Wondering Whether a Captive is a Good Alternative to Traditional Insurance? Here’s What You Need to Know

At some point, most organizations look at what they’re spending annually on insurance and question whether they can reduce their costs. That’s especially true for businesses with strong risk management practices and low loss ratios. They begin to think, “We’re not filing a lot of claims, so why do our premiums keep going up? Isn’t there a better alternative?”

This line of thinking inevitably leads some companies to consider whether participating in a captive program could reduce their insurance costs. However, a captive isn’t a panacea for all risks and isn’t feasible for all businesses.

If your premiums and loss experience have you contemplating a move to a captive, it’s important to understand how a captive works and what to consider when evaluating this strategy.

Why Companies Consider a Captive

A captive program is a form of self-insurance, in which the captive serves as the insurer and is owned by either a single insured or multiple companies. For businesses with a strong commitment to managing and mitigating risk, replacing traditional insurance with a captive holds some appeal.

In the current insurance market, even with a low loss ratio you might find your insurance premiums rising, particularly for lines of coverage where capacity is constrained. Yearly rate hikes of 10-20 percent are not unusual, even for companies with a better-than-average claims history.

If your average annual loss ratio over the past five years is below 40 percent, and you’re paying $100,000 or more in annual premiums for any single line of coverage (for example, commercial property or auto), you might start to think about a captive program. If you’re already investing significant resources in safety and risk management programs to mitigate losses, you’re even more likely to evaluate alternatives to escalating premiums. And if you’re finding certain types of risks uninsurable in the traditional market due to the nature of your business, you might contemplate a move to a captive.

Where your company is in its lifecycle also plays a role in whether a captive program could be viable. If you’re the founder of a middle market company and you plan to exit the business soon, the time and effort to move to a captive may not be worthwhile. But if you intend to remain active in the business for the long term or have a good succession plan, it may be worth evaluating the feasibility of a captive.

What Makes a Captive Program Appealing

For certain lines of commercial insurance—including auto, property, general liability, and workers’ compensation—a captive can effect significant change from a cost perspective, assuming your business is a good candidate.

Because a captive takes a performance-based approach to insuring against risk, the more effective your risk management efforts, the less you’ll spend to cover your losses. When the captive’s member companies experience fewer losses, the program can retain more of its capital—requiring less additional capital from members. That’s distinctly different from the traditional insurance market, where even external factors unrelated to your claims history, like the stock market’s performance, can impact your rates.

Equally important, participating in a captive program affords businesses greater ownership, control, and transparency over their insurance mechanism. As a captive member, you have full visibility into where the funds are coming from and where they are going.

Many businesses cite tax benefits when considering a captive program, especially in light of federal tax changes that have made the US a more competitive domicile. However, the tax implications of participating in a captive program are complex and should be discussed with a trusted accountant.

What to Consider If You’re Looking at a Captive

Leaving the traditional market in favor of a captive is a major decision, even for a single line of coverage. Before making such a significant move, it’s important to review key considerations like the following:

• Is a captive feasible for your business? Generally speaking, a company that engages in rigorous, proactive risk management and has a loss ratio below 40 percent may be a good candidate. A feasibility study can help determine whether a captive is viable for your business.

• How much capital will you need to reserve? The answer will depend on factors such as your average annual loss ratio and what you forecast your largest potential loss could be in any given year.

• Which captive structure is best? There are a variety of captive types, the two most common being single-member captives and member-owned group captives. For all but the largest corporations, a group captive is the most likely fit. These groups are formed by companies with similar risk management approaches and financial risk exposure, they focus on a single line of insurance, and their members share the program administration costs. Although new members invest the required capital gradually over time, the business is protected against covered risks from day one as an equity partner. Group captives are governed by a board with seats that rotate every two or three years, allowing every member company a chance to participate.

• How do you find the right captive? Assuming you’re looking to join a group captive, a consultant who knows the landscape can help you find captives offering the line of coverage you need. To determine the right fit, consider the captive’s member profile, risk exposure, and fee structure, looking for operating expenses that don’t exceed the industry average of approximately 30 percent. Find out if there is a tail fund in place or in the works (preventing current and former members from being liable for old losses) and determine if there is a defined exit strategy.

• Which domicile should you choose? There is often a misperception that you can choose from a broad range of jurisdictions for your captive. But in reality, most group captives are based in the Cayman Islands and most single-parent captives choose to locate in Bermuda. Changing tax regulations may make the US a more attractive domicile over time.

• What are the ongoing costs? With a group captive, all members share the cost of administering the program. Once you’re accepted, you’ll receive a capitalization schedule as well as a schedule of any fees and other costs you’ll pay annually.

• Will you need support from any third parties? To join a group captive, you must work through a broker. The other resources required to run the captive—such as a consultant, administrator, and legal counsel—will already be in place when you join, relieving you of any related burdens. The situation is different for a single-company captive, which must take on the task of setting up those resources themselves.

How B. F. Saul Insurance Can Help

The experienced advisors at B. F. Saul Insurance are well-versed in the captive landscape and what to consider before taking this major step. If you’re thinking about participating in a captive, schedule a call with a B. F. Saul advisor. We can help you assess the feasibility of this approach and guide you through the process with confidence.