Captive insurance

Captive insurance companies are insurance companies established with the specific objective of financing risks emanating from their parent group or groups but they sometimes also insure risks of the group's customers as well. Using a captive insurer is a risk management technique where a business forms its own insurance company subsidiary to finance its retained losses in a formal structure. The term "captive" comes from the "father of captive insurance", Frederic M Reiss, who coined the term while he was bringing his concept into practice for an industrial client in Ohio in the 1950s. The term "captive" came to Reiss when working with his first client, the Youngstown Sheet & Tube Company. The company had a series of mining operations and its management referred to the mines whose output was put solely to the corporation's use as captive mines. When Reiss helped them incorporate their own insurance subsidiaries, they were referred to as captive insurance companies because they wrote insurance exclusively for the captive mines. Reiss continued to use the term for his concept, and both the captive and the term have adopted a far wider context. The term also made sense as the policyholder owns the insurance company i.e. the insurer is captive to the policyholder. If the captive only insures its parent and affiliates it is called a pure captive.

Domicile

Captives are licensed by many jurisdictions with the primary jurisdiction known as the captive's domicile. Many captive insurers make their home "offshore". Belize, Bermuda, The Cayman Islands, Vermont, Guernsey, Luxembourg, Barbados, Malta, Singapore and the British Virgin Islands are a few examples.

Several offshore jurisdictions have lower capitalization requirements, which may allow captives to be set up for less. Offshore captive insurers also sometimes have lower tax rates on investment and underwriting income which reduces expected tax payments relative to domestic captives. However, many such advantages have been eliminated in recent years for U.S. entities that own offshore captives.

Bermuda is the leading captive domicile, although its market dominance has decreased as many jurisdictions enacted captive-friendly legislation in order to attract or preserve this business. The onshore regulatory burden and cost of operating either a US-based or Lloyd's-based captive in the early 1960s drove Reiss to seek out a jurisdiction that would allow his captive concept to flourish. After significant travel and investigation, Bermuda was Reiss' first choice for its geographic location, clean reputation and its position as a British Dependent Territory which removed the risks and uncertainties often experienced by international businesses operating in politically unstable and unaccountable jurisdictions. Bermuda's captives are predominantly owned by large U.S. corporations. Thus, for instance, American International Group (AIG) operated a captive insurance scam that involved fraudulent use of Bermuda as an offshore tax haven, see Lucy Komisar: "AIG’s Past Could Return to Haunt". International Press Service. http://thekomisarscoop.com/2008/12/19/aigs-past-could-return-to-haunt/. Retrieved on 2008-12-20. The Cayman Islands is the second largest licensing jurisdiction in terms of the number of captives licensed. Vermont is second in terms of insurance company assets but third in terms of captives licensed.

In the United States, Vermont is home to more captive insurers than any other U.S. state, with over 800 licensed captive companies as of December 2007. Other U.S. states with significant numbers of captive insurers calling the state home include: Hawaii, South Carolina, Arizona, Montana, Nevada and New York. In many U.S. licensing jurisdictions, a captive insurer is subject to an annual audit and annual loss certification by a consulting actuary.

Policies

Reiss conceptualized the captive to provide his clients with coverages they needed but could not obtain through the traditional insurance market, thereby reducing the high cost of insurance to large corporations. Almost simultaneously he recognized the tax advantages under the concept under the US Tax Reform Act 1962. The tax advantages often attracted corporations to form captives solely for tax-reduction, but, over the years the business purposes for establishing a captive remained long after the tax loopholes were gone. Companies have turned to captives to reduce costs, enhance risk management, gain greater control over their insurance and directly access the reinsurance market. Today, captives are established to insure a wide variety of risks. Virtually every risk underwritten by a commercial insurer is provided for in a subset of captive insurers. Examples include: property, workers' compensation, casualty (general and auto liability, product liability), and employee benefits such as long-term care and supplemental life insurance plans.

The most common use of captive insurance is to provide liability coverages for those lines of business, such as workers compensation, that have regular and predictable loss payments and for working layer professional liability coverage in order to access the reinsurance market, including Lloyd's syndicates, for excess protection that may be unavailable or cost-prohibitive at the primary level such as products liability, general and professional liability and directors & officers liability. Vehicle insurance, both property damage and third party liability of corporate fleets and vehicles is also quite common.

