Is Captive Insurance Too Good to be True?

If you’ve just been hearing the upside about captives, it’s not surprising that you might be left thinking that maybe this alternative to traditional insurance is right up your alley. As a business owner, you know when something sounds too good. You feel it in your gut. And your gut is usually right. And it’s that feeling you’re having now when comparing captives to traditional insurance options.

The short answer: captives certainly can be as good as they sound, but it comes down to making your safety and risk management programs more robust. You get out of it what you put into your programs. 

At ReNu Insurance Group, when we’re asked, “How can this captive thing really be possible?” or, “I’ve heard from two advisors that there’s no downside,” our first response is to raise a cautionary hand. There are always two sides to everything, and captives are no different. After working with over 130 businesses that are now captive owners, we’ve come to understand the intricacies of captives and how they can benefit businesses. 

After reading this article, you will better understand how captives work, how to know when you’re not being told the whole story, and what questions you should be asking as you grow your knowledge about the captive option. That way, you will have a better understanding of whether or not a captive would be beneficial to your business.

What could I realistically expect if I were to join a captive?

A captive is basically an insurance company that is owned and controlled by its insureds. Its primary purpose is to insure the risks of its owners.

A captive can be an excellent risk financing and risk management tool if it is well run and best practices are applied. In fact, most Fortune 500 companies today own captive insurance companies. 

However, it must also be said that problems can arise if the captive is poorly managed, bad practices are put into place…or if it is established for the wrong reasons. 

Suppose the disadvantages can be mitigated, and the benefits seem to outweigh the risks. In that case, the key thing to remember is that choosing to own or join a captive is a long-term strategic business decision. 

There are three key things that a business owner needs to have before they can realistically consider making that decision:

1. A detailed assessment of the business’s risk exposures and current risk management program.
2. An appetite for retaining risk (and for managing the captive account with a long lens).
3. A long-term commitment to safety and loss control. 

The most important thing to remember about captive insurance is that they’re a long-term solution. When the captive insurance market has its ups and downs, it can sometimes be tempting to return to that traditional risk financing model, but staying the course with a well-run captive can be hugely rewarding. 

Is captive insurance a good idea? Are there disadvantages of captive insurance?

Captive insurers can be a good solution that fits the needs of insuring your business. However, if you’re only hearing about the benefits of joining a captive, then you’re not being told the whole story. There are several benefits to choosing a captive over traditional insurance, but captives also come with potential drawbacks.

For example, with a well-managed captive, the captive owner can benefit from:

• Broader, more available coverage to meet the unique needs of each owner. 
• More predictable costs are not subject to the whims of market trends.
• Direct partnership with reinsurers with the capital to assume larger amounts of risk. 
• Improved cash flow and underwriting profits if premiums exceed claims.
• Customized structuring of how deductibles are allocated across multiple exposure units.
• Tailored processes for handling claims.
• Potentially, some tax advantages.

But there’s more. The part you may not be hearing about is that when a business owner becomes their own insurer, they need to be ready to assume the responsibilities that come with it. Compared to just paying a traditional insurance company and letting them take care of the details, captive ownership means assuming or outsourcing those administrative tasks, such as: 

• Ensuring that financial statements are filed.
• Meeting insolvency tests.
• Confirming that all regulatory requirements are met. 
• Having to deal with compliance issues.
• Coordinating with actuaries, claims administrators, auditors, adjusters, etc.

Suppose the captive owner doesn’t have the in-house resources to handle these burdensome tasks. In that case, they can be outsourced to a captive management specialist to do the bulk of the work. Still, even then, the captive owner has to be ready to deal with extensive delegation, acquisition of expertise, and a potentially significant capital commitment.

In addition, owning or joining a captive might bring with it new overhead expenses, as well as the possibility of being underinsured. 

Could joining a captive bankrupt my business?

There are plenty of misconceptions about captives that the insurance industry hasn’t properly educated people on. Contrary to what some business owners have been thinking, captive insurance has been shown to be more efficient and less costly than traditional insurance. This is because with the traditional insurance model:

• There is little (if any) flexibility for tailored coverage.
• The insured’s good performance only benefits the insurance carrier with respect to underwriting profits.
• Premiums can be subject to unpredictable (and sometimes absurd) rate hikes that have nothing to do with the performance of the insured.   

