Insurance is a necessity for the long-term success of any business, regardless of size or industry. Due to its significance, insurance can be a costly but required investment. While operating without it is not a viable option, there is an alternative: captive insurance.
What Is Captive Insurance?
When a business purchases standard insurance, the policy provides cover within a predetermined outline, offering limited flexibility. With captive insurance, businesses can choose to form their own insurance companies to cover their potential risks. For some businesses, this is a legitimate solution for their insurance needs. A business may choose to establish a captive insurance company for these reasons:
- Cost – A business can achieve a more reasonable insurance rate and premium.
- Cover – A business is able to insure high or ‘uninsurable’ risks associated with the company.
- Capacity – A business is able to tailor insurance plans to better fit its unique needs.
- Control – A business can dictate the direction, focus and impact of its insurance plan.
Depending on a business’ needs, the amount of captive insurance can supplement an existing policy or act as sole cover. Regardless of the size of the captive insurance policy, a business will still have to pay premiums to ‘the company’. However, by choosing to essentially insure itself, businesses are afforded a greater amount of flexibility within the provided cover and when filing a claim.
How Does Captive Insurance Work?
Each business has its own unique cover needs and there are a variety of shapes that captive insurance can take to meet those needs. While not every form of captive insurance requires that a business provides an initial financial investment, all do require that a business conducts financial studies and projections, estimates costs and submits an application.
The five distinct forms that captive insurance can take:
- Pure Captive (also known as Single Parent): This type is owned entirely by a business and provides cover for all types of risks. This form of captive insurance is the least costly to operate and provides the greatest amount of flexibility with policy terms, operating structure and lines of cover.
- Group Captive: Businesses that share similar interests or operate within related industries can form a collective captive. The captive splits the risks, costs and benefits among the parties.
- Traditional Rent-a-Captive: A client ‘rents’ out the captive to cover their risks. The captive provides all the benefits of ownership without requiring the initial financial investment. For this reason, this form of captive insurance may be more suitable for small and medium-sized enterprises.
- Protected Cell Company (PCC): Similar to Rent-a-Captive, this form of captive insurance segregates each business from one another to ensure that their assets and liabilities are kept separate.
- Incorporated Cell Company (ICC): This form of captive insurance is organised in a similar manner as PCC, except that the segregated businesses are able to conduct transactions among each other. This form of captive insurance offers a greater amount of flexibility with how a business’ accounts are able to operate.
What are the advantages of Captive Insurance?
There are three distinct advantages for a business that chooses to ensure its risks with captive insurance:
- Economic Savings – Depending on the cover needs of a business, there is the potential to pay lower, more consistent insurance costs. Captive insurance could additionally be more tax efficient than its more traditional counterpart.
- Efficiency and Quality – As a business supports and funds its captive insurance, it possesses a greater incentive to ensure that all potential risks are identified and mitigated. This heightened attention to detail provides the potential for senior management to have a more detailed concept of present risks. The increased degree of caution can also have the additive effect of lowered insurance payments.
- Quality of Cover – A business can obtain specific, detailed cover at a reasonable rate which would normally be unavailable or offered at a higher cost.
What are the disadvantages of Captive Insurance?
There are three notable disadvantages for a business that chooses to ensure its risks with captive insurance:
- Expensive Start-up and Maintenance Costs – While captive insurance can be a beneficial insurance alternative for some businesses, it is a costly investment. The scope of a business’ cover needs would affect the initial start-up costs. Once captive insurance has been established, there are operating expenses—government, legal and accounting fees among other additional costs. (Note: If a business formed captive insurance to provide cover for a previously uninsured risk, there will be a required regular insurance premium payment.)
- Increased Management Responsibilities – The establishment of a captive insurance policy requires a business’ management to take on additional, full-time responsibilities in order to monitor and manage the cover. These added responsibilities can expose a business to financial and insurance risks from mismanagement of the policy.
- Exposure to Loss – The capital that a business has built up to fund its captive insurance could deteriorate over time due to mismanagement. How the policy is managed could also potentially affect the underwriting profits.
How Will You Choose to Insure?
Captive insurance provides some businesses with a beneficial alternative to its more traditional counterparts. However, captive insurance is not right for every business.