Why form a captive?
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. This happens for a variety of reasons:
- Some companies decide to pay losses up to a certain amount and purchase insurance to cover the claims that are over that amount. This is often referred to as a self-insured retention and is similar to choosing a high deductible on your auto-insurance policy. You decide to choose a deductible of $1,000 to lower your premium payment from what it would be if that deductible were $500 In essence, you are agreeing to self-insure the first $1,000 of loss you may incur.
- Some companies may not know that insurance exists to cover certain potential losses and therefore, they self-insure that risk by default.
- Some may not be able to obtain insurance coverage even though it does exist. This could happen for many reasons. A risk associated with a particular segment of an industry could become too volatile for insurance companies to underwrite it. A company’s loss history for a certain type of risk could be too excessive to secure adequate coverage.
- Some companies may be in an industry where historical claims were so high (e.g., completed operations coverage for developers) that it was preferable to self-insure the risk versus paying large premiums to the traditional carriers. We found this to be the case when developers were being charged $1.8 million in premiums for a $2 million policy.
- Some companies may simply be unaware of certain risks to which they are exposed and therefore they never even consider obtaining commercial coverage for those risks.
- Some insurance that a company could use may simply not exist in a form that is adequate to meet the company’s needs.
When companies self-insure a portion of their risk—intentionally or otherwise—they are operating outside the confines of the commercial-insurance market because at some level, the traditional insurance market did not fit their risk-financing needs. A well-planned captive strategy will work with insurance markets in ways that allow organizations to achieve greater financial control and better management of their risks. This is possible because the insurer underwrites its own risks based on its own risk profile.
So why go to the trouble of setting up and funding a captive when you could just self-insure the risk? Isn’t the result the same? The short answer to the second question is “No, there are definite differences between the two strategies that are worth exploring.” We’ll answer the first question by reviewing some of the most prominent reasons why organizations choose to establish and run captives. Within the discussion we’ll also present scenarios where captive formation may not make sense.