The insurance your company is currently purchasing through the traditional market likely includes coverages such as general liability, property, workers’ compensation, product liability, directors’ and officers’ and auto. Many captive owners are perfectly comfortable with these coverages and wouldn’t consider moving them to a captive. However, there are times when the terms, conditions, or coverage levels that are available in the market do not meet a company’s needs.
There are likely risks your company is currently self insuring. Some of these risks are obvious to you; for example, you may decide that for certain risks where you have a history of frequent, small claims, you’d rather pay the claims directly instead of relying on insurance coverage. However, because you want to make sure you are covered in the event one of those small claims becomes a very large claim, you keep traditional coverage but maintain a high deductible. So, effectively, you are self-insuring your claims up to a certain “retention” level. You may even have excess or catastrophic coverage that goes beyond that initial policy limit.
At this point hopefully you are thinking a captive sounds great, but are wondering exactly what kinds of coverage can be written and what are the limitations? First, it’s important to understand that there are certainly types of coverages that are better suited for a captive. These are identified in the table below:
One of the most attractive advantages of a captive insurance company over traditional insurance is that the captive can underwrite almost any type of risk the captive owner desires. The important qualification is that it must be commercially reasonable—but it doesn’t have to be commercially available. In fact, this very advantage drives many to establish a captive. A business may have a specific risk that is either unique to the market or not common enough for the market to have enough experience with the risk to be comfortable underwriting it. In this common occurrence, self-insurance is the only option a business has unless that business operates a captive.
I am continually surprised at how many organizations are led to believe they can use a captive in ways that range from being wrong for their business to being simply illegal. For example, I spend much of my time speaking to attorney-, accountant-, and insurance-professional associations. As a result of my 30-40 presentations per year, we are blessed to be seen as a resource for these groups. I recently got a call from an attorney in California whose client just signed an engagement letter to form a captive with a national promoter. The captive was an offshore captive and the policy the client’s captive would write is terrorism insurance. I told their attorneys I needed more facts. Once they started describing that the client manufactured high-end, handcrafted musical instruments in a remote town of California with a population of less than 10,000, it did not make sense. With annual profit of $2,000,000, it was ridiculous to think the IRS would designate $1,200,000 in terrorism insurance premium an “ordinary necessary business expense.” In this case, the IRS would not even have to challenge the legitimacy of the captive insurance company; they could simply outright deny the deduction for the insurance.
There are many reasons an organization chooses to form a captive. The best way to fully understand the specific opportunities and benefits for your particular organization is to consult with a risk management advisor who has expertise in the captive, traditional, and the alternative risk transfer insurance markets. Such a professional would likely gather some initial information, evaluate the organization’s risk-management goals and then, if it appears a captive insurance strategy is at least a realistic possibility, recommend conducting a formal feasibility study. This process is an essential component of determining the projected return on the investment made to establish and manage a captive. After all, forming a captive is a risk-financing strategy. If the benefits are strong enough to meet or exceed the organization’s internal ROI requirements, then captive formation warrants serious consideration. Although the package of benefits behind each captive will be unique to the particular organization it serves, there are certain benefits that are relatively universal.
On Friday December 18th Congress passed the 'Tax Extenders Bill' as part of the "Protecting Americans from Tax Hikes (PATH) Act of 2015". On page 176 were new rules affecting small captive insurance companies.
The language is complicated, but in summary...
To understand the potential benefits of forming a captive insurance company, it is helpful to first recognize that the decision to establish a captive is not a decision to abandon the commercial insurance market. Every company that operates a captive also carries various forms of commercial insurance. In a well-designed strategy, the two methods work together to provide the greatest benefits to an organization.
It’s also important to recognize that the key principle behind the captive insurance concept—self-insuring some of your risks—is already practiced in some form or another by every company in existence. Said another way, no company regardless of its size or sophistication has commercial insurance coverage for 100% of its risk...
Based on the existence of more than 7,000 operating captive insurance companies and more than three decades of mainstream market and regulatory acceptance, the captive insurance model can be considered, by nearly all measures, a well-accepted risk-management option in today’s market.
This was certainly not always the case. State and federal insurance regulators and tax authorities have scrutinized, analyzed and challenged from many angles the use of captives. In the end, the captive market is better for it. What stands in the market today are captive options that have been clarified and refined. The long-term value of a well-structured captive is now much more clear and predictable.
The problems that are addressed today by captive insurance companies are problems that most organizations face in one form or another:
- unavailability of coverage
- coverage that is too expensive
- coverage that can’t be tailored appropriately for an organization’s needs
- premium rates that do not meet a particular organization’s loss profile
- inflexible policies
- inflexible terms
- inability to estimate loss frequency or loss severity
- lack of a tax benefit for retaining risk...