Written by Sabine VanderLinden

• Captive insurance market surged $6 billion to $60 billion post-COVID-19 as corporations sought control over emerging risks beyond traditional coverage gaps: Self-insurance subsidiaries wholly owned by parent companies provide tailored risk management through direct access to international reinsurance markets, tax advantages, enhanced cash flow, and retention of underwriting profits within corporate structure. Fortune 500 companies and large corporations with strong balance sheets, predictable cash flows, and significant uninsured exposures leverage captives to address pandemic-related exclusions, cyber threats, supply chain disruptions, and business interruption risks inadequately covered by commercial insurers.
• Arm's length premium rate calculations using actuarial pricing, market-based methods, and contract comparison approaches ensure regulatory compliance and financial viability: Oliver Wyman partner Daniel F. Gibson's case studies demonstrate that premiums set too low undermine captive solvency while premiums too high strain corporate finances. Independent actuarial expertise, balancing risk distribution, risk shifting, IRS scrutiny, and expected profit methods, enables captives to achieve competitive rates. This reflects actual loss exposure, maintains adequate reserves, prevents insolvency, and satisfies regulatory requirements while delivering superior financial efficiency compared to traditional insurance value chains.
• Captive insurance programs encompass property damage, liability, employee benefits, cyber threats, and non-traditional emerging risks through customized coverage scopes. Unlike traditional insurance value chains, which distribute profits among agents, brokers, and reinsurers, captive value chains retain cost savings and underwriting profits within the business. Streamlined corporate governance integrating financial risk and claims management processes enables a dynamic response to evolving market conditions, delivers bespoke policy design matching unique risk profiles, and provides CFOs, CROs, chief actuaries, and chief underwriters with enhanced control over insurance costs and enterprise risk appetite alignment. 

As I dive into Applying the Arm’s Length Principle to Intra-group Financial Transactions, a book published by Wolters Kluwer and where Daniel F. Gibson, FCAS, MAAA, Partner at Oliver Wyman Actuarial Consulting, Inc. shares a case study on determining arm's length premium rates using an insurance approach, I was particularly interested to understand why Captive Insurance had surged in popularity since the COVID-19 pandemic. I gather that chief underwriters, chief actuaries, Chief Finance Officers, and Chief Risk Officers find the captive model helpful to achieve cost savings and gain access to better controls on their insurance programs, particularly when dealing with the constant rise of emerging risks such as cyber risks.

Indeed, captive programs are a sophisticated form of risk management. It is a form of self-insurance where a company creates its insurance subsidiary to manage and mitigate its risks. These captive programs allow companies to tailor insurance solutions to their specific needs and potentially reduce costs. A captive insurance entity can be a strategic financial tool for a corporation as it operates as a private insurer that is wholly owned and controlled by its insureds. Its primary purpose is to insure the risks of its captive owner or captive owners. As businesses grappled with the unforeseen challenges and market volatilities brought about by the pandemic, many found that traditional insurance coverage was inadequate in dealing with such disruptions. To combat this lack of comprehensive coverage and to gain greater control over their risks and insurance costs, corporations have increasingly turned to captive insurance programs.

Organizing and structuring a captive insurance program requires a deep understanding of not only insurance but also of the specific needs of the business it serves to ensure alignment between the corporation’s growth objectives, its planned initiatives and its operational delivery units. These programs are not one-size-fits-all solutions and, therefore, must be meticulously designed to match the risk profile of the corporation. Ideal candidates for captive insurance are those corporations seeking to lower their insurance costs while assuming more control over their risk management. They often have a strong balance sheet and a stable, predictable cash flow. The scope of coverage can be tailored and may include property, casualty, liability, and employee benefits, among others. Moreover, distinguishing between the traditional insurance value chain and captive insurer value chain is critical, as the latter focuses on the unique interests of the owners. 

Dan highlights in the book that different approaches, such as actuarial pricing, market-based methods, and contract comparison methods, are used to determine arm's length risk transfer premium rates to ensure that the captive insurance company operates under regulatory compliance and sound business principles. Dan also provides best practice case studies to demonstrate the strategic value of group captives in managing risks effectively within various industry sectors but also the importance of the arm length principle and risk tolerance rule, while leveraging independent actuarial expertise.

Key Takeaways

• Captive insurance provides tailored risk management by insuring the risks of its owner or owners.
• These programs fit best with financially stable corporations seeking control over insurance costs and risk management.
• Premium rates for captives are calculated using stringent methods to align with regulatory standards and business efficacy.

Understanding Captive Insurance Programs

Captive insurance programs offer various tools and techniques to manage risks as it helps tailor commercial insurance coverage aligned with your specific business needs.

Definition and Purpose of Captive Insurance

Captive insurance is a form of self-insurance where a parent group or groups create a licensed insurance company to provide coverage for itself. The primary purpose of forming a captive is to improve your control over risk management and insurance costs and to benefit from direct access to international reinsurance markets. By setting up a captive, you can also gain from potential tax advantages and enhanced cash flow. Essentially, captives allow you to retain risks within your corporate structure, rather than transferring them to traditional insurers.

