Group Captives 101: How Does a Captive Insurance Program Work?

By Sean Flavin August 18th, 2021

Welcome to the third installment of our Group Captives 101 series: “How does a captive insurance program work?” Click here to check out the first two articles in the series, which answer the questions "What is a Captive Insurance Company?” and “What is a Group Captive?”

Captive insurance has experienced historic growth in recent years. Today, there are more than 7,000 captive insurance companies globally, compared to just 1,000 in 1980. While this growth is impressive, captive insurance programs are still not as well understood as conventional insurance plans.

To help close the gap, this article will address the question, "How does a captive insurance program work?" To answer that, we’ll look at two fundamental components of a group captive insurance program:

  1. The risk-reward loss-funding formula
  2. The structure of the program

This article will focus on how the group captives we work with typically (but not always) structure and fund their insurance programs. Keep in mind, there are several ways to operate a group captive, and the descriptions below may not apply to all captive insurance programs.1 

No. 1: A Risk-Reward Formula to Fund Losses

In the context of the group captives that we work with, explaining the risk-reward formula used to fund losses is essential in answering the question “How does a captive insurance program work?”

Captive Resources developed the risk-reward formula in the 1980s, and it has grown to be the foundation of our group captive model. Equitable and easy to understand, the formula incorporates risk-sharing among the membership for severity losses and ensures that members' premiums reflect their risks and loss history.

The funding formula is modeled around various layers designed to handle different levels of risk and protect members from catastrophic and aggregate losses. Here is a high-level visual representation of the formula and its layers.

How does a captive insurance program work-Risk Reward Formula-v2

Captive Retention Layer

In the captive retention layer, losses are the responsibility of the captive. This layer is comprised of two tiers: the A and B Loss Funds. The amount a captive retains varies based on the needs of each group but typically ranges from $250,000 to $500,000. 

The captives utilize an independent actuary to project how much each member needs to contribute to its A/B Funds. The actuary uses the member's actual loss history to estimate how much the company will need to finance its yearly losses.

How does a captive insurance program work-AB Funds-v2

The group captives employ the A Fund as the "Frequency Layer" to handle smaller claims. The A Fund pays claims up to a certain cost level determined by each captive — for this article, we'll use $100,000 as an example. Functionally, this means that the A Fund will pay for claims between $0 and $100,000 per occurrence.

The B Fund represents the “Severity Layer," which handles larger claims. The B Fund pays for claims above the A Fund to a certain level determined by the captive. For this example, we'll use $400,000 as the ceiling for this layer, which means that the B Fund would handle claim costs between $100,001 and $400,000 per occurrence. The B Fund layer is where risk-sharing/shifting occurs, which means captive members share losses in this layer. 

The captives typically also provide basket coverage (occurrences involving multiple lines of coverage) and clash coverage (two or more insureds suffer a loss from the same occurrence) for additional protection.

Reinsurance Layer

Above the captive retention layer is the reinsurance layer, where risk is transferred to a conventional insurance carrier across the various lines of coverage (e.g., workers' compensation, general liability, and automobile). Reinsurance protects the captive against catastrophic losses exceeding the captive retention up to a certain threshold — we’ll use $1 million for an example here. In our running example, that means the reinsurance layer will handle losses between $400,001 and $1 million.

Umbrella and Statutory Limit Layer

The next layer is comprised of two elements:

  • Umbrella Coverage: Placed outside the captive for additional flexibility (allowing individual members to secure different limits), umbrella coverage sits above the reinsurance layer for general liability and automobile coverage.
  • Statutory Limits: Placed above workers' compensation coverage to meet individual state requirements.

Aggregate Loss Coverage

The layers above protect the captive against large losses, but what happens when a captive's members experience a large number of small claims? The captive purchases Aggregate Excess insurance to protect itself against unexpected frequency claims. So, in the unlikely event that the captive exhausts its loss funds, the aggregate excess would drop down and pay any additional claims in the captive retention layer.

The captives also have a built-in mechanism known as an "Experience Adjustment” — a preset dollar amount that each member is assessed if its losses exceed actuarial projections. The adjustment is triggered before Aggregate Excess insurance to help ensure the captive has adequate funding, provides member-to-member protection, and creates a greater incentive for members to prevent losses.

How does a captive insurance program work-Aggregate Loss Coverage

No. 2: The Structural Flow of a Group Captive Insurance Program

The second essential component in understanding how a group captive insurance program works is the captive's structural flow. The simplest way to illustrate the flow is to first look at a conventional insurance arrangement. With traditional insurance programs, an insured pays a premium to their broker, who in turn buys an insurance policy and services from a carrier on the insured's behalf. The conventional arrangement offers insureds little control over the carrier, any reinsurers it may use, the operating costs, claims management, and other essential insurance functions.

In a group captive insurance program, the structural flow is unbundled — offering the insured much more control over the services and better isolating the captive from volatile market conditions.

Here’s an overview of the major participants in a captive insurance program:

  • Insured: Works with its insurance broker to find a captive that fits the company’s needs.
  • Broker: A trusted advisor that supports the insured on a regular basis.
  • Captive Consultant: An independent consultant that provides support, coordination, and oversight to the captive.
  • Captive Manager: A full-service management firm providing captive insurance services like license application, captive formation, accounting, and more.
  • Insurance Carrier: A carrier is still involved in the captive model to issue the policies, provide aggregate excess and statutory coverage, and back the full financial risk of the program.
  • Captive Insurance Company: Typically assumes the first layer of losses and represents the portion of the insurance arrangement that provides the member with the ownership, control, underwriting profits, and investment income.
  • Risk Control Provider: An independent company that works closely with the members and captive consultant to help members reduce losses.
  • Claims Administrator: A third-party administrator (TPA) dedicated to handling claims for captive members.
  • Independent Actuary: Calculates the amount members pay into their loss funds and performs other necessary actuarial functions.

Want to learn more about group captive insurance programs? Contact Captive Resources today.

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1Provisions also vary among the group captives supported by Captive Resources. Each captive’s program documents contain a complete statement of program terms that should be carefully reviewed.

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