Captives 101: Are They Right For Your Business?

Insurance is a risk management tool which has traditionally been and is still widely used by most businesses to transfer risks that they are unwilling to take on their books. Whilst most businesses understand how insurance works, many are not aware of Alternative Risk Transfer (ART). One such ART is a captive which has been around since the 1970s. Richard Li, our Head of Actuarial and Insurance Services, is passionate about captive insurance and is keen to spread the word out, which is why he is giving an elementary explanation of what they are and how they operate in this exclusive interview.

How would you define captive insurance? 

Let us first shed light on why commercial insurance companies exist. All businesses involve risks although the extent of the risks will vary for each business and industry. The business owner can decide to either retain or transfer the risks and it decides to transfer the risks, it needs to find another party that is willing to accept the risks. The principal activity of commercial insurance companies is to accept the risks of other businesses in exchange of an insurance premium and pools those risks together.

A captive is not much different from a commercial insurance company except that it is an insurance or reinsurance company owned by a non-insurance company and which insures some or all of the risks of its parents and affiliated companies.

How do they operate? 

The basic principles of a captive’s operations are relatively simple. Once the insurance programme for the business has been designed and agreed, the captive will issue an insurance policy to the parent company to cover the risks being insured. The captive will then keep part of the risks and will purchase reinsurance to protect it against large individual and/or high aggregate losses. This is very similar to what a commercial insurance company would do. The management of a captive insurance will usually be performed by a captive manager which is a company that provides specialised insurance management services.

What are the main benefits of forming a captive?

Whilst there is still much work to be done in the African continent for businesses to consider ART and adopt a captive, in North America and Europe, captives are very popular and widely used. This is particularly the case for North America where many businesses use a captive for their Workers Compensation.

There are many benefits to gain from using a captive. For me, the main benefit is to gain direct access to the reinsurance market and to know who is the ultimately risk carrier. For a business where the risk is financially important, taking an insurance policy with an insurance company which would certainly reinsure the risk – not knowing and not talking to the reinsurers or the ultimate risk carrier is really scary. I would be much more comfortable doing the negotiations directly with the reinsurance market and this is made possible through the use of a captive. Dealing directly with the reinsurance market will also reduce your insurance costs by eliminating intermediary costs.

Other reasons for using a captive are

1. Insuring the uninsurable: A captives can provide insurance cover for risks that are either unavailable or too costly to obtain from existing conventional insurance policies.
2. Tailored policies: There is a disparity between the wishes of the buyer and those of the insurer. Commercial insurance companies do not always grasp the idiosyncrasies of a business, resulting in an overpriced bundle of services that might not reflect the needs of a particular business. Having a captive allow a business to cover its specific risks with policies that match its financial goals and objectives.
3. Direct access to reinsurance: Bypassing traditional insurers means you also eliminate the significant markups they charge for administrative fees or broker commissions—markup costs that could, in fact, outweigh the startup costs of a captive.
4. Stability and continuity: The traditional market is very cyclical in premium costs, coverage and capacity which can result in fluctuation in premium costs. A captive can provide long term stable cover at steady costs without wild fluctuations.
5. Enhanced cash flow: With a captive, a company can time its premium payments in   accordance with its cash flow situation.

Africa particularly serves as a great example. It is not a surprise to see many businesses struggle to find the right risk transfer solution because of the lack of capacity in the continent for certain specialty risks. As Africa continues to develop, investments in oil, gas, infrastructure and technology are increasing, new risks are emerging, the demand for customised policies is growing which will result in the use of captives more and more.

What types of companies are ideal candidates for captives?

Captives are not for every business. The business will require a minimum level of annual premium. Having said that, captives are not only for the largest businesses. There are other criteria which when met would also benefit medium sized businesses, in particular those that have high frequency but low severity in terms of risks.

What types of companies are ideal candidates for captives?

Captives are not for every business. The business will require a minimum level of annual premium. Having said that, captives are not only for the largest businesses. There are other criteria which when met would also benefit medium sized businesses, in particular those that have high frequency but low severity in terms of risks.

Broadly speaking, ideal candidates are:

1. Companies that pay annual premiums in excess of USD 1 million.
2.  Companies with a strong claim and loss history, which is often reflective of solid risk management. A positive loss ratio speaks well of a company’s track record.
3. Businesses with multiple entities, multiple insurable assets and thus, diversified risks. A company with only one exposure in one location is an unlikely candidate.

Having said that, I would invite businesses to seek advice from experts who are experienced in advising, creating and administering captive insurance companies to carry out a feasibility study to assess and determine how a captive can work for them.