Commercial Insights

A Captive Idea: Your Own Insurance Company

Businesses with predictable insurance needs may find captive insurance a compelling proposition.

Captive or self-insurance — a financial risk-management tool large companies have used in the U.S. for more than 60 years — is making headway among small and midsize organizations looking to pare business insurance costs.

According to Dan Teclaw, associate director at AM Best, the captive segment’s inherent flexibility and control in managing risk drives profitability and retains earnings, while creating value for policy holders and stakeholders, regardless of market conditions.

Although there was an annual 2.5% decline in captives from 2015 – 2020, the recent net growth in the number of total captives is attributed to the hard commercial market, which has seen heightened use of pure captives for property and casualty (P&C) risk with high premiums rates — particularly cyber, directors’ and officers’ liability, umbrella liability and medical malpractice, according to Captive Insurance Times.

Jim Hill, Vice President for Regions Institutional Services, has seen corporations spanning a broad spectrum of industries jump into the insurance business to handle their own workers’ compensation, general liability, warranty, and other risk needs. Captives have long been popular with health care organizations such as hospitals, nursing facilities, and physician groups. Captive insurers are also popular with trucking companies, product distributors, and agricultural groups.

Generally, a captive entity can potentially ease financial pressures if insurance issues are an ongoing concern for a business’s operations. For example, a transportation company with frequent claims tied to its fleet of vehicles or an industrial company that deals with hazardous materials may find captives a compelling alternative to traditional carriers, as premiums for such companies could be prohibitive.

How Do Captive Insurers Add Value?

Companies establish captives as third-party entities to handle business insurance needs. “By forming a captive insurer, a company takes on its own insurance risk, as opposed to placing it with a commercial insurance organization,” Hill says.

Ideally, Hill states that such a setup offers benefits including:

• Tighter control of insurance costs
• Improved claims management
• Better operating practices
• Improved risk management
• The opportunity to steer the commercial insurers’ profit margin to a reserve account or the bottom line

Furthermore, captive companies can offset a portion of their risk, if not all of it. Hill says that when a company covers a certain level of potential liabilities — for example, the first $250,000 — through a captive entity, covering additional risk tends to be priced much more reasonably from a commercial insurer or reinsurer.

Typically, it may make sense for a company to consider a captive insurer when its annual insurance premium exceeds $500,000, according to Hill. Companies often start with workers’ compensation and general liability coverage in the captive entity, as well as property-casualty for companies that own vehicle fleets. Later, a company may move directors’ and officers’ liability coverage, warranty insurance, and cyber risk protection into the captive.

Captives Are Not a Wealth Transfer Tool

In November 2016, the IRS issued a directive that identified 831(b) elections as Transactions of Interest due to the potential for tax avoidance or evasion. As a result of the directive, industry observers have urged businesses to treat their captive insurers as an insurance vehicle, not as a means to avoid taxes or transfer wealth. More recently, there has been enormous IRS audit and litigation activity surrounding small captives. The IRS is looking to hire 200 experienced “tax shelter” lawyers to pursue their investigations for small captives. The IRS is seeking to audit all captives that have elected section 831(b).

Capitalizing on the Captive Opportunity

To pursue captive insurer possibilities, Hill suggests taking the following steps:

1. Engage a captive manager from a reputable insurance group to conduct an initial feasibility study.
2. Hire an actuary to conduct a full feasibility study that scrutinizes your company’s risk profile, financials, and cash flow, and to work with the captive manager to develop a business case for creating a captive insurer.
3. Concurrently, research possible locales for the entity, as captives can be housed in 28 states or certain nations offshore. Based on your due diligence, apply to the appropriate regulators and set up shop following approval.
4. Consider hiring an experienced investment manager to provide their services when managing the assets in your captive.

“Generally, a captive insurer covers a portion of your business’s overall insurance needs, so it must be coordinated properly with your commercial broker and your other insurance brokers,” Hill says. “But it’s a legitimate vehicle for financing risk within your company.”