Captives: An Alternative Form of Self-Insurance
Providing a Combination of Financial Advantages
There are many good reasons for an organization to form a captive insurance
company – not the least of which is creation of teamwork among the risk management,
treasury and tax-accounting functions for overall improved financial health.
In the simplest view, a captive is similar to any self-insurance vehicle: the
sponsoring organization acts to preserve its assets at the lowest possible cost, regardless
of the present cycle of the traditional insurance industry. Along with preservation of
assets come other beneficial events.
One leading national actuarial consulting firm has offered nine reasons to form a
captive insurance company:
1. The alternative to trading dollars with commercial insurers in the working
layers of risk.
2. Direct access to the reinsurance markets.
3. Coverage tailored to an organization’s specific needs.
4. Accumulation of investment income to help reduce net loss costs.
5. Improved cash flow.
6. Incentive for loss control.
7. Greater control over claims.
8. Underwriting and retention funding flexibility.
9. Reduced cost of operation.
Taking those reasons in greater detail:
The Alternative to Commercial Insurance
The first apparent benefit of forming a captive is to take control of the risk
management budget – for now and into the future. Underwriting cycles for first dollar
coverage become nonevents for the owner of a captive, and exposures that are difficult to
cover on the commercial market are secure in a captive.
Direct Access to the Reinsurance Markets
As an insurance company, a captive may purchase a selected level of loss
protection from reinsurance companies, according to Liberty Mutual Group. Unlike the
insurance market, the reinsurance market is largely unregulated concerning forms, rules
and rates. Unique exposures can be handled with customized policy language. Various
levels of protection could include features such as an all-lines stop-loss program.
Coverage Tailored to an Organization’s Specific Needs
Many organizations – to their dismay – experience shifting or evolving risks as
their business grow or take new directions. Exposures such as environmental risk,
employment practices liability, coastal flooding and many others can be actuarially
quantified and protected in a captive program while others wait for development of ―off
the shelf‖ programs from commercial insurers.
Accumulation of Investment Income to Reduce Net Costs
The captive has control over its investment income. As with any insurance
company, the captive invests the assets that support loss reserves and capital surplus.
Prudent investing can return profits greater than those that would be provided by a
commercial insurer and will help immunize the loss portfolio against unexpected
inflation.
Improved Cash Flow
A captive provides a place to store funds for future liabilities without paying for
risk transfer. The reserve funds don’t have to be identified for a particular exposure, but
exist in a pool. This pool can be used to fund any difficult-to-insure exposures without
further cost to the captive owner.
Incentive for Loss Control
It’s amazing how careful people can become if they have to pay for their
mistakes. The same holds true among owners of captive insurance companies. They
quickly understand the value of things like operational safety programs, careful
maintenance, staff training and peer review, depending on the exposures being covered.
It’s no coincidence that captive owners usually see decreased loss experience in the years
following captive formation. This results in healthier, more productive and profitable
organizations.
Greater Control Over Claims
Claims handling is performed at the direction of the captive owner rather than an
insurance company whose best interests are often served by delaying claims (see
Hurricane Katrina). Claims review includes all the necessary parameters and standards
that the captive owner requires for efficient risk management.
Underwriting and Retention Funding Flexibility
Many large organizations with decentralized operations may experience different
appetites for risk and different levels. For example, a parent organization may be able to
maintain higher risk retention than its local operation units can. A captive can be
extremely effective in its ability to spread risk according to the needs of the organization.
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Reduced Cost of Operation
In short, there is no point in forming a captive that will not reduce overall
operating costs. A captive may offer the early recognition of losses for federal income
tax purposes. Premiums may be tax deductible if the captive is found by the IRS to act
like an insurance company by insuring the exposures of those other than its parent.
Whether premiums will be deductible when paid needs to be addressed by any
corporation that considers forming a captive.
Forms of Captives
While many captive insurance companies are owned and controlled by their
insureds, that is not always the case. But they may take various forms:
Single parent captives are owned and controlled by one company and insure the
risk of those companies and/or their subsidiaries.
Association captives are formed for generally two purposes. The first would be
when an association already has a successful sponsored insurance program that allows it
to benefit from assuming some risk. The second would serve as a type of rent-a-captive
that may or may not take risk itself, but sponsors the captive on behalf of its members.
Group captives are insurance companies that are owned and controlled by two or
more non-affiliated organizations that the captive insures. The group captive can be
either homogeneous and insure similar types of risks or non-homogeneous and insure
risks of several types of organizations.
