Looking at the insurance market is already hard enough when you are figuring out whether to self-insure or stay in the traditional market. It’s like learning to solve a Rubik's cube. Then, you have the option of captives. Now you’re solving the cube with the lights off. Thankfully, you can be guided through how these options work.
The three predominant types of risk financing for businesses are:
- Traditional insurance
- Self-insurance
- Captive insurance
There are some similarities and several general differences between these options, but the three key traits that separate them come down to control, assumption of risk, and potential profit for the business owner.
In reality, there is a high degree of overlap between these traits—owning more risk leads to more control, more control leads to higher potential profit, higher profit can lead to more control, and so on—but in our years of growing (thriving?) within the captive insurance industry ReNu Insurance Group has come to appreciate the benefit of taking things apart. Hence, they make more sense when they come back together.
After working with over 130 businesses that are now captive owners, ReNu Insurance Group understands each of these options thoroughly.
Disclaimer: While ReNu Insurance Group helps businesses become captive owners, captive insurers aren't for everybody. Our goal is to give an overview of each option so you can determine what form of insurance best fits the needs of your business.
This article provides a brief overview of the similarities between the three main risk financing options and then addresses the control, risk, and profit features of each. Once you’ve read this article, you will be better prepared to look more deeply into the pros and cons of captive insurance.
Table of Contents:
- Overview of the basic types of risk financing
- Is captive insurance a form of self-insurance?
- How are these three insurance models different when it comes to control?
- How are these insurance models different in managing risk?
- How is making a profit different from these three insurance models?
Overview of the basic types of risk financing
Traditional insurance
With a traditional insurance plan, a third-party company creates and controls the insurance contract. The insurer charges a premium for the policy, and the insured business pays a deductible.
The premiums paid by each insured business pool with premiums from various other businesses and their insured risks, and if a claim is incurred, the insurance at least partially covers the claim.
In this model, the third-party insurance carrier assumes all the risk, and each insured business relies entirely on the insurance carrier to tell them what their coverage will cost from year to year.
Cost increases often reflect class underwriting, where large renewal premium increases are charged to an entire class of businesses based on the poor performance of a few members of that class, even though the top performers are experiencing low claims.
Self-insurance
Self-insurance is really just a rainy-day fund or a filled-up swear jar—a separate account where the business owner saves money to use if and when claims arise. This model doesn’t “check the boxes” needed for the regulator to recognize it as an insurance carrier, so the money being earmarked for claims is not deductible for federal income tax purposes. Comparatively, captive insurance is more formal because it is recognized as a small insurance company.
Also, in contrast to a self-insured business owner invested only in their risk management planning, a captive owner shares the risk with other captive group members, and all the members’ risk management programs are subject to oversight of the captive risk committee. This ensures transparency, accountability, and continuous improvement of their overall approach to risk management.
Is captive insurance a form of self-insurance?
Captive insurance is a form of self-insurance in the sense that the insured is also the owner of the source that will pay any claims, and the business owner takes on the financial risks of coverage. In both models, the owner could be financially ruined if risks are not effectively managed and mitigated. However, the similarity basically stops there.
The key characteristics of the three main types of risk financing are shown in the following table:
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Key Comparisons |
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Traditional insurance |
Self-insurance |
Captive insurance |
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· Price competition: cashflow underwriting, market cycle swings · Administrative expenses: high-profit loads, high overhead · Fronting: high fees, staking collateral, bundled services · Loss-sensitive programs: dividend plans, retrospective rating plans, self-insured retentions, deductibles, and · Disadvantages: inflexible, high overhead, stacking collateral · Premium increases are not related to your own loss ratio (class underwriting) |
· State-by-state qualification, high administrative & cost loads · Burdensome regulatory filings for statutory-required elements and solvency deposits · Guaranty or insolvency funds (some states) · Per occurrence and aggregate reinsurance · Third-party claims administration & claim fund · No immediate tax deduction for loss reserves · Put money into an account and pay directly… if it costs more, you could be sued, overdrawn (possibly extensively), and unpredictable. · No underwriting profit because it is not recognized as insurance |
· Greater control of the insurance program (you own the insurance company) · Reduced underwriting expenses and overhead · Reduced impact from market swings · Retention of underwriting profit and investment income · Bundled or unbundled services · Loan-backs and dividends · Direct access to the reinsurance market. · Bucket of money, invested capital, risk sharing with other members · The benefit of underwriting profit to replenish the money |
How are these insurance models different when it comes to control?
