There are many significant advantages to captive insurance ownership, but what are the downsides? As with all business decisions, a cost-benefit analysis is a must before deciding whether the captive option is a good fit for a particular business. While a successfully established and maintained captive program does yield tangible rewards, there are also some potential financial disadvantages to take into account.
ReNu’s success has been built on understanding and transparently sharing these and other, more general pros and cons of captive insurance. This article speaks specifically to the financial disadvantages.
What are the biggest financial drawbacks to captive insurance ownership?
Some of the most noteworthy financial drawbacks to joining a captive include:
- Capital commitment;
- Possibility of lost capital;
- Volatility of the reinsurance market;
- Short-term limitations in cash flow;
- Sub-standard returns on investment
- Runoff expenses;
- Delays in reclaiming the collateral; and
- Inability to achieve insurance accounting.
Why would I have to invest capital?
At least during the beginning stages of a captive formation, there is a burden on the business owner’s financial resources to fund the initial set-up costs and the capitalization required by the respective regulatory body.
How likely is it that my business's capital would be lost?
With a captive, the insured–that is, the captive owner—puts up collateral to ensure that the captive can handle unexpected claims in the first few years. If claims happen to be higher than expected and the collateral has to be used to keep the captive solvent, then additional capital will be required. There isn’t a high probability of this happening, but it can happen.
Where does the volatility of the reinsurance market come into play?
Generally speaking, the reinsurance market acts more quickly than the primary insurance market to reinsure a claimant. The reinsurance market tends to be experience-rated (where premiums closely reflect the loss history of the insured), whereas a reinsured risk of a captive insurer might face premium increases sooner than a reinsured risk of a traditional insurer.
Why are there short-term limitations in cash flow?
In insurance terms, cash flow is the organization’s ability to hold onto its money until it has to pay a claim. With traditional insurance, a large deductible plan allows the organization to keep the loss funds until they are paid. Conversely, captive insurance forces the policyholder to monetize those loss reserves in the form of a premium payable over the twelve-month policy term. While this disadvantage is usually overshadowed by a variety of benefits, it is still real.
Can’t I gauge the value of the captive primarily on a minimum ROI?
Each business owner has their own definition of a substandard return on investment. Gauging a captive’s value primarily on its ability to earn a minimum ROI is a faulty analysis. However, if the business owner mandates that the captive’s capital must meet or exceed a specific hurdle rate and/or provide positive returns within a relatively short time frame, captive ownership may not be a good fit. Getting into captive insurance is a long-term business strategy. At a minimum, business owners should have a five-year time horizon to see distributions of underwriting profit.
What would run-off expenses look like?
A change in the business plan or a merger might result in the captive subsidiary being placed in a run-off mode, and the related expenses produce no current economic benefit.
Why would there be delays in reclaiming the collateral?
With traditional insurance, the insured party simply pays their premiums without having to put up any collateral. That means that when the insured wants to exit from the insurance plan, there is no need to worry about recouping a capital investment.
In contrast, the captive insurance model relies on funds being immediately available to cover claims, carrying costs, etc., from the outset, which requires a capital investment from each member of the captive before premiums even start. That collateral could be put in jeopardy if the business owner is asked to pay an assessment and the captive is still on the hook for the tail liability…
Also, if a business elects to exit the captive, the captive will still need to hold its collateral to cover the tail liability, which means it could take five-to-10 years before the collateral is returned to that business.
Every captive creation has different versions of what the collateral and the tail liability will look like, so it’s important to look at this part of the package very closely as part of the due diligence needed before committing to captive insurance ownership.
If you're still confused about this concept, check out our video that covers collateral in captives:
Inability to achieve insurance accounting
The inability to comfortably assume that the captive will qualify for insurance accounting often kills the deal before it gets off the ground. The IRS is very specific on what it considers “insurance” for federal tax purposes. Trying to evade or side-step the IRS using a captive has put many business owners and advisors in jeopardy.
Are there any other cons to owning a captive
If you are considering entering a captive, it is crucial that you be informed about the potential financial drawbacks. What makes sense for one organization may not work for another, and this is certainly true when it comes to captive insurance ownership.
Perhaps the most important step in the decision on whether the captive option is a good fit is to call upon industry experts—whether they be ReNu consultants, actuaries, or attorneys—to help you have a solid understanding of ALL the pros and cons of owning captive insurance.
This article spoke to the financial disadvantages. To understand the more general pros and cons of captive insurance, you’ll want to read:
Our insurance specialists are available to discuss any questions you might have.
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