I'm thinking about buying a new car this year, and I find myself in a position similar to some corporate insurance buyers who are considering the type of insurance program they're going to go for next renewal.

I'd really like to buy a hybrid, but now that gas has retracted from the $3.00-plus-a-gallon price of a few months back, it's hard to justify the extra thousands that I'll have to pay for one.

But I really believe in the idea of saving oil and emissions. I'm also old enough to remember the gas shortages of the 70s and can see myself driving around in a hybrid—albeit slowly—when my friends can't find enough gas to get to work. I also think gas probably will go up again so think I'll recoup some of the initial investment eventually.

In some sense, corporate insurance buyers are facing the same dilemma. Do they stick with a traditional insured program when prices are low or move to a captive because of long-term, future benefits?

If I wait until gas costs $5.00 a gallon, there surely will be a waiting list for fuel-efficient alternatives. Likewise, if the corporate buyer waits until the insurance market is in crisis, forming a captive won't be nearly as easy as it is today.

We both have to consider the bottom line price today. But should the initial price of a captive, which may be higher than purchasing insurance in a soft market, have a disproportionate influence over the other good reasons to explore this alternative? When is the best time to form a captive?

In considering these questions, keep in mind that different types of captives are designed for different sizes and types of risks. These encompass single owner captives as well as multiple owner captives, including risk retention group captives, association captives, and agency captives.

However, even when setting up a multiple owner captive, the capitalization cost for individual participants may be high. And this may cloud the comparison of captive versus traditional marketplace, especially during a soft market when premiums are low.

Initial price, rather than ultimate program cost, often is the deciding factor.

Financial officers may ask, especially during a soft market, why they should pay more to invest in a captive when they can buy the same—or similar—coverage on the open market for a substantially lower price.

Captives and other alternatives should be viewed as investments in long-term solutions, not quick fixes to solve problems of escalating premiums during a hard market cycle.

The capitalization cost may actually make the initial years more expensive than the traditional market, especially in a soft cycle. And then there are the costs of staff and management. A feasibility study, which outlines these initial costs, may cause the idea to be abandoned.

All of this reinforces the need to look beyond short-term cost, considering it as one, but not the only—or even major—factor.

Given this, a soft market may, in fact, be the best time to consider a captive because it offers a better opportunity to get past cost and focus on the long-term ability to control a risk's vulnerability to outside forces.

After all, if the financial decision makers buy into the captive mentality during a soft market, a subsequent market swing will make the decision seem even more fortuitous.

Among the most important benefits are increased flexibility, increased focus on loss control, heightened need for aggressive claims management, and possible tax benefits, particularly if the captive provides insurance to non-owners.

Captives may provide flexibility in designing coverage to meet the needs of their insureds—both in potentially broader coverage and in well-defined, narrowly focused coverage such as for warranties or in terms of deductibles or retentions.

Captives still may be subject to the vagaries of the reinsurance market, but if the reinsurance program is designed narrowly, it may be greeted with greater than average enthusiasm by potential reinsurers.

Perhaps the most important benefit of captives is the fact that they not merely foster, but demand, a strong commitment to risk management and loss control.

Captive owners—individual or group—are more willing to invest in loss control than are similar risks that buy insurance in the traditional market.

This perhaps is because of their size and sophistication, but I prefer to think it's also because the decision makers intuitively understand the relationship between loss control (preventing losses) and ultimate cost.

Claims management for captive insureds also is surely more focused than with most traditional programs. Again, the company that chooses to invest in a captive has to realize that it is investing in more than a risk transfer or financing mechanism.

It must be prepared to make an investment in developing a claims management philosophy that reflects its corporate position on losses. For example, years ago a client was working under an insured loss sensitive program. The company wanted to take an assertive stance on liability claims, fighting those it felt did not involve negligence. The risk manager believed that the insurer was too willing to settle borderline claims in order to cap the liabilities. That corporation would be better able to promote this philosophy through a captive than a traditional insurer, but it would have to be willing to have the captive absorb the potentially down side of litigating such claims.

In regard to costs, although up front capitalization costs may eat up much of the early cost-savings, over the long haul costs probably will be lower. At the least, the costs will reflect the loss experience of the parent rather than of a group of insureds. Broker commissions may be decreased, although other management costs may increase. The parent will be less likely to share in the costs of bureaucracy that a large insurer may develop.

The captive also garners investment income on the loss reserves, instead of the investment income being earned by a third-party insurer.

All of these benefits may be earned regardless of whether the captive is formed in a hard or soft market. However, when gearing up in a soft market, the parent may find it easier to gain the attention of captive service providers and regulators. There tends to be more of a rush to captive vendors during a hard market, when more companies realize an immediate need to set up an alternative insurance vehicle.

In addition, companies that use soft market time to investigate and set up a captive have a vehicle ready and waiting before a move becomes critical.

My choice is easier than a risk manager's. I don't have to convince anyone else that it's a good idea to spend more today to save in the long run. But I'll still explore the options, hoping to spend as little as possible today to invest in a car for the future.

By Diana B. Reitz

From the March 6, 2006, issue of National Underwriter—Property and Casualty edition