Every risk financing alternative, with the possible exception ofguaranteed cost insurance, has benefits and risks. The key tosuccess, especially with captives, is to correctly compare thesalient benefits with the riskiest drawbacks for eachorganization. 

The National Association of Insurance Commissioners defines acaptive as an insurance company that is created and wholly owned byone or more non-insurance companies to insure the risks of itsowner or owners—essentially a form of self-insurance whereby theinsurer is owned wholly by the insured. Captives are typicallyestablished to meet the risk-management needs of the owners ormembers, and the entities forming captives range from majormultinational corporations—the vast majority of Fortune 500companies have captive subsidiaries—to nonprofit organizations.Once established, the captive operates like any commercialinsurance company and is subject to state regulatory requirementsincluding reporting, capital and reserve requirements.

A risk manager must be prepared to make an informed decisionregarding whether, and how, an organization should embark on thisnew path.

Potential Benefits of Captives

Underwriting Profit—For single-parentstructures such as captives, underwriting profit is not reallyprofit; it is the tangible economic value of paying less in lossesthan that which was originally funded. An organization cannotprofit from an enterprise in which it sells nothing to independentthird parties. 

Access to Reinsurance—Twenty years ago a riskmanager could not just pick up the phone and call a reinsurer orreinsurance broker—only primary insurance underwriters had directaccess to reinsurers. Today, the advantage of being able to accessthe reinsurance markets still exists with a formal risk financingprogram such as a captive; it is a matter of degree. At this pointwe must differentiate between excess insurance and reinsurance. Aformal risk financing vehicle has no impact on a company's abilityto access insurers that provide excess insurance. While there aremany structural differences between excess insurance andreinsurance, the major point to remember is this: the parentcompany purchases excess insurance for the captive and the captiveitself is the one that purchases reinsurance. 

Investment Income—Usually an organization canearn investment returns on only funds it controls. In awholly-owned captive, for instance, the owner controls thedisposition of the loss funds (within certain parameters) untilthey are paid out in losses. In some off-balance sheet vehiclessuch as cell captives, the cell captive owner determines the extentto which the policyholder benefits from investment income on itsloss reserves. Sometimes the cell captive owner will provide aguaranteed rate of return; other times it might guarantee a rangeof rates within which the return might fall. The point is that ifthe organization is going to take advantage of off-balance sheetrisk financing there are certain trade-offs, one of which is theamount of investment return. 

Usually only one or the other is purchased. So in this sense, ifan organization has a formal risk financing program such as acaptive, there is a choice.

Flexibility as to Form and Rates—This benefitgenerally applies only to non-fronted captives. Fronting insurersdictate rates and forms. Regardless of the underlying financingarrangements, fronting insurers remain ultimately responsible fortwo things: underwriting and claims handling. 

Underwriters generally require that the captive adopt theirfiled coverage forms as their good name is on the policydeclarations page. Rates are generally determined by the market inthe beginning of any formal risk financing program, but, as timegoes by, the captive's loss experience begins to influence itsprogram's rates. Direct (non-fronted) programs actually do providea fair opportunity for the captive to devise its own forms andrates.

Control—Control is a concept that is rarelyassociated with insurance, but it is one of the most powerful andimportant benefits of forming or being a part of a captive. Formany companies, the expenditures for event risk financing (such asthe cost of insurance) seem to disappear into a black hole.Captives and other formal financing arrangements wrest a degree ofcontrol away from the commercial insurance markets and allow thepolicyholder to take an active role in how it pays for theprimary-level, reasonably predictable losses. But so does the largedeductible or self-insured retention approach; however, that kindof control is temporal. It starts anew each year, and thepolicyholder gains no ground. In a captive the control growscommensurate with the captive's assets. The larger the captive'sloss reserves, the greater its ability to assume responsibility(control) for greater amounts of risk over time. 

