A “captive insurance company” is a subsidiary owned by one or more parent organizations established primarily to insure the exposures of its owner(s). The captive assumes a portion of the risks insured, and the balance is assumed by another insurance company known as a “reinsurance” company.
The term “captive” dates back to the early 1950’s when Fred Reiss created Steel Insurance Company of America for his client, Youngstown Sheet and Tube Company in Ohio. Youngstown owned its own mines, which it called “captive mines”, because they were used to mine ore for the company’s mills. Reiss created Steel Insurance Company of America to write insurance solely for those mines, thereby calling it a “captive insurance company”. Reiss was the first person to realize that he could create a profit center from the cost of insurance.
By 1960, there were more than 100 captive insurance companies in the United States, writing insurance for their parent companies. In 1986, there were over 2,200 captives worldwide, which grew to 6,700 by the end of 2018 (Source: CPA Journal, Captive Insurance Companies, 12/19/2018). Figure 1 illustrates how captive growth has accelerated over time due to the many benefits of captives which we will discuss in Section 2.
Figure 1: Captive growth has accelerated over time.
Source: IRMI, www.captive.com, “SRS Charts the Total Number of Active Captives for 2017”, March 2, 2018.
There are five types of captive structures – single parent, multiple parent, heterogeneous, rent-a-captive, and segregated cell. See Table 1 below for descriptions of each structure.
Table 1: Five Types of Captive Structures
Source: www.captives.com, “Five Questions to Ask When Considering Captive Insurance.”
Captives provide enterprise risk financing for the following types of coverage:
When considering a captive, it makes sense to look at your entire commercial risk portfolio in order to determine the optimal captive structure.
The “captive domicile” is the state, territory or country where a captive insurance company is located, that also licenses the insurance company and has primary regulatory oversight.
Below is a list of the top domiciles for captives both in the United States and internationally. Bermuda is the top domicile internationally followed by the Cayman Islands as both have favorable regulatory climates, established professional infrastructure (captive management, legal, and accounting firms), and favorable taxation. Vermont is the top domicile in the United States, but other states continue to pass laws to encourage captive creation.
Table 2: U.S. & International Domiciles Summary – 2017
A “fronting company” is a licensed insurer that issues an insurance policy on behalf of the captive without the intention of transferring any of the risk. The risk of loss is retained by the captive with an indemnity agreement. Fronting arrangements allow captives and self-insurers to comply with financial responsibility laws imposed by many states that require evidence of coverage written by a licensed insurer. The fronting company (insurer) assumes a credit risk since it would be required to honor the obligations imposed by the policy if the captive failed to indemnify it. Fronting companies charge a fee for this service, generally between 5 and 10 percent of the premium being written. (Source: IRMI.com)
The graphic below illustrates how captive insurance companies work and the flow of money between the parent, the fronting company, the captive, and the reinsurance company. As you can see, the “fronting” company is just a pass through and the captive – like a typical insurance company – uses a reinsurance company to provide excess coverage for unexpected and/or high claim losses.
Figure 2: The Flow of Money in a Captive Insurance Company
Source: http://www.stopbeingfrustrated.com/captive-basics.html
When set up and managed effectively, captives offer significant benefits, including:
Sources: Captive.com, “Captive Insurance – Why or Why Not?”, June 10, 2019; State of Vermont, Department of Financial Regulation, www.dfr.vermont.gov/captives/advantages-captive-insurance
Typically, the best candidate for a captive program is a company with high insurance premiums, low claim frequency, steady cash flow and palatable risk. However, there are other reasons (as discussed in the previous section) that a company may consider a captive. A company may also wish to combine its overall enterprise risk across not only its warranty program, but also its employee benefits, healthcare and/or workers compensation.
If you have determined that a captive could be a great option for your company, your next step is to contact a trusted captive expert that can help you conduct the necessary due diligence, determine the right partners, set up the captive structure and even manage the day to day captive operations.
After, Inc. (www.afterinc.com) has been offering Warranty Program Administration – including captive set-up and management – to top tier manufacturing clients for over 15 years. If you are interested in discussing a potential captive for your business, contact us at http://afterinc.com/contact/. We look forward to hearing from you.