Captives and Risk Pooling: An Overview
Increased interest in captive insurance across a spectrum of industries has led to recent growth in captive insurance company formation. Leading the surge are middle-market organizations who see captives as an attractive option that can complement their existing commercial insurance programs.
Sharing Third-Party Risk
Setting up a captive can be an option for managing risks, particularly those not addressed by commercial insurance, but organizations must understand the requirements necessary for a company to be recognized as a bona-fide insurance company.
One requirement is the need for risk distribution. Enough independent risks of unrelated parties must be pooled to invoke the actuarial law of large numbers. Distribution of disparate risks is one requirement by the IRS for the captive to be considered an insurance company for federal tax purposes.
For small to middle-market companies, it can be difficult to satisfy this requirement within their own insured programs. However, there are options available to the captive owner. One popular method is to participate in a risk pool which provides a reinsurance structure where risks of a number of captives are blended and shared.
Participants pay a portion of their direct written premium to the pool to buy reinsurance. They then assume an equivalent amount of risks from fellow participants. This concept has been underscored in IRS Revenue Ruling 2002-89, a safe harbor rule stating that captives with at least 50 percent of premiums from third parties satisfies the requirement for risk distribution.
Risk Pool Governance and Control
In addition to risk distribution at the individual level, best practices dictate that risk pools employ governance and control protocols to ensure structural stability and financial integrity. These include: providing timely and accurate reporting, demonstrating underwriting control with new and renewing participants, and maintaining the overall financial strength of the pool.
The risk pool must be independent, or run separately from the members, including separate books and records. The focus of pool managers is to protect all participating members; no single member’s needs are to take precedence.
Risk pools also must demonstrate risk distribution. This requirement does not just fall on the individual member captive; the pool itself must meet the same distribution requirement by having a sufficient number of members and an even spread of risk among those members.
Guidance: The Key to Understanding
Risk diversification can mean that individual participants may assume risks they are not familiar with or do not fully understand. Furthermore, it is likely that participants may be unable to control assumed risks.
Strategies to mitigate this include creating a pool of low frequency risks where loss activity is low, or conversely, a pool of high frequency risks in which the exposure is more easily identified and less volatile. The potential for misunderstanding the downside of risk pooling underscores the need for an experienced adviser.
Members should understand benefits and obligations of participation, as well as how transactions within the pool are handled.