Just as businesses are facing many emerging risks, caused by climate change or the adoption of new technology in the workplace, insurance costs are rising.
Property insurance premiums in some parts of the world are becoming unaffordable as insurers have been stung by more frequent and intense tropical storms, wildfires and flooding. At the same time, insurers can find it difficult to determine the right price and coverage for new risks, such as the use of artificial intelligence or cyber crime.
In this so-called hard insurance market cycle, where premiums become more expensive and coverage more limited, captive insurance is increasingly an option. Using this form of self-insurance, companies form their own related insurance company to insure specific risks instead of buying insurance in the commercial market.
Depending on the type of risk and the size of the business, captive insurance can be more cost-effective than traditional insurance. It can also offer a range of financial and risk management benefits, especially for risks that are either very expensive to insure or not insured at all by commercial insurance companies.
Lower premiums, more coverage
Creating one’s own licensed insurance company to provide coverage can be cheaper than buying insurance for several reasons.
Commerical insurers will typcially pool the risks of various insured parties. Whenever there is an unexpectedly high number of loss events, the cost of insurance is likely to go up in the following year, even for those insurance buyers that have not made a claim. Self-insurers in turn only manage their own risks, which they are very familiar with. The cost of captive insurance is therefore more aligned with the captive owner’s risk and loss experience.
Hospital chains in the United States for example can face extremely high premiums for medical malpractice insurance. An affiliated captive can provide dedicated coverage for the hospital’s physicians and staff, often at much lower cost. Medical malpractice is one of the most common uses of self-insurance and the cost savings can be be passed on to patients.
For the same reasons captive insurance can provide coverage that is not commercially available. Insurers tend to find new risks difficult to price, because there is no historical data to help calculate the likely frequency and severity of future insurance claims. For other risk, such as climate risks, insurers believe past experience of storms or wildfires, for instance, is simply no longer a good basis to predict how often they are going to occur and how destructive they are going to be in the future.
Data breaches and cyber attacks among different types of businesses and organisations are another type of risk that has been difficult for insurers to quantify. Due to the nature of quickly developing threats, a captive can be a solution by offering coverage that is more in line with the individual risk profile of the parent company than traditional insurance would.
Turning an expense into a potential profit
By running an affiliated insurance company, organisations can turn a business cost item into a potential profit centre. Premiums that are paid by the parent company to its captive insurer remain a tax deductible business expense. But the premiums are invested and any surplus from the investment returns can be shared with the captive owner via dividend payments, if no insurance claims have been made.
By buying commercial insurance any such surplus would be retained as profit by the insurance company.
Commercial insurers will also pass on their operating overheads to the insurance buyers. Running a well-managed captive insurer can therefore potentially be less expensive in comparison.
Self-insurance can prompt better risk management
Moreover, having to pay directly for their own losses might encourage companies to pay more attention to risks, improved safety and loss management programmes than they would if they had taken out insurance.
Overall, a captive will incentivise and allow an organisation greater control over its risk management. Having a licensed insurer gives a company, for example, access to the reinsurance market that it would not ordinarily have. Reinsurance, a form of insurance for insurance companies, enables captive insurers to pass on some of their risk to third-party reinsurance providers.
In the event of a loss, owning a captive insurer also allows more efficient handling of the claims and cash flows.
Captives are managed by service providers
Forming an insurance company can seem more daunting than it actually is. Captive insurers are run by a service provider, a so-called insurance manager.
The insurance manager will help a company draft a business plan that will then be presented to the insurance regulator to obtain an insurance licence.
Once operational, the insurance manager will create insurance policies, calculate premiums, oversee investments and handle claims. Service providers ensure regulatory compliance, make all the necessary filings, and manage the captive’s finances.
They will also participate in board meetings and report on the captive’s performance.
While originally a captive insurer would only insure the risks of its parent company, there are now many different types of captive insurers. In addition to single-parent captives, group captives can be cost-effective in cases where individual premiums are not able to support the running costs of a single captive.
In a group captive unrelated companies can come together to take advantage of greater economies of scale and the ability to spread the risk among the captive owners.
Associations can use a similar model to insure homogenous risks of their members in an association captive.
Not for everyone
Despite the many risk management and cost benefits, captive insurance is not for everyone. Because establishing a captive requires a significant capital investment, it is only suitable for larger, financially stable organisations that are willing to commit to the long-term advantages of self-insurance, after the initial set-up costs.
Larger companies are also more likely to be exposed to a wide range of risks that could benefit from customised insurance solutions. In particular organisation that have large or unique risks should consider if self-insurance offers a better risk management alternative. For many other risks, commercial insurance may still be a viable option, even in a hard insurance market.
