In the grand scheme of things, there are three dispositions to a risk exposure:

1. Self-funding or financing through a captive arrangement,
2. Purchasing insurance on the open market to cover any potential losses, or
3. Avoidance.

The third option can be limiting because it affects the operations of the company. To avoid all risk exposures would be equivalent to ceasing operations of the entity and shutting down. There are many risk exposures that can't be avoided and need to be handled through options one or two, or some combination.

History shows us that if an entity is paying out at least $500,000 for its insurance costs, a captive cell arrangement is worth investigating. If the payout is at least $1million, a wholly-owned captive is worth investigating. Anything below $500,000 would need to be an exception to the rule for a cell or wholly-owned captive, but it could be a good candidate for a group captive.

The 3 C's

Control, cost and coverage represent the three C's of captive formation. With a captive arrangement you gain better control over your insurance-buying and risk-financing mechanisms, which should lower your costs. You're able to select the various service providers who will assist you in operating the captive and in doing so, lower the cost of services. You have the ability to cover exposures that are uninsurable or too expensive to cover in the open market along with having the ability to manuscript policies if you so desire to plug any holes in your current coverage from the traditional carriers.

From a claims standpoint, you become more involved in the management of claims. This gives you better control over the decision process of whether to deny a claim, fight a claim, adjust a claim in due course or to settle.

Related: Could macro-insurance become a reality? The one-policy-covers-all-risk approach

Before deciding on whether to use a captive, an organization has several factors to consider, including frequence and severity of losses as well as tax implications. (Photo: Shutterstock)

Loss experience

When looking at loss experience in determining whether to use a captive, there are two categories of losses to analyze: frequency and severity. Frequency refers to the number of claims that occur over a given time frame whether that be over the policy period or calendar year. Severity refers to the total dollar value of any particular claim over the measurement period.

In the captive arena, we typically look at frequency losses in the first $100,000 to $250,000, depending on the nature of the business and the size of the entity. There are obviously entities that have formed captives for which this range is too high, and they would need a lower attachment point. Still other entities are so large that this range is insignificant, and they would be looking to put an even larger loss through their captive.

With frequency type losses, the entity needs to see whether there is a predictability to the losses from year to year. This frequency layer is well suited to be run through a captive arrangement. By buying insurance from the traditional market for the frequency layer the entity is trading dollars with the insurance company at a cost that is typically higher than covering the exposures through its own captive arrangement.

As for the severity type losses, these are much harder to predict and are best left to the traditional market with a few exceptions. From a captive perspective, these losses should be limited to the captive with excess coverage purchased from a traditional carrier. This is typically done for severity losses that don't occur every year. For example, windstorm and earthquake coverage is written through captives with a low layer limit that is expanded each year as funds are built up in the captive during the years when no losses occur. This is the classic, “saving for a rainy day” scenario. If by doing this the entity can reap the benefits of a tax election such as the Section 831(b) election where the underwriting income is tax exempt, all the better.

Related: Insurers face $3 billion payout for severe weather in May

Tax issues

Is there ever a time that you enter into an arrangement to form a company requiring capital and resources to operate for a particular purpose when the tax ramifications of such an endeavor wouldn't even be contemplated? Of course not. However, given some of the preferential tax elections available to insurance companies, there is potential for some abuse, which has triggered added interest and scrutiny from the IRS.

When it comes to forming a captive, it should be formed for risk management purposes not for tax purposes. Analyzing how the newly formed captive will affect the overall tax position of the corporate entity is simply prudent business activity and should be one of the determining factors in moving forward. It should never be the only reason for moving forward.

Typically, one of the benefits of forming a captive is cost savings. Part of that cost savings can be the deferral of federal income tax if the captive can be treated as an insurance company for tax purposes (the requirements of which are beyond the scope of this article). Corporate entities that have a net operating loss may see limited benefits from a captive in regard to the lowering of costs. In these circumstances, an entity needs to weigh the many other benefits that a captive can bestow on its parent company versus the cost of formation and ongoing operations. Those benefits can best be uncovered with the assistance of a qualified captive insurance professional.

Related: Is using a captive the right move for your organization?

Jeff Kenneson is president of R&Q Quest Captive Management LLC. He can be reached at [email protected]