With traditional insurance, the third-party insurance carrier holds the reins in all facets of the company’s risk financing. The business is subject to terms and conditions that apply to an entire business class, with little or no opportunity to modify or customize the coverage to align with its specific risk profile.
Traditional insurance policies can be structured with one of the following structures:
- Deductibles
- Self-Insured Retentions (SIRs)
- Retrospective Rating (both incurred & paid)
- Dividend Plan
Most businesses are in one or more of these structures before they decide they are ready to own the risk themselves and join a captive.
Captive insurance gives the business owner more control and flexibility over their coverage, provides the ability to keep the related profits, and relies on the business owner managing their risk effectively to meet their unique risk profile. While assessments for frequency claims are very possible, the business owner still has a traditional insurance carrier as a backstop for severe claims.
Self-insurance gives business owners the ultimate program and financial control of their risk management program. However, with this level of control comes the highest risk because the employer has no way to ensure that they will have enough to cover claims if they should arise.
The following graph illustrates the fact that both insurance program control and financial control increase as the insurance paradigm moves from traditional insurance through captive insurance toward the fully self-insured model:
Figure 1: Comparing the differences in program and financial control
With this figure, you can learn about other forms of risk financing and figure out which route you want to go to best insure your business.
How are these insurance models different in managing risk?
No matter how extensive insurance coverage might be, there will always be an element of risk.
Traditional insurance
With traditional insurance, the carrier assumes the risk and, in return, reaps the benefits of the premiums that their insured parties pay and that are controlled solely by the carrier. For some companies, such as those that are just starting, haven’t had time to create a loss/claims history, or are still in the process of establishing a robust and comprehensive risk management program, this is often the best option.
Once a business has found its feet around risk management and has a solid understanding of what the other insurance options are, it might be time to consider how things would look if they were to assume more of the risk themselves instead of continuing to buy insurance from an outsider, but never owning it.
Captive insurance
With a captive, the business owner owns their risk. This means they must be prepared to cover unexpected claims, based on the “rule” of having enough cash available to cover the unexpected occurrences that might arise during one year in every five. Depending on how the captive is formed, the business owner could end up spending 2.5 times their premium if an unexpected loss occurred (including collateral, possible assessment, etc.).
Unlike traditional insurance, which pools risk from a wider customer base, captive insurance focuses on the risks associated with a specific business or a group of related businesses. As such, the business owner’s claims experience is directly tied to their premium. This means if the business experiences higher-than-expected claims, the renewal premium will be more than prior years.
However, the opposite is also true. If there are fewer claims than expected, the premiums will decrease. This means the business owner is no longer subject to surprising premium fluctuations at renewal time.
How is making a profit different between these three insurance models?
Having to implement and enforce their own risk mitigation measures creates a safer environment for captive and self-insured businesses, potentially reducing insurance costs along the way. Also, unlike traditional insurance, where premiums can fluctuate, captive insurance offers cost stability. The captive owner’s renewal premium is based solely on their results, so if the owner manages their risk better, they will not only pay less for their coverage, but they can also accumulate underwriting profit.
Furthermore, as effective risk management strategies are implemented and losses are minimized, premiums may even be reduced. These long-term cost savings and greater predictability for budgeting purposes can have a positive impact on any business's financial health and overall profitability.
With a well-run company and a robust risk management program, captive owners can experience a 50% reduction in the total cost of risk.
Make sure you’re learning the intricacies of captive ownership
In this article, we’ve compared and contrasted captives to both traditional and self-insurance. We’ve looked at who takes on the risk, how your business can be affected, and the potential profitability.
For many of you, captives almost sound too good to be true. And they can be. Like anything that sounds great in the world, there are also plenty of cons. The same can be said about captives.
If you’re interested in captives, you need to read our article about the pros and cons of captive ownership. That way, you can weigh out your options to make sure captives are a good fit for your business.
If you need to talk to a real-life human who specializes in insurance, don’t hesitate to contact ReNu Insurance Group.
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