United States: What's All This I Hear About Captives?

In our experience, a lawyer specializing in insurance coverage—even a whole group of insurance coverage lawyers—can practice for decades hearing the word "captive" thrown about by brokers or risk managers in large companies without being asked to address legal issues relating to a captive and without understanding what the heck a captive is or how it works. The National Association of Insurance Commissioners ("NAIC") and the Center for Insurance Policy Research define a captive as "an insurance company created and wholly owned by one or more non-insurance companies to insure the risks of its owner (or owners)."1 So at its core, a "pure" captive is a quasi-insurance company set up and funded by a business to serve as a form of self-insurance.

Captive Facts and Figures

While captives have been in existence in some form for 100 years, the use of captives has exploded in the last thirty-five years. According to A.M. Best, there are approximately 6,000 captives globally, up from 1,000 in 1980. The businesses who take advantage of this form of risk retention range from huge multi-national corporations (most Fortune 500 companies use captive subsidiaries) to small businesses in highly regulated industries (e.g., trucking) to sophisticated non-profits (e.g., hospitals). The formality, complexity, and size of captives ranges similarly. For instance, of the 6,000 captives currently operating, A.M. Best rates 200 of them. A.M. Best explains why a captive would want its rating services:

Although a rating on a captive is comparable to any other rating issued by A.M. Best, we recognize that captives serve special purposes and typically have an operating style that differs from the conventional market. A rating can be of benefit to a captive by demonstrating its financial strength and its best practice performance to a variety of stakeholders, such as fronting insurers, reinsurers, and a parent not otherwise engaged in insurance.2

In a parallel regulatory regime to conventional insurance companies, the organizing entity of a captive insurer must "domicile" the captive in a particular jurisdiction. Few jurisdictions, however, provide for captive-domiciled insurers, although that number is growing. The most popular domiciles for captives are Bermuda, the Cayman Islands, Guernsey, Luxemburg, Ireland, and Vermont (who would have thought?). Each of these domiciles provides a statutory regulatory structure which imposes greater or lesser requirements of reporting, capital, and reserves. For example, Vermont's insurance statutes contain a lengthy section devoted to the establishment and regulation of captives. See 8 VSA § 6001, et seq. Along with the regulatory regimes, an industry of lawyers, accountants, and actuaries has grown up to provide the services necessary to support captive insurers.

Why Form A Captive?

So why would a business with no experience in the insurance industry go to the time and expense to set up a captive insurance company in the Cayman Islands (sounds good for winter board meetings) or Vermont (sounds good for winter or summer board meetings) to cover its risks? The answer to this question differs depending on whether a company considers the use of a captive as an alternative to real self-insurance or as an alternative to purchasing a conventional insurance policy.

As an alternative to real self-insurance where a business simply absorbs and pays out of income all of its losses, a captive offers financial and administrative benefits. First, the premiums paid to a captive insurer that serve as the reserve fund for the payment of losses are tax deductible. This is not the case for losses paid directly by the business, even if the business has set up a separate reserve fund. Second, if a business faces a significant volume of claims, the establishment of a captive can reduce balance sheet uncertainty by providing historical claims and loss data, and can professionalize the approach to claims handling and reserve setting.

As an alternative to commercial insurance, a captive offers both significant advantages and some notable disadvantages. Based on the perceived riskiness of their industry, or a history of significant claims or other perceived blots on their record, some business are simply unable to purchase needed insurance at a reasonable price—or at all. Commercial insurance also sometimes includes exclusions or coverage language that does not match the risks of the business and is accordingly not worth the premium. Formation of a captive can take the place of commercial insurance, or can provide a primary layer of insurance that makes it more palatable for commercial insurers to sell excess above the captive layer. Running insurance through a captive using a reputable actuary to make projections for several years provides historical claims and loss payment information and reserving data that may eventually lead to commercial insurers taking on the risk. Depending on the type of business, a captive primary level, or a captive reinsuring a commercial fronting insurer, can save significant money. In an insurance tower, primary insurance is typically the most expensive. A well-run captive can reduce the primary layer cost by eliminating the commercial insurer profit margin and risk premium and layers of overhead. (Some estimate the savings at 15-30 percent).

All those advantages do not come without disadvantages. For instance, some business entities are simply not equipped to establish and run an insurance company, no matter whether it is minimally regulated or heavily regulated. To do the job properly, the business must hire experienced claims administrators to take in and evaluate claims, assign claims handlers or hire outside counsel, supervise outside counsel, work with actuaries to set appropriate claim reserves, work with accountants to properly administer the books and records of the captive, set up a formal governance structure with a board and annual meeting in the domicile, and interact with the regulators. In a huge corporation with many claims, the captive administration is a big business. Because large corporations have insurance towers in every segment of their risks (D&O, E&O, cyber/IT, EBL, fiduciary, etc.), the captive insurer is the primary claims administrator and its handling of claims may affect the interests of the excess insurers. Once a large claim hits that may call on excess insurance, excess insurers will undoubtedly flyspeck the work of the captive and even deny claims based on alleged negligence or intentional misconduct by the captive which typically might include faulty notice and under-reserving. Regulators may claim that a captive has over-reserved, a practice that shelters more income of the sponsoring entity from taxation.

Captives Come in Different Flavors

As stated above, the "pure" captive insures only the risks of the parent, sponsoring company or owner. There are also "group" or "association" captives that are formed by unrelated groups of entities for the purpose of insuring the group against similar risks. There are also "rent-a-captive" arrangements where a company may sponsor a captive and then "rent" out the capital of the captive to other businesses who then maintain an account within the captive, but do not have the burden of maintaining and administering the captive's insurance functions. There are "protected cell" or "segregated cell" captives which provide for separate accounts within the captive for different business entities where the capital of each cell is not exposed to the liability risk of the other cells. Each of these captive types carries its own advantages and disadvantages, greater or lesser administrative burdens and higher or lower expenses.3

So what's not to like about captives? They can cost less, cover more, and provide for much greater control by the sponsoring companies in the handling of claims. But the advantages come with complexity, statutory regulation, the need to engage professionals, and the imperative of scrupulous oversight.

Footnotes

1 "Captive Insurance Companies," http://.naic.org/cipr_topics/topic_captives.htm (Updated 3/28/2016).

2 AM Best Captive Update, News of Alternative Risk Markets From A.M. Best Company, January, 2016.

3 While the subject of captive insurance – like actuarial science – seldom appears on the top ten most exciting insurance topics, the most current "hot topic" in captives relates to the establishment of captives by insurance companies to finance a particular type of reserves in the universal life context. In some circumstances, understood only by those steeped in the topic, these reserves are considered excessive or redundant statutory reserves. Insurance companies set up captives to fund these redundant reserves and can use assets to capitalize the captive that would not permitted reserves on their own books (non-admitted assets).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions