Captive insurance

What is captive insurance?

Captive insurance is basically self-insurance using a company owned directly or indirectly by the insured. That captive company is an arms-length entity and will have to be regulated as an insurer. However, due to the company’s ultimate ownership and control of the captive, there can be advantages in structuring risk mitigation using a captive. Most captives are formed in jurisdictions that specialise in this type of business, including Guernsey, the Isle of Man and Bermuda.

What are the advantages of captive insurance?

Lower insurance costs

The use of a captive insurance company can result in a potential reduction in overall insurance costs. The costs of commercial market insurance takes into account the claims, overheads, and profit retained by the insurance company. In the case of a captive, the profit (assuming a profit is made) will remain with the business of the owner, in effect allowing the owner to share in the underwriting profit on its own insurance. A captive may also reduce insurance premiums by charging a premium that more accurately reflects the claims history of the parent/owner.

Form of investment

As with any other kind of investment, profits of the captive’s business can be paid out to its owners (although reserves must be maintained to meet the potential liabilities which are insured against). Any losses must be made good.

Access to the reinsurance market

Reinsurers are the international wholesalers of the insurance world and the costs of reinsuring are consequently usually lower than the ‘frontline’ costs of insuring numerous small risks. The captive’s ability to deal directly with reinsurers can produce additional cost savings. The reinsurance market can also have additional capacity and a willingness to insure more difficult risks.

Unavailability of coverage

A captive may be able to provide insurance coverage where none is available in the commercial market, or only at a prohibitive cost.

Cash flow

The use of a captive can give a business cash flow advantages, as well as increasing the control of the business over claims and the insurance process in general. Premiums collected and reserves held for unpaid claims, otherwise kept by a commercial insurance company, can in some cases be invested by the captive. This takes advantage of an insurance company’s ability to establish such reserves from pre-tax income that is not possible for a non-insurance entity.

Taxation

There may be tax advantages. A captive may prove to be a more tax-effective approach than simply self-insuring on a formalised basis. The extent of this advantage will depend partly on the tax residence of both the captive and its owners. Generally speaking, arm’s length insurance premiums of captives, as with any other insurance company, are an allowable expense for tax in the country from which they are paid. UK companies with captives in the jurisdiction will generally be able to take advantage of this under UK tax law.

And what are the disadvantages?

Captives will not be suitable for every business. In parallel to the potential benefits, several disadvantages exist which must be assessed thoroughly before a decision to establish a captive is taken. These include:

Capital Commitment

The parent must contribute the capital required to support the captive’s business plan which must be agreed by the insurance regulator in the captive’s chosen domicile. This necessarily puts a large sum beyond the reach of the company as a form of outlay.

Risk of Adverse Results (losses)

The captive’s capital could be eroded by adverse operating results. Although it is normal to build into any captive programme a degree of protection against adverse underwriting results, it is only possible to minimise the risk to the captive, never eliminate it.

Operating Cost

In its formation and operation, a captive may incur, depending on the domicile chosen, various expenses including: „

  • implementation costs „
  • management fee „
  • legal and auditing fee „
  • local taxes „
  • regulatory / licensing fees.

In addition, a captive will require a commitment of the parent company’s management time.

Why consider captive insurance?

To plug gaps in existing insurance cover

Captive insurance is often used to fill gaps where commercial insurance providers will not provide cover, or where the cost is uneconomic: it rarely replaces commercial insurance. Common areas of risk that can be included in a captive are the deductibles and exclusions contained in the commercial insurance cover.

In some cases, where facts exist which mean that commercial policies are not available for certain common risks a captive insurer might be used to provide cover. For example captive insurance might be used to plug gaps in policies covering business interruption, loss of key customers, credit default, extended warranty claims, directors and officers, errors and omissions, litigation defence, construction defects, pollution and natural disasters, where commercial insurers would decline to provide such cover.

To obtain specialist coverage

A captive may also be worth considering for more specialist coverage that is not necessarily connected to a business, for example, to insure an art collection. Form of captive vehicle

Captive insurance structures can take various forms, including a “pure” captive which insures only the liabilities of its group companies, and cell captives.

Cell Captives are entities consisting of a core and an indefinite number of cell entities which are kept legally separate from each other. Each cell has dedicated assets and liabilities ascribed to it, and the assets of an individual cell cannot be used to meet the liabilities of any other cell. A core cell company may also have non-core assets, which may be made available to meet liabilities that cannot be attributed to another single cell.

Captive insurance as part of an estate plan

Use of a captive also can provide opportunities to retain and transfer family wealth to other members of the business owner’s family. Funds that would otherwise would have been paid to a third party to purchase insurance cover are retained within the family, either by the business owner, an associated company, or a trust set up for the benefit of the owner’s family. In some cases, it may also be appropriate for the captive to be held through a pension plan.

Conclusion

A captive insurance company can provide some businesses with an effective means of funding self-insured risks, lowering the cost of certain types of insurance, and maintaining greater control of the risk management process. There may also be opportunities for individual business owners to transfer substantial wealth to younger generations in a tax-efficient manner.

Setting up and operating a captive is a complex matter and can involve several different areas of law. Our team of specialists can work with you and your other advisers to determine whether captive insurance is appropriate to your circumstances.