In contrast, the premium rate with a captive reflects the insured’s unique risks rather than industry averages and typical exposures. Yes, there are upfront costs when first joining a captive, but as a long-term strategy, it makes sense to view these initial costs as a long-term investment. 

But what if there’s an unexpected accident or other large claims?

This is a critical question with a very simple answer: A well-managed captive will have a well-managed loss reserve. 

This is often the biggest liability on the balance sheet of any insurance company because it is the primary safety net. The highest percentage of insolvencies related to captives is due to inadequate loss reserves.

While it might be tempting to draw money from the loss reserve in a good year, as much money as possible must be kept in the captive so it’s available for its original purpose if the need arises. The reserve will continue to earn interest while growing to keep the captive insulated from maximum losses and as premiums come down when there are no losses.

This is discussed in more detail in our article How do I manage my risk in a captive if I have a huge claim or multiple claims?

What questions should I be asking about the captive option for my business?

When formed or joined under the right circumstances, with the right leadership, and for the right reasons, captives can be very beneficial. There are five key considerations that a business owner needs to think about when considering whether captive insurance is right for them:

1. What is the maximum possible premium in a given year?
2. What about my firm's loss history?
3. How much collateral will I need, and when would the captive need to call it?
4. How much risk is too much risk?
5. Who will manage the captive on a day-to-day basis?

What is the maximum possible premium in a given year?

Start-up costs and the ongoing cost of operating a captive can make a captive unaffordable for firms with insurance costs below $300,000 per year. Businesses with annual expenses much less than this run the risk of having to make assessments or collateral calls to cover frequency losses. Every year, the captive owner(s) should know what the maximum premium will be.

What about my firm’s loss history?

If a business has had low losses over the past five years yet is somehow subjected to annual premium increases related to commercial market cycles, then a captive may be an option. One important note is that the captive risk committee will want to confirm that a robust risk management program accompanies the low losses and is not just the result of luck. 

If a business has had frequent losses in the previous five years, it will likely not be considered a viable candidate by a reputable captive manager or risk committee.

How much collateral will I need, and when would the captive need to call it?

When it comes to captive insurance, collateral is a line of credit or cash used to secure funding for the payment of claims. Basically, it's money on reserve in case of an emergency.

To better understand what collateral is when it comes to captive insurance, read our article What is Collateral in Captive Insurance? And Overview of How It Works. And here's a video covering collateral and its costs:

When entering a captive, the business owner must provide enough collateral to cover losses exceeding the premium collected. Each captive is run a little differently, but the collateral is generally based on the following formula:

collateral = annual premium x 36% 

If there is a loss that exceeds the premiums paid, then the balance may be paid through an assessment or drawn from the collateral. If the collateral is drawn, then the business owner will need to provide more collateral or be removed from the captive.

How much risk is too much risk?

Because the business owner owns the captive, unexpected losses for the captive will necessarily impact the business owner's profits. This is especially impactful for single-parent captives. Therefore, the business owner must carefully consider whether their firm has the risk tolerance to support a captive over the long term.

Who will manage the captive on a day-to-day basis?

Captives come with both the potential for huge benefits and the potential risk of unexpected losses. Where a business falls on the spectrum between risk and benefit largely depends on ensuring that the captive is managed properly and well. Ideally, this should include an experienced captive manager operating with complete confidence and access to senior management.

So, a captive might be a real solution? 

Formed for the right reason and run properly, the Captive is a true performance-based, long-term insurance solution. In contrast to buying traditional insurance, it generates a return on investment instead of an expense, reduces insurance costs, and improves cash flow. And perhaps one of the best benefits is that members share in the underwriting profits that typically go back entirely to the third-party insurance carrier. 

If you’re still unsure about captives, read our article on the pros and cons of captive insurance companies. 

If you’re considering going with a captive or have additional questions, contact ReNu Insurance Group to help you out.