Ten best things about captives

So what’s all the fuss about captives? For over 50 years they have been helping companies with their risk financing needs, and are still relevant today. There are many reasons as to why captives have prospered despite prolonged soft markets and unwelcome attention from regulators and tax authorities over the years. Here are just ten of the best reasons to have a captive.

1. Cover those tricky risks
If you can’t insure a risk, and are forced to self-insure, then it makes sense to insure it through the captive where reserves can be built up, the risk can be incubated, underwriting data can be gathered, and the risk modelled and priced. It may also be possible to find reinsurance cover for such risks at a high level. All of which may mean that, given time, the risk can be taken to the insurance market and cover obtained. Or if not, or the price is too high, keep it in the captive.

2. It’s a great risk management tool
Captives are a useful way of gaining an immediate benefit from any risk management or loss control measures put in place. The improvement in the risk can be reflected in the premium set by the captive from day one, without having to wait for any improvement to show up in the loss statistics down the line. And it allows a risk manager to use a carrot/stick approach where a group has a number of operating units or subsidiaries, rewarding or penalising individual units according to how they implement the group risk management programme, or individual loss control initiatives. Units can be penalised by raising the cost of insuring into the captive, or by increasing the local deductible, or rewarded with lower insurance costs.

3. It’s your flexible friend
The captive is a highly flexible tool. A captive can design its own programmes, giving broader and more flexible coverage than could be obtained in the traditional market. So where there is a lack of capacity, policy restrictions, or complicated wordings, a captive can largely dictate its own terms and conditions, as well as creating capacity. The captive can allow the company to take a large retention via the captive, and then go to the market to purchase catastrophe cover.

4. Smoothing the bumpy ride
Okay, the captive cannot control the cycle, but it can reduce the effects of the cycle to more manageable levels. Insurance market volatility is a huge problem for companies, and while the soft market has been prevalent in recent times, individual classes continue to see pricing volatility. And no one wants that, not least a finance director, who ideally wants the insurance spend to be kept reasonably constant (or to continually fall of course, but that is wishful thinking). A captive won’t remove volatility, but it can often avoid the worst peaks and troughs of the cycle.

5. Retain more, deduct less
The captive centralises the risk financing objectives of the parent organisation. It becomes, in effect, the centre of risk, whether insurable or uninsurable. This is particularly valuable for multinational organisations, since above the deductibles of the individual units, the corporate risk retention can be directed centrally through the captive. A group can opt for a very high retention level, but it will be applied to the group through the captive. The captive can then set its own local deductible levels to the operating units. This enables the group to benefit from the high group deductible, and the cheaper premiums it attracts, and yet give local units realistic deductible levels that provide an element of comfort to local managers.

6. Low cost risk taking
Captives are often set up with the aim of either reducing primary insurance costs. The captive is able to reduce the net cost of insurance by removing the costs of the insurance company from the equation (administration costs, marketing costs and course a profit element). Captives may have to pay management fees etc, but are still able to operate at lower expense ratios than insurers.

7. Saving for a rainy day
The captive can also provide investment income through the investment of the premiums it receives from the parent group and its operating units. Premiums paid to commercial insurers are paid at the beginning of the year of risk, and the insurer can then invest the premium until a claim is paid. A captive can improve the cashflow of the company, since the captive can use the premiums paid to it, by investing them until such time as a claim needs to be paid.

8. You get to play with the big boys
Access to reinsurance markets is one of the big benefits of a captive. Reinsurers are the ultimate risk takers and there is a natural desire for them to get closer to the original risk, and vice versa. Reinsurers often have considerably lower overhead charges than direct insurers, with much less infrastructure to support. Reinsurers therefore generally have a lower cost base than insurers. Risk managers are aware that it is often reinsurers that call the shots, since they accept the ultimate risk. As such, organisations want to be closer to those making the decisions about rates and capacity, and to have a proper dialogue with them, and the captive is an ideal vehicle for developing a closer relationship. Reinsurers also have expert knowledge and experience of catastrophe coverage and large exposure risks.

9. The risk manager holds all the cards
In these days of soft markets, the captive can be used as a tactical weapon in negotiations. In other words, using the captive in negotiations with insurers about cover and premium rates. If insurers are looking to increase rates, restrict coverage or tighten terms and conditions, minds can be changed on the basis that the company has the ability to pull out of the insurance market and place the business in the captive. And that same threat can help to encourage insurers to broaden the coverage, or lower the rate further.

10. Away days in Bermuda…Guernsey…Luxembourg…Dublin…
Choose your captive’s domicile carefully. Restaurants, golf courses, weather and Air Miles are all important. Just don’t tell the finance director.