Closing the circle

Innovative risk management strategies are on the rise

Captives - insurance companies established to insure the risk of its parent company and affiliated organisations - have been around since the 1920s, but until 30 years ago very few companies used them. Located offshore in places such as Bermuda and the Cayman Islands, they have few regulatory restrictions which allow a more favourable tax treatment compared to domestic captive insurance companies.

Captive insurance companies first used captives as tax-reduction vehicles but over the years many have turned to captives because some of their insurance premiums have risen significantly. More and more companies are establishing captives to insure a variety of risks, including property and casualty, general and auto liability, product liability, and employee benefits such as long-term care and supplemental life insurance plans.

Captives allow businesses to purchase excess insurance coverage directly from reinsurers since reinsurers have less stringent regulation. Captives also allow firms to retain a large portion of its risk and still satisfy insurance requirements, regulations, and demands from third party certificates.

In 1975 the hard market for property and casualty insurance compelled businesses to form their own insurance companies to cover their risks. Acordingly, the liability insurance crunch of the mid 1980s led even more companies to utilise a captive to make liablility insurance more affordable. More recently the far reaching construction defect lawsuits of the 1980s and 1990s has, along with the events of September 11, led many builders and developers to cry mercy at the obscene cost of general liability insurance. Many of these companies sought refuge by setting up their own insurance companies to write this coverage.

The growth and use of captives is becoming a fairly predictable pattern. Rocketing premiums force companies to seek alternatives to traditional insurance. Therefore, it is no surprise that more and more businesses are turning to captive insurance companies to cover their employee benefits.

There are a number of commercial advantages to using captives to provide a better risk management than conventional insurance:

Flexibility. When the market is soft, the captive can take advantage of the low rates by reinsuring a relatively large proportion of its risks. The low cost of reinsurance allows the captive to build its reserve base. When the market hardens, the captive is able to retain a larger proportion of its risks, and can maintain cover for its parent even when commercial insurance is unavailable or prohibitively expensive.

Claims management. The process of making a claim from a third party insurer can be long and involve a good deal of cost for the claimant. Where the insurer is a captive, the claims handling procedures can be dictated by management, cutting down on the delays and bureaucracy that are often a necessary part of the claims handling procedures of commercial insurers.

Claims experience benefits. Captives generally retain a portion of the overall risk and reinsure the remainder. For this reason, when claims experience is better than anticipated, the excess of net premiums over claims is retained by the group. The reinsurance taken out by the captive is tailored to minimise the group's exposure where claims experience is worse than projected.

The types of risk that a captive can underwrite for the parent include property damage, public and products liability, professional indemnity, employee benefits, employers liability, motor and medical aid expenses. For example, if the medical claims of your company are lower than those of the industry as a whole, then a captive can be used to recoup the difference between the premiums paid and the dollars used to pay claims. In many cases corporate clients have paid fairly large premiums with fairly modest claims experience. In any of those instances did the carrier offer to split the profits, or refund some of the premiums to the client? Of course they didn’t. Now consider the captive insurance company. When claims close lower than the premiums paid, the profit is retained by the captive, not the commercial insurance company. Profit is often made greater by an operating ratio that trounces those of traditional insurance carriers.