Welcome to Group Captives 101 — a regular series of articles from Captive Resources (CRI) to help you better understand group captives and captive insurance in general. In our first installment, we’ll tackle the question, "What is a captive insurance company?"
To help us answer that query, we put together a list of related questions (starting with the overarching one) about captive insurance. Use the links below to jump to a specific question or scroll down to read them all.
If you’re interested in learning more about group captive insurance for your company, click here to get in touch with one of our experts.
According to the recent white paper from the Insurance Information Institute (Triple-I) — A Comprehensive Evaluation of the Member-Owned Group Captive Option — a captive insurance company is:
An insurance subsidiary formed to provide risk mitigation services to its parent company. Basically, a parent company retains the cost of insurance coverage through the captive instead of paying premiums to a third-party insurer for commercial insurance.
Said another way: A captive is an insurance company owned by the organization (or organizations) that it insures. Rather than paying a conventional commercial insurance company, a captive owner chooses to retain certain risks at lower costs while still transferring others (often, catastrophic losses) to an insurer.
The Internal Revenue Service's (IRS) answer to the question "what is a captive?" is much more concise: According to the CPA Journal:
The IRS defines a captive insurance company as a "wholly-owned insurance subsidiary." Insurance can be defined by three basic tenets initially derived from Harper Group v. Comm'r [96 T.C. 45, 47 (1991)].
Each captive must adhere to the three tenets referenced in that definition. According to the IRS, these tenets are:
There are several types of captive insurance companies, which can be categorized on two main dimensions:
As the name implies, owned captive insurance companies are typically owned exclusively by the organizations they insure (i.e., the policyholders). The policyholders manage the captive operations and hold the capital.
According to Triple-I, a rented captive (i.e., “rent-a-captive”) is a “licensed insurer owned by an outside organization (such as an insurance broker or captive manager) that provides many of the functions of the captive for a fee. Their services include the underwriting, rating, claims management, accounting, reinsurance, and other areas of financial expertise.”
The second dimension involves whether the captive is a subsidiary of a single company or a joint arrangement of multiple companies. Single-parent (i.e., pure) captives are typically reserved for larger companies that can afford to retain large, complex insurance risks independently, are able to administer the captive in-house, and have a need for many different coverages, some not easily obtainable or affordable in the commercial market
Group captive insurance companies are owned by a collection of companies. The group captive structure allows small- and mid-sized companies to enjoy the advantages of captive insurance by pooling their resources and sharing risk with like-minded organizations. Group captives themselves come in a variety of forms. At Captive Resources (CRI), we specialize in helping companies form and manage member-owned group captives.
A member-owned group captive is an insurance company formed by multiple organizations to insure the risk of the member-companies’ businesses. There are a couple of crucial introductory distinctions to make with the member-owned group captive model:
There is much more to cover in understanding group captives, but that brief introduction should suffice in helping us answer the question, "what is a captive insurance company?" For more information, download the full white paper from Triple-I: A Comprehensive Evaluation of the Member-Owned Group Captive Option.
According to Triple-I (emphasis added):
Captives are usually formed to supplement other commercial insurance coverage and allow the parent company to retain some risks at a lower cost. The captive can provide coverage that is unattainable or inadequate in the private market. In addition to the opportunity to obtain more comprehensive or specialized coverage for the company's risks, the parent company can achieve cost savings, tax savings, and better control over claims decisions. The captive can be especially cost-efficient because the parent company retains what it would otherwise pay a third-party insurer.
The bolded text here is a critical motivator behind forming a captive insurance company. Conventional insurers have significant overhead costs — e.g., company profits, taxes, marketing, acquisition costs, etc. — that are passed along to their insureds. By circumventing conventional insurers, companies that form captives can enjoy more control over these costs or eliminate certain costs entirely.
To explain how captive insurance companies are structured, we’ll again turn to Triple-I’s white paper:
Captives must be capitalized and domiciled in a jurisdiction that legally allows captives to operate as licensed insurers. The captive insurer is an unlicensed, non-admitted insurer except in its own domicile. Because it is generally illegal for an unlicensed insurer to issue policies, captive insurers typically contract with a licensed insurer to issue policies. However, the captive does not transfer the risk.
These fronting arrangements allow captives to comply with various state financial responsibility laws that require evidence of coverage for certain lines, such as workers' compensation, to be written by an admitted insurer. The captive determines the types of risks that will be covered and establishes premiums that are paid to the captive by the business owner(s). If claims exceed premiums in the captive, the company, or group of member companies, is liable for the excess cost. On the other hand, if losses for the coverage are less than expected, the excess premium can be distributed back to the business owner(s).
The point of a captive is not to retain all risks. Group captive members still transfer some risk to conventional commercial insurers. While captive insurance allows companies a means for managing risks that traditional insurers don't cover, the risks that group captives most commonly retain share some distinctive characteristics:
Given these characteristics, group captive insurance is most often used for standard casualty lines like:
Of these lines of coverage, workers’ compensation coverage is the most common risk pooled in a group captive.
In its modern format, captive insurance dates back to the late 1950s, when poor market conditions led to increasing premiums, higher deductibles, and tighter policy conditions, prompting several large companies to form single-parent captives.
At the time, the captive insurance model was only financially viable for larger companies with significant capital. Today, captive insurance has become commonplace among larger corporations as approximately 90 percent of Fortune 500 companies have captive subsidiaries, according to the National Association of Insurance Commissioners (NAIC).
While originally a formal vehicle for large companies to self-insure, captive insurance became accessible to mid-size companies thanks to group captives. In the 1980s, CRI’s founders developed a unique funding model for member-owned group captives in the wake of the insurance crisis of the previous decade. At the time, business owners were paying exorbitant premiums for traditional insurance coverage or struggling to obtain coverage at all. The crisis inspired the company’s founders to create one of the first member-owned group captive insurance companies. The model has since become an accepted standard in the group captive industry and is widely used today.
Overall, captive insurance has enjoyed steady growth over the years. Between 1960 and 1986, the number of captives grew from 100 to more than 2,000. Thanks in part to the emergence of group captives, that number has continued to grow: Today, there are more than 6,000 total captives worldwide, according to Business Insurance. Since its inception, CRI has also experienced an upward trajectory: Today, we consult to more than 40 group captives comprised of more than 5,300 member-companies.
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