With commercial insurance, your premiums reflect the risks and claims of a broad pool of companies, as well as a projected profit margin for the insurer. A captive ties your insurance costs more closely to your own claims experience, allowing strong risk management to work to your advantage.
Your company may spend millions annually on commercial insurance, but not all of that money covers your own risk. Your premiums also fund the insurance carrier's expenses, profit margin and losses across a broader pool of customers. Even if you have a good year with few claims, the financial benefit generally stays with the insurer rather than your business.
A captive changes that arrangement by allowing your company to retain some of the risk it would otherwise transfer to a commercial insurer.
A captive is a licensed insurance company that a business creates and operates to insure its own risks.
With self-insurance, you set aside funds to pay claims. In contrast, a captive is a separate legal entity that collects premiums, holds reserves, pays claims and is regulated like any other insurance carrier.
Companies typically don’t transfer all their risk to a captive. A captive gives you more flexibility to decide which risks to retain. Large companies usually buy coverage in layers, each covering a range of potential losses. For example, a company with $100 million in liability coverage may buy one policy covering the first $20 million of any loss and then buy additional policies covering losses above that amount, up to $100 million. The more risk a company retains in its captive, the more capital it may need to cover potential claims.
A captive typically works best in the first layer, known as the “working layer,” which covers smaller, more frequent claims, including losses you would otherwise pay through a deductible. The company pays the premiums to its captive to cover the working layer, then uses commercial insurance carriers for larger, less frequent losses above that amount, known as the “excess layer.” This arrangement can reduce your commercial insurance costs.
Consider a company spending $20 million annually on workers’ compensation premiums with a commercial carrier. If it forms a captive to retain 60% of that risk, covering its frequent and predictable claims, $12 million in annual premiums would flow into its captive insurance company. Any funds the captive doesn’t spend on claims and expenses remain in the captive, rather than going to a commercial insurance carrier.
Savings can come from several sources. Captives typically have lower overhead and fewer fees than commercial insurance carriers, and their premiums don’t include a commercial insurer’s profit margin. A captive that meets IRS requirements for risk transfer and risk distribution may qualify for insurance tax treatment, potentially allowing you to deduct your premiums. The captive can also earn investment income on funds it holds.
Captives can cover two broad categories of risk, each with different opportunities for savings.
Property and casualty captives cover risks such as workers' compensation, general liability and property. Savings potential generally increases with premium spend, but actual results depend on how effectively you manage and reduce your risks.
Accident and health captives are most commonly used for medical stop-loss coverage, which protects a self-funded health plan against unusually large individual claims or larger-than-expected total claims. Potential savings depend heavily on the workforce and are measured per employee rather than by premium spend. For illustration, an employer with a younger, healthier employee population and a clean claims history might save around 30%, compared with about 10% for an older population with higher claims.
Some companies may use captives to cover property and casualty risks as well as health risks, with CFOs overseeing the former and HR and benefits leaders managing the latter.
Forming a captive isn’t the right move for every business. Good candidates tend to share a few traits.
A captive generally makes more sense when there is enough insurance spend to create meaningful savings. Potential indicators include $1 million to $10 million or more in annual commercial insurance premiums and a total cost of risk of about $5 million or more. For health captives, employers with roughly 1,000 to 5,000 or more covered lives may be better positioned to benefit.
Financial strength and the ability to set aside capital also matter. Factors to consider include stable cash flow, consistent earnings before interest, taxes, depreciation and amortization (EBITDA) and sufficient net worth. Predictable losses and a strong track record of managing risk can also make a captive more attractive.
There also needs to be a long-term commitment, as a captive requires capital that’s separate from existing insurance spend, along with ongoing governance, including officers, board meetings and regulatory oversight. Finally, you must be comfortable with risk, recognizing that greater potential savings also come with greater exposure to losses.
Forming a captive is a structured process, most of which follows a predictable path.
Once your captive is up and running, outside specialists can handle much of the technical and day-to-day work. A pricing actuary, often part of the broker’s team, sets premiums and designs the policies while a reserving actuary certifies each year that reserves are adequate. The captive manager handles day-to-day accounting, compliance and regulatory filings, while independent auditors and tax advisors assist with the financial statement audit and tax returns. Meanwhile, you and the captive's officers remain responsible for oversight and key decisions.
Establishing a captive can require a significant upfront capital investment. The amount depends on factors such as the domicile's regulatory requirements, the risks insured, premium volume and coverage limits. For the right business, the potential long-term savings can outweigh the costs of establishing and operating the captive.
If you’re interested in forming a captive, start by reviewing your insurance spend, loss history and risk management practices. Experts on our Captive Insurance Services team can help you determine whether a captive is right for your business and plan your next steps.
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