Part V – Certain Benefits of Forming a Single Parent or Pure Captive

After identifying the most salient risks facing a company (which should be a part of any company’s risk management function) management considering captive insurance should evaluate the following:

• whether commercial insurance coverage is available for those risks;
• whether the available commercial coverage for those risks have such a high deductible and so many exclusions that the company is effectively self-insuring the potential losses from those risks;
• whether the premiums charged by the commercial providers are not only affordable but also less than the company could provide itself through forming a captive subsidiary for those risks, given the probability of the occurrence of the risk events actually occurring and the magnitude of the loss if the event were to occur; and
• whether commercial insurance for those risks are likely to remain available at such affordable costs for the foreseeable future.

One of the primary values of the single parent captive is the parent’s ability to customize policies that insure against business and operational risks that are not available from third-party insurers or at costs that are unreasonably high given the risk and the potential harm to the company. Captive insurance rarely replaces third-party insurance. Rather, it serves as a gap filler to provide coverage that commercial carriers do not provide at a reasonable cost. 

In a nutshell, analyzing the considerations listed above and examining other benefits from implementation of captive insurance discussed below, coupled with a subsequent feasibility analysis, may result in the business case for a management decision to implement captive insurance which should be the drivers in deciding to form a captive insurance subsidiary. Although there are tax benefits that may apply in forming a captive insurance subsidiary, they are beyond the scope of this Part V. Part V discusses only the non-tax benefits and considerations that comprise the business case for implementing a captive subsidiary that is discussed in this post. Certain of those other non-tax benefits are discussed below.

Opportunity to Lower Premium Costs and Negotiate More Favorable Terms for Commercial Insurance Utilized to Insure Company Risks Not Covered by the Captive Subsidiary   

If the parent company has a captive subsidiary, it can use it to compete with commercial insurance carriers to negotiate lower premiums and better terms and conditions on the policies for insurance coverages not provided by the captive.    

Investment Opportunities with Respect to the Premiums Paid to the Captive Subsidiary

Premiums paid to the parent’s captive subsidiary that are not needed to pay claims can be invested by the captive subsidiary in instruments approved by the applicable insurance regulatory authorities to earn additional income. The captive may ultimately grow into its own profit center for the parent company that formed it. For those captives that incorporate in a tax-free domicile, the premiums paid to it may continue to grow tax-free, such that more money is available to be reinvested to meet increasing regulatory capital requirements, pay claims and, to the extent of regulatory approval, pay dividends to the captive’s parent company.

Reinsurance

The parent, through its captive insurance subsidiary, will have access to the less expensive reinsurance market from which it can purchase its own insurance to provide the full extent of the coverage it has agreed to provide to its brother-sister affiliates. Reinsurance is available only to insurance companies.

Improved Claims Handling Efficiencies and Control

A good captive manager can devise and implement claims handling policies and procedures that may be more efficient and tailored to the needs of the brother-sister affiliates than the third-party insurer may provide.

Improved Risk Management

Implementation of a single parent captive insurer often forces management to more closely examine the risks of operating the business to determine the appropriate risks of the brother-sister entity to insure and the amount of the insurance the captive should provide to insure those risks. Through this process, management may identify and quantify its risks leading it to develop ways to substantially reduce those risks.  Identifying, quantifying and taking steps to reduce risks will demonstrate to the company’s board of directors, audit committee, safety committee and outside entities such as the company’s lenders and investors that the company is committed to risk management and cost reduction throughout the company.  It should also result in reduced claims to be paid by the captive insurer and the cost of reinsurance thereby reducing the company’s costs.   

Clearly there are insurance and economic benefits in forming single member and pure captive insurance companies. However, no management analysis would be complete without examining all considerations. Our sixth and final blog posting in this series will discuss those factors and concludes the series with a brief summary of the analysis we suggest management conduct in considering whether captive insurance is the right enterprise risk management tool for it.

Next and Final Blog Posting in this Series: Costs, Expenses and Other Considerations in Forming a Captive