Insurance Accounting and Premium TaxDeductibility—Insurance companies and most captives enjoya particular tax advantage as compared with a non-insurancecompany. A company's annual earnings are subject to U.S. federalincome taxation. So are the earnings of insurance companies, butbecause insurance companies' products consist entirely of a promiseto pay for losses, it must have sufficient reserve funds to fulfillthis promise. Thus, loss reserves are allowed to accumulate untaxeduntil they are taken as earnings (those not paid out for losses).This allows the parent company to pay its captive a premium andrealize what is tantamount to an accelerated tax deduction,assuming the circumstances permit. 

Enhanced Loss Prevention and ClaimsManagement—In the absence of these critical activities, nocaptive or any other formal risk financing program will succeed.However, for any type of captive, establishing and maintaining highloss prevention and claims management standards and protocolsalways pay dividends in the long run. 

Premium and Loss Allocation—Captives,especially the single parent variety, can be wonderful tools toconsolidate and manage the administrative side of financing eventrisk.

Defensive Strategies—Not all captives areformed to take advantage of the usual and customary benefits.Sometimes there are special circumstances that a captive caneffectively address. Captives can be employed to create a formalsystem of ring fences around a pool of funds designed to pay forcertain types of claims. These circumstances usually include thepotential for heightened legal activity due to an environment that,correctly or not, encourages the emergence of potential plaintiffsfiling suits against the organization. The most prevalent of thesesituations involves product liability and occupationaldisease. 

A risk manager's budget is under pressure. The company grewrapidly over the last several years and was paying more than $2million for liability insurance.

Rate/Loss Disparity—Is the organization payinginsurance premiums based on its industry's collective lossexperience when the organization's loss experience is far betterthan that of the industry? If so, the risk manager might want toconsider retaining significantly more risk, in a captive orotherwise, as illustrated by the following example. 

The company's general liability loss experience was far betterthan the industry's experience. The company had not paid a loss inexcess of $100,000, with the vast majority of claims settling belowthe $50,000 self-insured retention (SIR). 

An actuary calculated expected losses within three optionalper-occurrence retention levels, $50,000 (the current SIR),$100,000, and $250,000. At the $250,000 retention, the combinationof captive premiums and premiums for insurance excess of thecaptive (up to $20 million) was $1.5 million, an immediate savingsof $500,000 over the previous program's premium. The expectedlosses at the $250,000 retention were only marginally higher thanthe expected losses at the $50,000 SIR. 

Expected losses at the $50,000 SIR were $800,000, but at the$250,000 level, only $900,000. The company obtained insurance costproposals for coverage excess of $100,000 retention and $250,000retention. The excess insurance premium at the $250,000 level was$800,000, and at the $100,000 retention it was $1.1 million. Thecombination of the loss funding and the costs of excess insuranceat the $250,000 retention appeared to make the mostsense. 

 Over time, the captive investment created thefollowing outcomes:

• Since the company assumed significantly more riskthan it did under the previous arrangements, the risk manager paidmore attention to loss prevention and claimsmanagement. 
• In succeeding years the captive's assets grew tothe point where the company could afford to take additional risk.So at the end of the third year, the risk manager increased theretention to $500,000, resulting in a reduction in the cost of theexcess coverage with little additional loss costs.
• At the end of the fifth year, the captive declareda dividend, as its capital and surplus position was more thanadequate based on the relevant solvency ratios.

Potential Risks or DrawbacksAssociated with Captives

Opportunity Costs on Dedicated Funds—One of theproblems with any formally funded risk financing scheme is the factthat the loss reserves are just that: reserves put aside to pay forlosses. Yes, there are a wide variety of investment vehiclesthrough which a captive's assets can earn a decent rate of return,but there are all manner of potential uses that could certainlyproduce better returns than that of a captive. 

InexperiencedManagement—Inexperienced management is often disregardedas immaterial because almost all of the captive's services,including captive management, are usually outsourced toprofessionals. The potential risk involved with inexperiencedmanagement applies to the captive's executive officers and boardmembers. With the exception of rental and cell captives, mostcaptives are run by people who have never before managed aninsurance company. Single-parent and group captive directors andofficers must rely on the knowledge and experience ofconsultants. 

