on commercial insurance industry.
2. 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. Since the management of captives remain directly in the hands of the owners the cost can be well managed and reduced. 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.

3. 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.
4. 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.
5. 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.
6. 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.
7. 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.
8. 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.
9. 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.
10. 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.

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.

11. 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. Claims settlement procedures could be customized, simple and faster as compared to the cumbersome process of standard insurance companies.
12. 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.
13. 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.

 

Some possible drawbacks:

1.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.

2.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.

3.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.

4.Merger or Acquisition: A captive’s existence may complicate merger or acquisition activity.
5.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.

6.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.

7.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

8.Tax Benefit Orientation: The attractive tax benefits associated with the smaller captives can sometimes cause business owners to forget that the captive must operate as a true insurance company. The use of an experienced and capable captive management company is an essential element of the normal operations of such an entity.

The need for annual actuarial reviews, annual financial statement audits, continuing tax compliance oversight, claims management, and other regulatory compliance needs puts the day-to-day management of a captive insurance company beyond the skills of most general business people. Likewise, the involvement of the management company in the investment activities of the captive is essential from a planning perspective to assure that the captive’s liquidity needs are met.

Captives to do non-captive insurance:

Traditional insurers do not meet every risk-management need for every business. The captive insurance industry initially developed to formalize a large business enterprise’s self-insurance program. However, the captive insurance marketplace today is much more diverse than when it began. As risks evolve, responses to managing them change. It is incumbent upon insurance regulators to keep pace with this ever-changing, dynamic marketplace.

The most recent test is the evolving nature of the risks transferred to captive insurers in the form of third-party insurance risk. We plan to report on the activities of the Captives and SPV Use (E) Subgroup as it considers the merits and issues associated with the use of captives to cover third-party insurance risk.

Experts argue why Captives should be allowed to do business other than captives. The cited reasons are many, few of which can be summarized as- Captives by doing own underwriting and exposing to reinsurance market has got enough skills and power to underwrite the business of others at a reasonable price. Like covering own risks against unavailable insurance cover or highly priced commercial insurance, the captives can expand their activities to the other non-parent companies.

These captives can set a competition with the commercial insurance giving a scope to the insuring public to choose the bests. There are many commercial insurance companies which could never match with the capacities of many Captive companies. Some argue if it is made open, it will lose its sanctity and will lose the arguments being made against the commercial insurance companies. This stands still to be a debatable issue as to whether the third party business can be accepted by Captives.

 

Captive in India:

Improved risk finance efficiency helps protect and benefits the general public. Increased strategic use of captives makes the insurance industry more efficient, stronger, and better able to compensation those suffering hardship or loss. And there is greater incentive to control loss from risk when a captive insurance company is part of a risk management process over simply buying traditional insurance coverage.

Critics of the captive industry sometimes overlook this. Captives are the newest sophisticated tool in the arsenal to plan for and to manage loss efficiently and effectively. Captives give great control and flexibility over risk and loss management assets and resources by addressing specific needs and circumstances or loss. Captives are helping build a stronger and more efficient global economic system for our children.

By helping people and organizations better plan, manage and save for risks, captives are playing a vital role by encouraging increased investment for the future. They help keep traditional insurance companies more competitive as well fits the general public.

Law in India does not permit operation of captive insurance. Government regulates the ownership of foreign held assets and imposes strict requirements on Indian nationals maintaining overseas companies. But like any developed country, India has a number of giant corporate who given a chance will prefer to have their own mechanism of risk management through Captive insurance.

Time was there when the insurance field was under the hands of government bodies only. After opening up of the market, there are now more than 50 players doing business in the insurance sector. The insured public is gaining the benefits of competition and innovation. The government decisions change as per the need of the hour for the benefit of the public. The way such changes are taking place it is hard to say No to any possibility of allowing Captive insurance in India in future though it does not seem to be so soon now.

 

Conclusion:

Every captive insurance company is uniquely designed to achieve special goals and objectives. Captives are a mature risk transfer and finance vehicle utilized throughout the world. Captives routinely do business with large traditional insurance companies. In fact, many large insurance companies have formed their own captives.

As the captive industry matures, transactions between unrelated captives will be increasingly common including increased merger & acquisition activity to achieve further efficiencies. Someday perhaps a publicly traded stock and bond investment classification for captives will emerge, bringing with it increased investment and wider ownership in captives.

Captive insurance is an integral part of every good risk manager or executive officer’s vocabulary. In the right situation a captive can provide significant benefits to its parent(s) organization. Its review and implementation should, however, not be taken lightly as it is a complex structure subject to rigorous regulatory environments. Only a well planned and managed captive program will achieve full potential and be in a position to adjust to its parent(s) needs.

By N M Behera, Deputy Director, IRDAI HYDERABAD.

This article was published in The Insurance Times