British Virgin Islands: Captive Insurance Companies - What Are They?

A captive insurance company is, in its simplest and purest form, an insurance company that only insures all or part of the risks of its parent. This definition is, however, rather narrow and fails to reflect the way in which captives have developed over the years. A captive may more usefully be described as an insurer that writes risks whose origins are restricted or risks to which it has unique access.

In the last 20 to 30 years there has been phenomenal growth in the number of captive insurance companies so that today there are well over 4,000 captives worldwide writing more than $20bn in premium. These companies have capital and surplus estimated at over $50bn.

The captive insurance industry can be said to have its origins in the formation of mutuals and co-insurance companies in the 1920s and 1930s. However, the start of the real growth of the captive industry can be traced to the early 1950s and the move by parent companies, to establish their captives offshore.

The greatest stimulus to the development of captives has been the expense or lack of availability of certain types of insurance cover in the commercial market. Other considerations apply, however, and these have become so important in the minds of risk managers and finance directors that, even when commercial premium rates have been extraordinarily low, the interest in captives has been greater than ever.

Evidence of this interest is provided not only by the number of captives being formed but also by the increasing number of domiciles available for their incorporation. Long-standing domiciles, such as Bermuda, the Cayman Islands, Guernsey, the Isle of Man and Luxembourg have been joined by the likes of Vermont, the British Virgin Islands, Gibraltar and Dublin. In a move that demonstrates forcibly the emergence of captives into the mainstream of the insurance and risk management arena, the Council of Lloyd’s passed a byelaw in November 1998 permitting the establishment of captive operations at Lloyd’s.

In its simplest form a captive can be defined as a wholly owned insurance subsidiary of an organisation not in the insurance business whose primary function is to insure some or all of the risks of its parent. Since captives were first formed the industry has looked at new ways of developing the captive model to provide appropriate vehicles for a wide range of different owners and users. There are now many types of captive, including:

• Single-parent captives, underwriting only the risks of related group companies.
• Diversified captives underwriting unrelated risks in addition to group business.
• Association captives which underwrite the risks of members of an industry or trade association. Liability risks such as medical malpractice are frequently insured in this way.
• Agency captives formed by insurance brokers or agents to allow them to participate in the high-quality risks, which they control.
• Rent-a-captives are insurance companies that provide access to captive facilities without the user needing to capitalise his own captive. The user pays a fee for the use of the captive facilities and will be required to provide some form of collateral so that the rent-a-captive is not at risk from any underwriting losses suffered by the user.
• Special purpose vehicles (‘SPV’s) are used in risk securitisation. They are reinsurance companies that issue reinsurance contracts to their parent and cede the risk to the capital markets by way of a bond issue.

Captives may be established as direct-writing companies issuing policies to, and receiving premiums from, their insureds but the insurance industry is generally highly regulated and, in many jurisdictions, certain risks may only be written by an admitted insurer. Usually, and particularly in the case of smaller captives, it is simpler for the captive to operate as a reinsurer accepting the risks of its parent, which have been insured by a licensed direct-writing company (a ‘fronting company’) and then ceded to the captive. The fronting company will charge a fee for its services and may require a letter of credit to guarantee the captive’s ability to pay claims.

It is popularly thought that a captive is primarily a tax minimisation device. In fact, captives are usually formed for other economic reasons with the main drivers being risk management and risk financing. Some of these reasons are summarised below.

• Lower insurance costs. Commercial market insurance premiums must be adequate to meet the cost of claims but, in common with other commercial enterprises, insurers are in business to make money and will therefore include in the premium an element to provide for their acquisition costs, overheads and profit. This portion of the premium can represent as much as 35% or 40% of the whole. In establishing a captive, the parent seeks to retain the profit within the group rather than see it go to an outside party. A captive may also help reduce insurance costs by charging a premium that more accurately reflects the parent’s loss experience.
• Cash flow. Apart from pure underwriting profit, insurers rely heavily on investment income. Premiums are typically paid in advance while claims are paid out over a longer period. Until claims become payable the premium is available for investment. By utilising a captive, premiums and investment income are retained within the group and, where the captive is domiciled offshore, that investment income may be untaxed. Additionally the captive may be able to offer a more flexible premium payment plan thereby offering a direct cash flow advantage to the parent.
• Risk retention. A company’s willingness to retain more of its own risk, particularly by increasing deductible levels, may be frustrated by the inadequate discount offered by insurers to take account of the increased deductible and by the fact that the company is unable to establish reserves to pay future claims. Establishment of a captive can help address both these problems.
• Unavailability of coverage. Where the commercial market is unable or unwilling to provide coverage for certain risks or where the price quoted is seen to be unreasonable, a captive may provide the cover required.
• Risk management. A captive can act as a focus for the risk management and risk financing activities of its parent organization. An effective risk management programme will result in recognisable profits for the captive. Risk management can be viewed by a captive owner not as a cost centre but as a potentially profitable part of the company’s activities. A captive can also be used by a multinational to set global deductible levels by enabling a local manager to insure with the captive at a level suitable to the size of his own business unit while the captive only buys reinsurance in excess of the level appropriate to the group as a whole.
• Access to the reinsurance market. Reinsurers are the international wholesalers of the insurance world. Operating on a lower cost structure than direct insurers they are able to provide coverage at advantageous rates. By using a captive to access the reinsurance market the buyer can more easily determine his own retention levels and structure his programme with greater flexibility.
• Writing unrelated risks for profit. Apart from writing its parent’s risks, a captive may operate as a separate profit centre by writing the risks of third parties. In particular, an organisation may wish to sell insurance to existing customers of its core business. For example, retailers may sell extended warranty cover to customers with the risk being carried by the retailer’s captive. The claims pattern of this type of business is usually very predictable with a large number of small exposures and can provide the retailer with a valuable additional source of revenue.
• Tax minimisation and deferral. The tax considerations in forming a captive will depend on the domicile of both the parent and the captive. Integration of a captive as part of an overall tax planning strategy is a complex subject so that professional legal and tax advice is essential.

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