Excessive Expenses—Captives can become theequivalent to an ATM for a wide range of interests. Group equitycaptives, which are formed by third-party promoters, often add awide range of expenses designed to pay a variety of so-calledstakeholders, including the promoter, the insurance broker, theassociation (if the captive is formed for a particular associationor affinity group), and various consultants. As a rule of thumb,captive expense ratios should be no higher than 30 percentexclusive of excess insurance or reinsurance. 

Underemployed Capital—Like every other companycaptives require capital. A company's capital structure should beas efficient as possible. The same logic applies to a captive, butits capital structure usually consists of only one source:equity. 

Most captives are formed with the minimum amount of capitalallowed (or suggested) by the domicile regulators. Over time, thecaptive accumulates earnings (excess loss reserves) and uses it tobolster the capital account. 

Inability to Achieve Insurance Accounting—Whileinsurance accounting is a positive and often necessary consequenceof captive ownership/participation, it should not be one of thereasons for forming the captive. However, the inverse of thisargument is usually not true. Often the inability to comfortablyassume that the captive will qualify for insurance accounting killsthe deal before it gets off the ground. The heart of insuranceaccounting is the ability to deduct loss reserves from incometaxes. Only when excess reserves become earnings are they subjectto U.S. federal taxation (for most captives with U.S. owners). Inthe absence of insurance accounting, the captive must use depositaccounting. 

Substandard Returns on Investment—Whether asubstandard return on investment exists depends on the parent'sdefinition of substandard. Gauging a captive's value primarily onits ability to earn a minimum ROIC is a faulty analysis. However,if the parent company mandates that the captive's capital must meetor exceed the company's hurdle rate and/or provide positive returnswithin a relatively short timeframe, perhaps, three years, acaptive would not be indicated. 

Short-Term Cash Flow—In insurance parlance,cash flow means the organization's ability to hold onto its moneyuntil it has to pay a loss. In a large deductible plan theorganization keeps the loss funds until they are paid. Conversely,captives force the policyholder to monetize those loss reserves inthe form of a premium payable over the twelve-month policy term.While this disadvantage is usually overshadowed by a variety ofbenefits, it is nevertheless real.

Insufficient First-Year Premiums—Many groupcaptives start out with the best of intentions but also withinsufficient premiums, relying on the notion that, as the yearprogresses, they will successfully attract additional members. Thisassumption is exacerbated by the fact that, in order to open thecaptive, they need to contribute enough capital and surplus on dayone to support the marketing plan—the business they believe willmaterialize within the first year. 

Legal and Regulatory Risks—All formalself-insurance arrangements are built on a legal and regulatoryframework that are assumed to withstand the vagaries of thepolitical landscape. These risks are real and can emanate from avariety of sources: the IRS, the Financial Accounting StandardsBoard (FASB), the Securities and Exchange Commission (SEC), statedepartments of insurance, foreign governments, and the U.S. federalgovernment. Regulations are changed partly due to ideology andpartly due to lobbying pressure. Unfortunately, many politiciansand regulators remain skeptical about the validity and publicpolicy implication of captives. In early 2008, the onshore captiveindustry was threatened with an IRS ruling that most observersbelieved would have effectively destroyed onshore captives, sendingthe majority of that business to offshore domiciles. The industryfought back, and the IRS relented. It withdrew its proposed ruling,an unprecedented move by the IRS. Next time (and there will be anext time) the industry may not be so lucky.

Risk Sharing (Distribution)—Risk sharing is oneof the pivotal requirements, as per the IRS, for a captive toqualify for insurance company status. The problem is that risksharing can be an extremely uncertain proposition. Its most potentapplication is in small group captives. For example, risk sharingamong group captives with seven to ten members is a majordeterminant of the captive's ultimate success. Risk sharing,fortunately, does not have to be all-encompassing. Usually, only acertain portion of a group captive's risk is shared, the rest stayswith the individual member. Even so, assuming a portion of anothercompany's risk reduces or eliminates direct control over lossprevention and claims management. 

The content in this publication is not intended or writtento be used, and it cannot be used, for the purposes of avoidingU.S. tax penalties. It is offered with the understanding that thewriter is not engaged in rendering legal, accounting, or otherprofessional service. If legal advice or other expert assistance isrequired, the services of a competent professional should besought.