5 Crucial Considerations When Forming a Captive

The benefits of owning or participating in a captive may be well reported, but what are the additional factors that firms need to consider when forming a captive?
By: | August 21, 2020

A hardening market, a persistently low interest rate environment and the onset of the COVID-19 pandemic have all prompted many companies to turn to captives for their insurance needs.

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That’s not to mention the added pressure of reductions in coverage, limits and terms and conditions by the standard market, with some lines being pulled altogether.

Marsh Captive Solutions alone has reported a whopping 227% year-on-year rise in captive formations in the first half of 2020. The biggest take-up has been in property, excess liability, directors and officers and product liability.

The benefits of owning or participating in a captive are obvious: They can enable you to secure more flexible, wider and more affordable coverage tailored to your needs, greater control and management of claims, underwrite third party business, and add access to the reinsurance market, as well as some obvious tax advantages.

But what factors do firms need to take into account when forming a captive?

Here, we have identified five key considerations to bear in mind:

1) Identifying your needs and risks you want to cover.

The first step businesses need to make is to decide if they need a captive at all.

“The very first step is to determine whether a captive actually makes sense for your insurance needs,” said Michael Serricchio, managing director for Marsh Captive Solutions.

To do this, businesses must identify their key insurance problems, assess their entire program and determine exactly what they need in terms of coverage.

Then, they need to look at all their risks collectively and decide which ones they want to retain and self-insure through the captive. Within this evaluation, they have to weigh up all the regulatory and contractual requirements, as well as establishing the policy limits they need.

“You need to look at your complete insurance program, not just one or two lines, to decide what is going to be the best strategy for you moving forward,” Serricchio said.

2) Establishing your risk profile/appetite.

It’s also critical for companies to establish how much risk they are willing to and can afford to take on.

Jason Palmer, director, Global Captive Practice, Willis Towers Watson

“In the context of a wholly-owned pure captive, it is very likely that the captive entity will be consolidated into the financial results of its owner, therefore it is critical to ensure that the captive’s risk profile and appetite align with that of its ownership/insureds,” said Jason Palmer, director for Willis Tower Watson’s Global Captive Practice.

The company needs to realize that forming a captive is a long-term commitment for which they must be prepared to incur premium fluctuations and losses, whether individually or as part of a group of participants.

A typical profile of a firm looking to establish a captive is that they have $30 million or more in gross revenue, spend $200,000 or more annually on property and casualty coverage and have 75 or more employees.

They should also have a proactive approach to risk management and a strong balance sheet.

“Additionally,” Palmer added, “captives can serve as a valuable tool to contend with inter-organizational risk profiles and appetites.”

3) Assessing your costs/capital requirements/financials.

Businesses must also look at the costs involved in forming a captive and determine how much capital they need to hold to protect themselves against the risk. Other expenses include administrative costs, premiums and losses, as well as any other financial needs directly related to them or their industry.

That requires the company to carry out a feasibility study to compare these costs with the benefits of setting up a captive. They should also examine their historical and market losses to try and predict what they will likely have to pay out in premiums and claims in future years using different scenario models.

“You need to consider not only what you will be spending on coverage, but also the claims likely to be paid out at the back end,” said Nate Reznicek, director of operations at CIC Services.

“You also need to determine how much risk your balance sheet is able to withstand.”

4) Determining the right structure of captive.

There are an array of different types of captive structure to choose from, including pure or single-parent, group, association and protected cell captives, and risk retention groups.

Elizabeth Steinman, managing director, Risk Finance & Captive Consulting Practice, Aon

Each has its own set of benefits, depending on whether the parent company wants to have complete control of its risks or pool them with a group of other companies.

“There’s no cookie cutter approach,” said Elizabeth Steinman, managing director of Aon’s Risk Finance & Captive Consulting Practice.

“It’s really about determining your size, risk appetite and individual challenges as a company and then assessing what would be the best fit.”

The choice of captive will generally be determined by the ownership structure and level of capitalization. Having carried out the feasibility study, firms should be able to establish the structure best suited to their needs.

5) Choosing the right domicile.

Another key consideration for businesses is finding the best domicile for their captive.

There are a host of domiciles ranging from U.S. states like Vermont and North Carolina to offshore financial centers such as Bermuda or the Cayman Islands.

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“Offshore tends to be a little easier to do some third party business; their licensed structures tend to be designed to suit that model, whereas onshore is more accessible in terms of travel,” said Dave Provost, deputy commissioner of the State of Vermont’s captive insurance division.

“You also need to look at what is required in terms of compliance and the set-up, strengths and experience of that particular regulator.”

It’s also important to choose a captive manager that is represented or is licensed in more than one domicile so that you are being offered a good selection of options rather than the one that is most convenient for them.

They must also be experienced in making recommendations on key third party administrators needed to run a captive, including actuaries, auditors and lawyers. &

Alex Wright is a UK-based business journalist, who previously was deputy business editor at The Royal Gazette in Bermuda. You can reach him at [email protected]

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The R&I Editorial Team can be reached at [email protected]