Captive Insurance As an Alternative Risk Management Technique

A captive insurance company is one that is owned by its parent and/or other similar parents for the sole purpose of insuring the parent’s exposures to claims of losses. Captives are usually owned by a single organization, although, sometimes it can be owned by an association of similar types of businesses.

The carrier issues policies directly to the business owner and provides the risk transfer mechanism that the insured desires. Since the client owns the captive insurer, the insured will be able to participate in all or some of the profits. On the downside, the business owner will also participate in any and all of the claims and losses. Clearly this arrangement presents the insured extreme control over the underwriting, claims and investments. Captives are usually created in industry sectors that are considered high-risk or have high risk exposures for loss.

Most professional liability industries, such as doctors, attorneys, engineers, and other professional organizations have these types of plans for their member organization. Captives can also be formed to deal with catastrophic events that are reoccurring and somewhat predictable overtime. Usually you see this along the coastal waterways with the high wind exposure to loss on property accounts. As with a self-insured plan, which this highly resembles the company profits and commissions are savings that are passed through to the insured. In high risk industries by the nature of their business or because of high risk exposures of loss, captives can provide some continuity in insurance pricing overtime. High risk industries that have exposures to malpractice claims tend to go in cycles depending on laws and regulations and other in inherent global factors.

Businesses that are exposed to catastrophic damages such as hurricanes, earthquakes, floods and the like have losses that tend to come in climactic cycles over long periods of time. These contracts can help prevent these premium highs and lows by stabilizing the premiums over time. Just like self-insured plans, there usually is a tremendous amount of capital that must be invested to make the program work. Thus entering and exiting this program can be complex and difficult just like a self-insured plan. The Captive has tax advantages by having your own captive insurer but it is highly regulated and normally the captive would need to allow outside businesses to access the plan in order to receive favorable tax deduction of premiums.

Within this category of captive insurers there are legislative laws in place allowing risk retention groups to be formed. These groups operate as a sharing of mutual risk financing by insuring all of its owners. Risk retention groups can form quite easily with very little capital as long as the group is a homogeneous group of business owners.

  • Usually depending upon the tax ramifications captive insurers can either be domiciled in the state where the insured is domiciled and thus this is called a domestic insurer.
  • The captive insurer could be based in another state other than the insured State and this would designate the captive insurer as a foreign insurer.
  • Finally, it might make sense to base the captive insurer in another country and that would give it the designation of an alien insurer.

Captive Insurance Company’s fill a certain niche and usually works well within the niche and not so well outside their niche.

How Captive Insurance Really Benefits the Business Owner

When an insurance company is owned by its parent company to protect its own assets and risks it is called captive insurance. In such cases, the policy holder is a parent company that usually owns many subsidiaries or related companies. The formation of the captive insurance company is done to protect itself or its subsidiaries against losses in case of any business related mishap. In this tumultuous and litigious climate that most businesses operate in, having a captive insurance company in place makes immense sense. Captive insurance companies are increasingly becoming an essential part of risk management.

Where captive insurance really benefits the business owner

Companies, whether they are big or small, are finding it increasingly difficult to afford traditional insurance. The cost of insurance premiums continue to soar and it does not appear that this trend will reverse itself anytime soon. Additionally, qualification standards for traditional insurance are increasingly stringent, given the bad experiences the insurance companies have had in the recent financial crisis. When companies do manage to qualify, the premiums are steep and unaffordable. As a result, companies for bear certain kinds of insurance and thereby expose themselves to potentially encounter huge losses. In order to avert such situations, captive insurance becomes a necessary and powerful solution.

There are many benefits to captive insurance. First, as compared to traditional insurance companies’ premium structures, the cost of insurance is much lower. One of the major reasons for this is that a company is not paying to cover any overhead costs or profits of the insurance company. The primary intention of what is captive insurance company, does not have to be profit generation, but to provide better coverage at lower premium costs. Another big benefit to forming a captive is that the claims process is greatly simplified. In a normal scenario, with a traditional insurance company, the parent company is subjected to a biased claims process. However, when a captive is present, the Parent is in complete control of the claims review process, thus it dictates whatever decision it feels appropriate to best serve its interests.

