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 fact that 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.

Captives are licensed by many jurisdictions with the primary jurisdiction known as the captive's domicile. 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. Many captive insurers make their home "offshore". Bermuda, The Cayman Islands, Guernsey, Luxembourg, Barbados, Malta, Singapore and the British Virgin Islands are a few examples. Bermuda has more captive insurers than any other licensing jurisdiction in the world and is home to captive insurers owned by many large U.S. corporations. 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.

These locations have attractive regulatory structures and some offer favorable tax treatment. Captive owners initially used captives as tax-reduction vehicles but over the years many companies have turned to captives purely because their insurance premiums have risen significantly and they've been able to reduce costs and/or gain greater control by owning their own insurance company. More-and-more companies have established captives to insure a wide variety of risks. Today, 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. Loss finance through captives is essentially self-insurance but with the formality a captive offers. In many U.S. licensing jurisdictions, for example, a captive insurer is subject to an annual audit and annual loss certification by a consulting actuary.

Offshore captive insurers sometimes have lower tax rates on investment and underwriting income which reduces expected tax payments relative to domestic captives but many such advantages have been eliminated in recent years for U.S. entities that own offshore captives.

Captives also allow businesses access to reinsurance. Reinsurance companies are insurers that operate with minimal staff but provide risk bearing capacity. Captives enable non-insurers the ability to get access to these reinsurance markets that were previously only accessible to commercial insurance companies.

Captives also allow firms to retain risk and still satisfy insurance regulatory requirements and demands from third parties. 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 parties perspective is the commercial "front".

The administration of a captive 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.

The most common use of captive insurance is to cover medical malpractice, due to the high cost of such coverage by traditional insurers. Vehicle insurance, chiefly for physical damage and passenger liability, is also quite common.

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.

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.

In many cases, Captives are used for hiding money from the IRS. This is done through self-insurance and the issuance of bogus and needless insurance policies by the parent company. Here's an example: Smith Dentists Inc. create an off-shore insurance company called Acme Insurance which in turn insures Smith Dentists Inc. for loss of employee wages, fire, loss of computer equipment, etc., etc. Acme Insurance then sets the premiums for these policies at $50,000. Smith Dentists Inc. pays the premiums and then deducts the $50,000 as an insurance cost from its taxes.