Insights

Captives are an Efficient Risk Management Tool For the Right Company

September 8, 2020

Property & Casualty

Captive insurance has many far-reaching benefits as a risk management tool and is a growing solution for many companies as part of their overall risk management strategy. The captive insurance industry has continued to grow over the past 10+ years. While it is effective for many, it is not a one-size-fits-all strategy; so it’s important to analyze its feasibility in the context of your particular company.

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In this article, we’ll unpack some of the benefits of this alternative to self-insurance, but also examine the common challenges with this strategy. We’ll also drill down into the largest area of industry growth: 831b captives. Here, we’ll explore what is driving this growth trend and where captive owners should take caution when pursuing 831b captives.

What is a Captive?

In its simplest form, a captive is a wholly owned insurance subsidiary of its parent, functioning in the same way as a commercial insurance company. A big misunderstanding is that a captive lets organizations assume more risk. Rather, a captive can be a risk management tool assisting the financing (or funding) of the selected amount of retained risk, leaving the decision for how much risk to retain independent of the captive. For example, if a company is looking to increase retentions on its insurance program, it can decide to do this whether a captive exists or not.

Common Captive Benefits

The benefits of a captive fall into two basic categories: economic and strategic. When reviewing a captive as a strategy, it’s important to analyze it in contrast with an alternative, which is commonly a high retention program not using a captive.

From an economic standpoint, the main benefit of using a captive to finance risk is that it accelerates the tax deduction of captive premiums paid, leading to a lower after-tax cost. (Captive premium expense is deducted when the premium is paid, versus a non-captive program where the paid losses are expensed over time.)

Apart from the economic benefits, captives offer strategic, value-added benefits, from solving for coverage needs of uninsurable or underinsured risks to formalizing risk retention among subsidiary companies, to direct access to reinsurance markets.

What are the benefits of a captive?

  • Solves for coverage needs
  • Formalizes risk retention among subsidiary companies
  • Provides direct access to reinsurance markets

Common Captive Deal Breakers

The reasons why a captive might not be right for you can also be generalized into economic and strategic buckets. On the economic side, the recent reduction in corporate tax rates may affect captives in the long term. For example, while there is still a robust population of insureds that aren’t taxpayers and still use captives for solely strategic reasons (i.e., much of the healthcare industry), a lower tax rate reduces the economic benefit of a captive.

The cost of capital and the commitment associated with funding a captive and holding reserves is the other reality that prevents many companies from forming captives. If the captive is earning 2% on the funds held, a company that can generate a higher return (by pursuing M&A, paying down debt, etc.) might prefer to allocate that capital to those higher-return investment areas versus tying it up in a captive.

From a strategic standpoint, the common deal breaker, apart from the time commitment, is that there isn’t always a meaningful value-add that the captive is bringing when compared to the existing strategy. It’s a long-term commitment, so it’s important to consider the incremental benefits and how that compares with the alternative.

831b Captives

The growth of the 831b captive marketplace is in large part due to the unique value proposition these captives bring in contrast with other types. Specifically, these captives don’t pay income tax on underwriting income (yet still allow the entity funding the premium to deduct the insurance expense), creating a compelling economic advantage for these captives. Think of traditional types of business risks that might be insured through these captives, such as litigation expense or loss of a key customer. The current premium cap for captives that can elect this treatment is $2.3 million on an annual basis.

831b captives don’t pay income tax on underwriting income but allow the entity funding the premium to deduct insurance expenses.

Since these captives commonly insure low frequency/high potential severity types of risks, an 831b captive adds near-term expense (administrative costs) for the company. Over the long-term, however, for the tax reasons above, it’s extremely efficient to finance these risk areas because the underwriting income isn’t taxable.

The other main strategic benefit of these captives is access to reinsurance for these retained captive risks through risk pools, where risk is shared among other small captives. This helps smooth the profit and loss volatility in the captive. Since they are commonly uninsurable in the commercial insurance market (examples include loss of key customer or litigation expenses), risk pools also provide true risk transfer that is cost-effective and adds value.

While the compelling economics have led to the growth of 831b captives, it has also led to abuse, drawing the focus of the IRS. When exploring these strategies it’s important to be compliant, working with reputable consultants to ensure the strategy can ultimately stand up to close scrutiny.

Despite headwinds, captives remain a robust strategy that thousands of insureds utilize, funding hundreds of billions of dollars in annual written premium. As part of your ongoing risk management strategy, it’s worth regularly considering captives in terms of its value and alignment with your business.

Determining whether a captive is right for your organization can be a challenge, given the diversity of captives and the range of problems they can help solve. In your evaluation, objectively challenge and isolate the true advantages for your company. While there are many potential benefits, keep in mind that many areas commonly cited as benefits aren’t truly unique to captives.

Joining a captive insurance group is an alternative way to manage risk—offering control, consistency, and a way to stabilize your cost of risk over time. Woodruff Sawyer’s captive experts can guide you through an unbiased process to determine whether you’re a good candidate for a captive and will remain with you every step of the way.

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All views expressed in this article are the author’s own and do not necessarily represent the position of Woodruff-Sawyer & Co.

Chris Kakel

Senior Vice President, Casualty

Contributor, Property & Casualty

Chris is accountable to his clients for providing strategic casualty advice, efficient insurance and risk financing program options, analytics to support insurance purchasing decisions, and direct advocacy in the marketplace.

720.593.5406

LinkedIn

Chris Kakel

Senior Vice President, Casualty

Contributor, Property & Casualty

Chris is accountable to his clients for providing strategic casualty advice, efficient insurance and risk financing program options, analytics to support insurance purchasing decisions, and direct advocacy in the marketplace.

720.593.5406

LinkedIn