Wealth accumulation through captives

Because the parent company owns the captive, it can tailor make its coverage limits, policy requirements and premium pricing. So the parent, typically, pays lower premiums which will drive cash flow and profits. And, the parent retains the premium dollars it pays to the captive, which it then invests in a variety of investment vehicles. Overtime, with prudent investing strategies and low claims made, the company can become a sizable and powerful asset to the parent company.

Any company that is profitable, has identifiable business risk, and pays high existing insurance premiums is usually a good candidate to form a company.

Formation is a straight forward process of

1) generating a feasibility study

2) writing policies, pricing premiums

3) physical formation of the entity

4) on going management of the company, typically using a qualified 3rd party management company.

Tax Compliance in the EU – A Thorny Issue for Captive Insurers

Insurance Premium Tax (IPT) is an often overlooked source of risk for captives and their parents.

Now that the tax benefits of self-insuring through offshore parties are generally eroded, the captive industry is largely dependent for its success on a high level of risk transfer and risk management expertise. The requirements of IPT payment in the EU complicate these processes and can be an unwelcome and time-consuming distraction for captives not adequately informed or prepared.

Complying with European Union IPT tax laws is an issue for all captives – and traditional insurers – insuring risks within the EU, regardless of where they are domiciled. This is because EU law determines liability for IPT according to Location of Risk.

The EU’s Second Non-Life Directive defines the Location of Risk as the specific country where the insured risk is situated. This ensures consistency in risk assessment and avoids IPT being double taxed – each IPT payment can only be collected in the country where the risk is located. This directive is one area of IPT on which the EU has provided some uniformity.

This concept can be illustrated by the example of, say, a captive with a Dutch corporate parent insuring a factory in Spain: the captive must charge and collect IPT on the Spanish share of the premium and appoint a Spanish tax representative to act on its behalf with the authorities, paying and reporting IPT according to Spanish legislation.

Captives based within the EU (such as in Gibraltar or Malta), in Europe but outside the EU (Jersey), or in any other location (including Bermuda and the Cayman Islands) are all subject to these principles when insuring risk within EU countries.

However, there is no harmonized system of IPT settlement and collection within the EU itself – individual countries are free to decide how and whether to tax insurance premiums. Currently 21 of the 27 EU member states operate IPT regimes, but these vary widely in terms of business classes liable for such taxes and in terms of collection processes.

The complexity of EU IPT is therefore evident, and is deepened further by the 23 official languages and 13 different currencies used in the EU. A multinational corporation operating across several EU territories, perhaps moving its employees and goods from one location to another in the course of its business, can find itself subject to a plethora of national tax codes, practices and cultures.

Captives working within such organizations are often managed by independent insurers whose skills and know-how are focussed on risk, not tax. The potential for non-compliance with IPT regulation in such cases is considerable, and the reputational and financial consequences captives and their parents can suffer are serious. In 2001, the European Court of Justice set a precedent in the Kvaerner case, giving national tax authorities the right to pursue buyers of insurance for premiums unpaid by their insurers. The pressure on captives to come up with complete and reliable solutions for IPT compliance is clearly significant.

The desire for financial and operational efficiency that drives most captives means that many now choose to outsource the management of IPT payments entirely. In addition to keeping captives’ structures lean, this can bring greater transparency to the compliance process than has often been the case, and also reduces a web of multiple relationships to a single point of contact – a ‘fire and forget’ approach to IPT compliance that is rapidly gaining ground. Other captives may still choose to manage the situation directly, typically overseeing a network of local fiscal representatives in various EU states. In choosing between these options, it is important for the captive to decide the level of administrative involvement it desires and, for compliance purposes, to confirm that they will receive documented proof that taxes have been correctly calculated and paid.

IPT is a fact of life when managing risks in the EU, but should not exert undue influence on the commercial decisions taken. By finding the right solution for its needs, a captive can focus on its core task, confident that its tax compliance is assured.