Captive Insurance and Reinsurance
What began in the 1870s as “Protection and Indemnity Clubs” has come into its own in the first decade of the 21st century. Captive insurance is an alternative risk transfer solution now practiced by 40 percent of major U.S. corporations, according to a recent primer published by Towers Perrin, a global professional service firm. The same source also reports “many multinational companies own one or more captives.”*
Three Drivers
The movement toward captive insurance has been driven largely by key advantages: cost savings, control, and coverage or capacity. Captive insurance tempers the cost of insurance over the years — providing predictability of premiums and producing more safety conscious companies with fewer claims and reduced expenses. Captive insurance lowers administrative costs and reduces or eliminates broker commissions.
The control advantage captives offer appeals to entrepreneurs who want to take charge of their insurance destiny. By owning rather than renting insurance, business owners are ultimately able to turn premiums into profit through sound — and often professionally guided — management of rates, regulations, retentions, claims, investments, taxes, and accounting. Captive owners who practice proactive risk management strategies see a direct positive impact on corporate culture and long-term claims reduction.
The third major driver of captive insurance is coverage or capacity. Although captive insurance companies typically provide limited capacity, they offer direct access to the reinsurance market — which might not otherwise be available.
Captive Structures
Captive insurance companies take many forms — their structures include single-parent, group or association, rent-a-captive, agency captives, and Risk Retention Group (RR G), to name a few. The most common structure is the single-parent captive — representing three out of four captive companies.
The Risk Retention Group is also a highly selected captive structure. It is the outgrowth of the Products Liability Risk Retention Act of 1981. Under this federal law, RR Gs are captives that provide liability coverage for their owners, who are required to be in the same general business. An added RR G advantage is the right to operate in every state, even if only licensed in one.
Fiscal Principles
Regardless of structure, successful captives are founded on three fiscal principles: insureds participating in providing proper capitalization, rates based on actuarial recommendations, and the right amount and type of reinsurance.
Historically, early adapters to the captive insurance concept did so because the coverage or capacity they needed was not available through the traditional insurance market. Initially, startup captive risk factors and the controversial unbundling of services caused the reinsurance market to look cautiously at captives. Now that unbundling has become common and captives have a track record of loss reduction, reinsurance companies are more interested in “capturing” captives as customers.
Reinsurance Access
Reinsurance protects insurance companies — including captives — from excessive loss. Such coverage may be purchased on an occurrence basis or as an annual aggregate. Captives purchase coverage directly from the reinsurance market. This direct access yields several advantages. Reinsurance helps captive companies leverage their capital. Because the reinsurance market has deeper pockets and is less regulated than the insurance market on rates, rules, and forms, customized policies can be developed to cover unique exposures. Reinsurers may also offer all-lines stop-loss coverage, which limits a captive’s total potential liability.
Because reinsurance is critical to the success of a captive company — and the businesses the captive was created to protect — the decisions related to reinsurance are critical. Before selecting a professional reinsurance provider and program, captive managers need to consider the purposes of reinsurance, including (but not limited to) the following list.
- Catastrophe protection for high-risk industries and geographic regions.
- Underwriting support through partnering reinsurance company expertise.
- Capacity access to coverage for high-limit exposures.
- Profitability stabilization by leveling captive loss experience.
A common practice and easy solution to the complexities of reinsurance is for captives to purchase reinsurance coverage for all losses over the life of the captive. Other captive companies “unbundle” their reinsurance needs and purchase from a variety of providers for various needs on a year-to-year contract basis.
Reinsurance Types
The numerous types of reinsurance available can complicate the purchase process. However, two general categories help buyers understand their choices. Treaty reinsurance is a contract in which the primary insurer is required to cede or transfer the business and its risks to the reinsurer. The second category, Facultative reinsurance, does not require ceding of business or acceptance of risk. Treaty reinsurance works well for groups with similar risks. Facultative reinsurance works best for non-homogeneous (individual) situations with large risks. Excess of loss reinsurance is what its name suggests: coverage for risks that surpass a stated loss limit. Contractual agreements for this protection usually place base coverage with the primary insurer and excessive individual or aggregate loss (higher loss claims) with the reinsurer. This arrangement may be based on per risk or per policy.
Some reinsurance types of shared risk are classified as pro-rata. In such arrangements, percentages of premiums and losses and ceding specifics are agreed upon by the captive and reinsurer to provide surplus protection.
Special Arrangements
Some reinsurers make special offers to ensure long-term relationships with captives. These might include contingent profit commissions that share program profitability with the captive company. Such arrangements, while attractive to captives, can affect taxes in the short- and long-term.
Finding the Captive Advantage
Captive insurance and the direct access captives provide to reinsurance offer many advantages to businesses seeking capacity, consistency, control, and cost savings. However, the complications of captives and reinsurance require concentrated management and professional guidance in determining the most advantageous structure and most favorable relationships.
* Captives 101: Managing Cost and Risk, Towers Perrin