Risk retention groups that are enabled and protected by the federal Liability
Risk Retention Act are a form of group captive that may be licensed in one domicile to
operate in all states. At present risk retention groups are limited to liability exposures.
SIIA formed the American Risk Retention Coalition (ARRC) to lobby Congress to
expand possible coverage of RRGs to include property insurance, excess workers’
compensation and other forms of coverage. That advocacy work is current and ongoing.
Agency captives are formed and controlled by insurance brokers who have
chosen to participate, together with insurance companies, in the risks of their own clients.
Protected Cell Captives
Within a captive, exposures may be separated by insureds or risks. These are
called protected cell captives. In these, cells of risk are ―protected‖ from the insured
risk exposures and liabilities of other cells. Protected cell design structures are flexible in
makeup. As examples, they may be made up of single insureds, controlled books of
business, homogeneous groups of by line of coverage.
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Protected Cell Captive Insurance Company
State Statutory Limits
$5,000,000 Traditional
Reinsurance
$4,000,000 State Capacity
Retention Level
Statutory
$3,000,000 Captive Retention
Limits
Limit
$2,000,000
$1,000,000 $900,000 $750,000 $500,000
Cell Retention
$ 1, 0 0 , 0 0 0 . 0 0
$500,000
$ 10 0 , 0 0 0 $250,000 Limit
$0
HEALTHCARE PROFESSIONAL AUTO WORKERS OTHER RISK
REIMBURSEMENT LIABILITY RISK COMPENSATION TRANSFER
RISK RISK RISK OPPORTUNITIES
Captive Bookends: Fronting Carriers and Reinsurers
Most states require a traditional insurance company to ―front‖ the policies of a
captive, retaining responsibility for the captive’s regulatory and statutory compliance and
ultimate financial responsibility to the insureds. Fronting companies may issue policies
and provide attendant services or allow the program administrator to do so with or
without other professional service providers. Stable pricing and consistent coverage
availability can be achieved through a long-term partnership between the captive and
fronting company. In practice, the insured pays a premium to the fronting company,
which in turn cedes to the captive a proportional part of the premium as stipulated in the
reinsurance agreement between the front and the captive.
Reinsurers accept risk of the captive beginning at an agreed attachment level,
serving as a ―stop-loss‖ insurer. Reinsurance may be provided by the fronting company
or from within the reinsurance marketplace.
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Captive Versatility: Two Models
Single Parent Captive
In this example, a captive is formed to cover an organization’s casualty lines,
including general liability, auto liability and workers compensation. The fronting carrier
underwrites and issues the policies on a fully insured basis. The front enters into a
reinsurance agreement wherein the captive guarantees to reimburse the front for the
program’s negotiated deductible.
MODEL I
Fronting Insurance Company
Single Parent Captive
Optional risk assumption by line of
coverage, i.e.
$250,000
$500,000
$1,000,000
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MODEL II
State Medical Community
This more complex captive structure is a state-funded risk retention group that
creates underwriting partnerships with both a traditional reinsurance company and a
protected cell captive insurance company that is owned jointly by the state medical
society and hospital association.
As the chart illustrates, coverage limits and retentions may vary.
State Medical Community
Alternative Risk Transfer Funding Model
State Funded Risk Retention Group
(Medical Malpractice Liability, Miscellaneous Professional Liability, and General Liability Coverages)
($1,000,000/$3,000,000 Coverage Limit)
Risk Retention Group Traditional
Reinsurance
20% quota-share risk assumption A.
750 X 250
A. $50,000 per occurrence risk assumption. B.
B. $100,000 per occurrence risk assumption 500 X 500
C. $200,000 per occurrence risk assumption C.
None
State Medical Society
&
State Hospital Association
Owned Reinsurance Captive Insurance Company
80% quota-share risk assumption
A. $200,000 per occurrence risk assumption
B. $400,000 per occurrence risk assumption
C. $800,000 per occurrence risk assumption
Note: Specific and annual aggregate stop loss reinsurance is purchased by the RRG (optional)
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Continuation of Model II
Program’s Coverages
1. Medical Malpractice Tail Liability coverage $1 million / $1 million
2. Medical Malpractice Liability coverage $1 million / $3 million
3. Miscellaneous Professional Liability coverage $1 million / $3 million
4. General Liability coverage (optional) $1 million / $3 million
Footnotes
1. State advances initial required capital and surplus for the risk retention group utilizing (a)
letter of credit; (b) surplus note with an interest rate of prime plus 3; and (c) seed capital
for required professional services, RRG application review fee, State Insurance
Department actuarial review fee, and licensing fees.
