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What Risk Can a Captive Address?

Addressing risk: captive vs. traditional market

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

Like any good business venture, the companies that make up the traditional insurance market are motivated by making a profit. They are in a sense investment companies. They assess market risk, determine what risk they are willing to take based on market averages, take premium payments against those risks, invest the premium payments and ultimately they hope to pay out less in claims than they were able to earn in premium payments and investment income.

Within this business strategy, there is little room for any significant deviation from broadly established principles of acceptable levels of risk and the projected amount of premium payment required to cover those risks. This means opportunities to negotiate better-than-average market rates and opportunities to negotiate customized coverages are limited—even if the company negotiating better rates has a risk profile that is substantially better than average. In fact, insurance companies are counting on these low-risk companies to offset the risk associated with higher-risk companies who are in effect paying less than they should.

At its core, a captive insurance company is a risk-financing tool. It places more risk-management control and financial control into the hands of the owner of the captive than exists in a typical commercial insurer-insured relationship. Unlike what occurs in the traditional insurance market, the risks that are underwritten by the captive are precisely the risks that the insured needs underwritten. The policy terms are designed to meet the specific needs of the insured and the rates are based on the specific loss profile/loss experience of the insured—not the average loss rate of the market.

You can think of it in terms of buying clothing. While the traditional insurance market offers small, medium or large, a captive insurer measures a precise fit for its insured. However, unlike the choice between custom-tailored and “off the rack,” a well-planned, well-structured captive strategy will most likely cost the insured less than the traditional commercial-insurance route. The combination of custom-tailored and less expensive is the reason captives have become so prevalent today.