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Captive Insurance Companies

An FEI member from a mid-sized healthcare company recently asked, "What are the advantages and disadvantages of using a captive insurance company instead of traditional insurance?"

The Researcher found a very informative Web site, Captive.com, "The Business to Business Risk & Insurance Exchange," www.captive.com. This site has a number of interesting features, including a "Captive Basics" link that defines and describes captive insurance organizations:

"Captive insurance organizations include insurance companies that are owned and controlled by their insureds. A captive insurance company is described as single parent captive if it is owned and controlled by one company and insures that company and/or its subsidiaries.

"A group captive, on the other hand, is an insurance company owned and controlled by two or more non-affiliated organizations the captive insures. A group captive can be either homogeneous and insure similar types of businesses risks, or non-homogeneous, and insure risks of several types of organizations. In the U.S., group captives are licensed by a domiciliary state and use a fronting carrier, or they operate under the Federal Risk Retention Act. The companies may be stock, reciprocal or mutual in organizational form."

Captive.com also has an "Ask the Expert Forum" that offers frequently asked questions about captives. "Captive Explorer" is an interactive tool that allows users to develop their own examples.

The Researcher also found "Your Risk Management Angel," an article from the April 1999 issue of The CPA Journal: www.nysscpa.org/cpajournal/1999/0499/Features/F280499.HTM 

This article discusses the advantages of captive insurance companies, describes the current state of the captive market, provides information on reporting requirements and taxation and how to avoid adverse tax consequences, and tells companies how to set up a captive.

Among the compelling advantages it points out:

* Meeting unique insurance needs.

* Providing a self-funding mechanism.

* Reducing the impact of the insurance industry's underwriting price cycles.

* Taking advantage of the favorable experience and thereby reducing the cost of managing their risk. Conventional insurers may not take into account the full effect of an insured's good experience when pricing risk. Companies with low loss ratios on property risks may pay premium rates very similar to those of their competitors with high ratios.

* Providing opportunities for the organization to improve risk controls by centralizing the risk management function.

* Increasing control over funds flowing through the organization, through use of possible tax benefits and reducing the cost of risk management.

What Are the Disadvatages?

Are there any disadvantages in using this approach? The Researcher found a Web site called Captive Guru, www.captiveguru.com, and used the service called "Ask the Captive Gum" by simply typing "disadvantages."

According to the Captive Guru, there are three primary disadvantages:

1. Capital Commitment: There are minimum levels of capital that must be injected into a captive, and the actual capital requirement may exceed the minimums, depending on the insurance program. While not applicable in all cases, a premium-to-capital ratio of approximately three-to-one should be considered appropriate. There is an opportunity cost to putting up capital funds, since those funds cannot then be used internally. Captives must be able to demonstrate their contributions to the bottom line, which can be difficult because captives are normally, but not always, operated as cost centers. The risk manager must be prepared to demonstrate that the savings from a captive program generate a return at least equal to the minimum internal rate of return required on other capital projects being considered by the organization.

2. Variability of Financial Results: While captives are designed to reduce costs over several years, actual loss-reporting patterns may create negative variances in any one reporting period. The CFO may want these variances explained.

3. Conflicting Profit Strategies: As previously mentioned, captives are normally cost centers, which may create some friction when a cost center "competes" for funds with profit center departments. Alternate means of justifying the captive must be produced -- i.e., can cost savings over a fully insured program be calculated and expressed in terms of return on investment?

To view additional information generated from the "Ask an FEI Researcher" service, visit the FEI Research Foundation Web site: wwzo.fei.org/rf.