Regulation

For some lines of business a captive can operate without restriction. In other cases, such as workers' compensation in the U.S., for example, a captive often must go through a fronting process. They pay a fee, usually somewhere between 5 and 15 percent, to participate in the risk. The fronting insurer issues the required policy using its insurance licenses and then the company "cedes" (sends some or all the risk and some of the premium) to the captive. If there is a loss, the captive provides the funding to pay the loss even though the contractually responsible party from the injured party’s perspective is the commercial "front". Because premiums paid to captives are deductible, the terms of the policy (including the premium amount) must be reasonable. A captive cannot arbitrarily set the premium amount simply to generate a deduction for the parent. For example: Smith Dentists Inc. is insured by the company's captive, Acme Insurance for loss of employee wages, fire, loss of computer equipment, etc. Acme Insurance cannot arbitrarily set the policy premium at $50,000, but rather, should base the premium amount on actuarial projections.

In the European union a new set of regulatory requirements (Solvency II) is planned with additional tasks and responsibilities for captives and reinsurance companies. Some European captives ask for simplified regulation.

Captive Manager

Reiss created the first captive management company, International Risk Management Limited (IRML), in Bermuda in 1962 to provide the administration of his client's captives. Most captive management is usually outsourced to a captive manager located in the jurisdiction that holds the primary license for the captive. The two largest captive insurance company managers in the world are units of Marsh & McLennan Companies and Aon Corporation -- the two largest commercial insurance company brokerages in the world. Each manages more than 1,000 captive insurers.
In 2007, Frederic Reiss was posthumously inducted into the Insurance Hall of Fame for his significant achievements in the insurance industry.

Types of captive

There are several types of insurance captives, the most common are defined below:

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 companies 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.

Commercial advantages and issues

The key issues with captive insurers is that they are conduits for risk -- unless risk is placed with the captive it remains with the owner. There are a number of commercial advantages to using captives to provide a better risk management than the conventional insurance market.

Cost. Premiums charged by commercial insurers include amounts to cover the insurer's profit margin and overheads. Such overheads can be significant when considering insurers with large corporate structures to maintain.

Flexibility. When the market is soft, the captive can take advantage of the low rates by reinsuring a relatively large proportion of its risks. The low cost of reinsurance allows the captive to build its reserve base. When the market hardens, the captive is able to retain a larger proportion of its risks, and can maintain cover for its parent even when commercial insurance is unavailable or prohibitively expensive.

Claims management. The process of making a claim from a third party insurer can be long and involve a good deal of cost for the claimant. Where the insurer is a captive, the claims handling procedures can be dictated by management, cutting down on the delays and bureaucracy that are often a necessary part of the claims handling procedures of commercial insurers.

Claims experience benefits. Captives generally retain a portion of the overall risk and reinsure the remainder. For this reason, when claims experience is better than anticipated, the excess of net premiums over claims is retained by the group. The reinsurance taken out by the captive is tailored to minimize the group's exposure where claims experience is worse than projected.

The types of risk that a captive can underwrite for the parent include property damage, public and products liability, professional indemnity, employee benefits, employers liability, motor and medical aid expenses.

Captives are becoming an increasingly important component of the risk management and risk financing strategy of their parent. A number of reasons have been put forward as the basis for the growth in the use of captives:
heavy and increasing premium costs in almost every line of insurance coverage.
difficulties in obtaining coverage for certain types of risk.
differences in coverage in various parts of the world.
inflexible credit rating structures which reflect market trends rather than individual loss experience.
insufficient credit for deductibles and/or loss control efforts.

Setting Premiums

Because premiums paid to captives generate valid business deductions, the terms of the policy (including the premium amount) must be reasonable. A captive cannot arbitrarily set the premium amount simply to generate a deduction for the parent and, on a consolidated basis, a US taxpayer gets no deduction for premiums paid to wholly-owned captives that write only related business. However, on a consolidated basis, a non-insurance parent can deduct amounts actuarially accrued as loss reserves, on a discounted basis for tax purposes and, for most lines of business, an undiscounted basis for US GAAP earnings. Other corporations may not accrue or expense any general loss provisions, insurance-related or otherwise until the amount is identifiable, measurable and owed. Incurred-but-not-reported (IBNR) losses are excepted from this accounting rule for insurance and reinsurance entities.