Risk sharing among unrelated entities, also referred to as “risk distribution,” is one of the main criteria that has to be met for a captive to be legally recognized as an insurance company. Whether you form a single parent captive or join a group captive composed of multiple other members, the risk-sharing requirement must be met.
At ReNu Insurance Group, we have extensive experience ensuring that business owners are informed about exactly how this important aspect of the captive model works and what has to be done to make sure it works to their greatest benefit. You would hope so after working closely with over 130 captive owners.
After reading this article, you’ll understand how other entities share their risk and be closer to determining if a group captive is a good fit for your business.
And hey, check out our video about your business being in a captive with other companies:
Do I share risk with other businesses in the traditional insurance model?
Absolutely. The problem is you have no idea who you’re sharing your risk with while in the traditional market.
A traditional carrier punishes you no matter how good you’ve been with managing your risk and minimizing claims. You pay higher renewal premiums because the carrier is losing money when other businesses in your line of work are screwing up. The issue is you have no idea who the problem is. The carrier is focused on making a profit, which typically means higher premiums for all their insureds (including you). Remember the teacher in school who punished the class because one kid couldn’t get it together?
In a group captive, you get complete transparency over which business is causing the risk-sharing expense. By identifying the problematic captive member, the risk committee can see how their issues can best be fixed. An improvement plan will be implemented to minimize future risk-sharing losses.
Why is it necessary to be in a captive with other businesses?
The risk distribution criteria for captives are very clear. For a captive to be considered a bonafide insurance company, the risk distribution must entail a “pooling” of premiums from many insureds, and that pooling must cover enough risks that the law of large numbers applies—meaning there are sufficient risks that the law of averages will result in accurate predictions of overall loss.
Group captives
The IRS regards a group captive as insurance if no participant owns more, represents more premium, or has more voting power than 15% of the overall captive.
How is it decided which businesses are in a group captive?
The captive manager who starts a group captive sets the criteria for the kinds of businesses that will be included in a given group. The underwriting process is then written to align with that criteria, and applications are considered accordingly.
Any business owner looking into joining a group captive will likely wonder, “Which other companies would be in my captive, and how would I know they’re good?” That is a fair question, and it works both ways.
The existing captive members will wonder the same thing about this new company, “Are you good enough to go into this with us? Because we’re already here.”
When a business tries to join a group captive, the existing members will want to know who this new business owner is. There’s a reason why captive insurance ownership is often referred to as “the most exclusive country club in the world.”
How would sharing risk with other businesses impact my business?
If losses for a given business cost more than expected, then risk sharing provides that the pooled resources are available to cover the difference. This is great for the affected business but can become a drain for the member businesses who are perhaps managing their risk more effectively—especially if it keeps on happening. If most businesses in a captive are paying more than their “fair share” to cover the losses of less-well-managed businesses, then risk sharing becomes an unreasonable burden.
One goal is to minimize risk sharing, which can be managed in the way the captive is set up. Each captive manager sets up risk sharing a little differently with respect to the claim level at which risk sharing starts.
Ultimately, if a captive member cannot effectively manage their own risk, they will be compelled to leave the captive. The risk committee will vote them out in a group captive like it’s an episode of Survivor—just without the cameras. That captive member will be “voted off the island.”
You know about the risks with captives. Now, what’s the reward?
You’ve learned about different types of captive insurance companies, which companies are allowed in a group captive, and how risk sharing impacts your business. Now, you need to learn more about the financial impact of captive ownership by reading our article on how captives affect cash flow.
If you are wondering how much you would need to invest to join a captive and how much you can make in underwriting profit, take our insurance calculator to get your results.
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