2. Each participating insured (hospitals, clinics, physician groups, independent physicians,
and supporting medical services providers) pays to the risk retention group an additional
one-third of each insured’s first-year annual premium as a subscription fee. The fee may
be paid as the premium, with 25% down and balance paid monthly in 11 equal
installments (finance fee may be charged—optional). This formula perpetuates the
appropriate capital and surplus requirements for the program’s financial success,
supported with formal underwriting standards and a proactive pre- and post-loss risk
management program.
3. The medical malpractice tail liability coverage may be funded over a three to five year
period, at which point that coverage will require no further premium payments.
4. The State will be reimbursed for monies advanced and associated costs over an
unspecified period of time from within the program’s underwriting profit.
5. The State Medical Society and the State Hospital Association will be given the first right
of refusal to own the program’s reinsurance captive insurance company as equal
shareholders. If this is not of interest to either organization, I would then suggest a
consortium made up of the six -based hospitals, giving it the second right of refusal.
Lastly, the formation of an LLC whose ownership is offered to the docs.
6. The captive will be structured as a segregated cell captive, which will allow multiple
configurations of cell ownership, i.e., the medical society, the hospital association,
individual hospitals, individual clinics, practitioner groups, docs’ specialty discipline
groups, i.e., OB-GYNs, general practitioners, etc. Each cell owner will be responsible to
fully collateralize the cell’s risk assumption, giving the captive host the option to assume
no risk or selected participation of risk assumption.
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S ta te M e d ic a l C o m m u n ity
C a p tiv e In s u r a n c e C o m p a n y , L L C
F u t u r e U n d e r w r it in g G r o w t h ( to $ 5 ,0 0 0 ,0 0 0 )
$ 1 ,0 0 0 ,0 0 0 C a p tiv e 's
R e in s u r a n c e
$ 9 0 0 ,0 0 0
$ 2 5 0 ,0 0 0 ( o p tio n a l)
$ 8 0 0 ,0 0 0
$ 5 0 0 ,0 0 0 $ 5 0 0 ,0 0 0 $ 5 0 0 ,0 0 0
R e t e n t io n L e v e l
$ 7 0 0 ,0 0 0 C a p tiv e 's
R e te n tio n L im it
$ 6 0 0 ,0 0 0
$ 5 0 0 ,0 0 0 $ 1 ,0 0 0 ,0 0 0
$ 5 0 0 ,0 0 0
$ 4 0 0 ,0 0 0 $ 2 5 0 ,0 0 0 C e ll R e te n tio n
$ 4 0 0 ,0 0 0 L im it ( o p tio n a l)
$ 3 0 0 ,0 0 0 $ 5 0 0 ,0 0 0
$ 2 0 0 ,0 0 0
$ 2 5 0 ,0 0 0
$ 2 5 0 ,0 0 0
$ 1 0 0 ,0 0 0
$ 1 0 0 ,0 0 0
$0
I n d iv id u a l I n d iv id u a l M e d ic a l O B -G y n Cat
H o s p it a l H o s p it a l C lin ic Fund
G r o u p o r In d iv id u a l C e lls
HOW IS A PROTECTED CELL CAPTIVE STRUCTURED
Protected Cell Structured Notes
• There are no restrictions to the number • Insureds may receive a program
of cells a captive may have. dividend for favorable loss
Independent physician groups, clinics experience from within their
and hospitals have the opportunity to assigned protected cell. (Optional)
own protected cells.
• Each protected cell is responsible for • RRG or cells buy financial
claims up to its risk retention limit. catastrophe reinsurance
Risk retention may vary by cell. All provided by the CAT Fund cell.
cells and the captive are protected by (Optional)
an agreed specific loss and aggregate
stop loss limit.
• Each cell is protected from the others • Insureds may participate as
potential for adverse loss experience. captive investors. (Optional)
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Getting Started With a Captive
A captive insurance company becomes operational upon licensing by an offshore
or domestic captive domicile (domestic only, in the case of risk retention groups).
Formation of a captive typically requires the services of a captive manager to serve as
quarterback of the application process and professional service providers including
actuary, accountant and legal advisor.
The domicile license application requires evidence of sufficient capital assets, an
actuarial report, business and investment plans, along with specific required forms.
Annual reports and audits are required by the licensing domicile and an annual board of
directors meeting is usually required to be held within the domicile.
Captives: The Last Word
Formation of a captive insurance company is a financially beneficial form of
alternative risk transfer for organizations with significant exposures, an appropriate
appetite for risk and an entrepreneurial view of risk management.
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