As the commercial insurance market continues to firm, insurance buyers face mounting challenges in higher premiums, reduced coverage and lack of capacity. For many buyers, alternative risk financing vehicles, including captives, are increasingly becoming integral parts of the solution to help address management liability risks.
For many companies, captives are already a well-established element of their efforts to take control of their risk. A captive can serve as a valuable tool to shield the business from insurance market volatility, reduce the total cost of risk, achieve greater insight into and control over claims and gain direct access to the reinsurance market.
While businesses form captives in any market, the hard market has prompted an increase in interest in alternative risk transfer vehicles. Today there are more than 7,000 captives worldwide, with approximately 90% of the Fortune 500 operating captive insurance companies.
What’s needed to consider a captive
Businesses looking to form their first captive should consider using it to cover high-frequency, low-severity risks to start. A captive is a long-term risk financing solution that needs time to grow; starting with cyber or other catastrophic exposures could potentially bankrupt the captive before it has time to become established.
Most often, in its early stages, the captive serves as a tool to finance current deductibles and retentions. Later, as the captive matures, it is generally used to take higher deductibles or retentions, cover additional exposures or plug gaps within coverage towers. An actuarial analysis can help a business determine its risk appetite and how much risk is appropriate for the captive.
It’s also important to determine if a captive is indeed a viable consideration. A sufficient amount of capital is necessary to support the risk and is required as a regulated insurance entity. Companies considering forming a single-parent captive typically should have at least $3 million to $5 million in premium and/or retained losses. Companies with lower premium and loss levels might find a solution in the group captive or cell captive space.
The organization also must recognize that a captive is a long-term commitment that requires dedication to risk management as a regulated insurance company taking on risk. An emphasis on risk mitigation is essential to reducing losses. This enables the captive to recognize an underwriting profit so it can function as a true insurance company, not just a bank account.
The captive formation process
A business forming a single-parent captive should anticipate the process taking roughly six months.
The first two months of the process are usually spent doing a captive feasibility study, including actuarial forecasting. That study will determine the viability of a captive insurance solution for the business and includes domicile analysis and recommendation. There are approximately 70 jurisdictions around the world that allow the formation of captive insurance companies. Bermuda, the Cayman Islands and Vermont are the three largest domiciles, with Guernsey, Luxembourg and Ireland being the leading players in Europe.
Various factors might come into play in selecting a domicile, including the experience and knowledge of the domicile’s regulatory team, travel considerations associated with required in-domicile board meetings and whether the business might want to form a captive in its home state.
After the business chooses a domicile, the business will work with a captive manager to put together the captive business plan and application. Domicile regulators typically take around 30 days to review the application, though that timeline can vary by domicile and time of year. During their review, regulators might have questions for the prospective captive parent.
For an organization too small to form a single-parent captive – or one needing a captive solution quickly – a cell arrangement can be a solution. In some cases, a cell can be formed within days, providing a tool for filling a gap in insurance programs.
Understanding management liability
In a challenging insurance market, directors & officers (D&O) liability is proving to be particularly arduous for many businesses. Those difficulties are prompting many organizations to consider how they might use a captive to address the risk and access capacity.
Side A D&O coverage – the portion of coverage protecting directors and officers personally from claims when the company is not providing indemnification – is not viewed as appropriate for a captive given the nature of the coverage and the risk that the captive may be viewed as an asset of the organization in bankruptcy.
However, organizations are often looking to captives to cover Side B and Side C exposures. Using the captive for Side B and C coverages can allow the company to concentrate its capital resources on acquiring Side A capacity from the traditional market. Some organizations are fully retaining Side B and C in the captive, while other organizations use it to fill a challenging Side B and C portion of a layer on the program.
Other captive benefits
The captive insurance company can provide direct access to reinsurance markets which, if nothing else, can provide additional sources of capacity as a company looks to build out its insurance program. What’s more, incumbent insurers may view the simple presence of a captive as additional competition at renewals, allowing the captive owner to achieve more favorable terms and pricing.
More broadly, a captive can deliver benefits across the insurance market, most notably as it matures over time into the parent organization’s ”underwriter of choice.” A mature captive can also provide the risk manager a valuable tool in determining how to optimize the insurance program to effectively manage the total cost of risk. Over time, a captive can be a nimble vehicle for risk financing creativity, evolving alongside the changing nature of the organization’s risks.
Aon is not a law firm or accounting firm and does not provide legal, financial or tax advice. Any commentary provided is based solely on Aon’s experience as insurance practitioners. We recommend that you consult with your own legal, financial and/or tax advisors on any commentary provided by Aon. The information contained in this document and the statements expressed are of a general nature and are not intended to address the circumstances of any particular individual or entity.
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