Evolution and Popularity Post-COVID-19

The popularity of captives has surged recently, especially after the COVID-19 pandemic impacted the traditional insurance market. With premiums increasing by over $6 billion to $60 billion. As new risks continue to emerge, it is clear that more companies will recognize the benefits of captives and captive insurers. When commercial insurers were constrained by mounting claims and exclusions, especially for pandemic-related losses, captives provided a reliable fallback for corporations. They offer flexibility in the face of unprecedented risks, enabling corporations to adapt to evolving threats while maintaining coverage stability. This has led to an increased focus on tailoring captive programs to address specific risks that are otherwise challenging to insure in the conventional insurance market.

By understanding these key aspects of captive insurance programs, you're better equipped to evaluate if this risk management strategy aligns with your objectives, risk tolerance and insurance needs.

The Structure and Organization of Captives

To effectively leverage a captive insurance program, understanding its structure and organization is paramount. You'll see that the framework strikes a balance between regulatory compliance, risk control, operational efficiency, and financial benefits. 

Key Components of a Captive Insurance Program

A captive insurance company is an insurance entity wholly owned and controlled by its insureds. Its primary purpose is to insure the risks of its. The key components include the parent company, which is the primary entity that owns the captive insurer. Captives operate under a specific domicile, a jurisdiction with legal and regulatory structures in place for formation and operation. The selection of domicile impacts corporate governance, tax, and capitalization requirements. More complex structures will welcome a reinsurer, too, as part of the design. 

Operational Framework and Management

For your captive to function smoothly, a robust operational and regulatory framework is crucial. This framework comprises a captive management team or a third-party captive manager that handles daily administrative tasks, ensures regulatory compliance, and oversees a robust claims management process. The management team also collaborates with actuaries and underwriters to establish appropriate premium rates that accurately reflect your risk exposure. 

Tax Considerations and IRS Involvement

Tax considerations play a significant role in the organization of a captive. You need to structure your captive to comply with IRS regulations and standards to ensure its recognition as a legitimate insurance company. The IRS scrutinizes captives for risk distribution and risk shifting, and adherence to these principles is necessary for tax benefits. Your captive must demonstrate that it operates in a manner akin to a traditional insurer.

Selection Criteria for Potential Captive Participants

Selecting the right corporations for a captive insurance program involves understanding your company's risk profile — or your enterprise's capacity and risk appetite toward risk — and ensuring that the captive formation of the program aligns with your business needs. It's a strategic decision that could offer control over your insurance coverage gaps and corporate risks.

Identifying Suitable Corporations

When considering participation in a captive insurance program, it is crucial to evaluate whether your organization's business plan aligns with its growth prospects. Fortune 500 companies and other large corporations often benefit from forming a captive due to their size and financial capabilities. You should conduct a thorough feasibility study to assess whether your company can consistently support the captive's business plan both financially and operationally.

• Large, established companies with significant and predictable risks
• Corporations in industries with limited insurance market capacity or costly commercial insurance premiums
• Businesses with a strong balance sheet and cash flow to support the captive
• Organizations seeking more control over risk management and insurance costs

Evaluating Risk Profile and Insurance Needs

Understanding your company's risk tolerance through profiling is essential in determining whether the group's risk appetite to launch a captive program is adequate. You need to analyze current risks, legacy liabilities, potential exposures and the way they change over time.

• Risk Profile: A detailed assessment of the types of operational risks your company faces, looking at both frequency and severity.
• Insurance Needs: Outlining the scope and scale of insurance coverage necessary, including areas where the commercial insurance market may fall short in meeting your needs.

By assessing your risk profile with precision, you can better match it with the extensive capabilities of a captive insurance company. Not every corporation will find this route advantageous. It's specially tailored for those who are effectively self-insured or are seeking to be. A captive insurance solution offers a bespoke coverage scope—crafted around your unique business needs.

Coverage and Financial Aspects of Captives

In the captive world, a captive insurance company help you gain more control over your risk management, which directly influences your coverage options and financial outcomes. The scope of coverage, premium calculations, the structure of your risk financing and the captive's value chain must all be tailored to your company's specific needs, offering a unique level of financial insight and security.

Scope of Captive Insurance Coverages

Captive insurance programs allow you, as a corporation, to customize a policy that fits the unique risks of your business. These coverages can range from general liability to professional liability and other forms of coverage not typically provided by traditional insurers. By taking on these risks through a, you're allowed to manage your claims and protect against financial risk with greater precision. It’s like tailoring a suit: where every stitch aligns with your company's contours—your risk profile and.

Premium Calculations and Fiscal Management

Determining your premiums calls for a comprehensive actuarial analysis. This includes considering deductibles, projected claims, underwriting profits, and overall costs. A sound premium calculation affects not only your ability to cover claims but also the financial health of your captive program. For example, Dan explains in the case studies in the book that setting premiums too low can undermine your solvency, while setting them too high could strain your corporate finances, so leveraging independent advice can help mitigate such issues. Moreover, by closely managing these insurance premiums, your captive may yield financial returns.

The Distinctiveness of the Captive Value Chain

In a traditional value chain, profits are distributed among various stakeholders, including agents, brokers, and reinsurers. But with captives, you operate your own insurance company. This means that the cost savings and underwriting profits stay within your business. Furthermore, integrating financial risk and claims management processes into the corporate governance structure is a critical feature of the model.  This results in a streamlined process that enables you to respond more dynamically to evolving market conditions and risks, particularly in a post-COVID-19 landscape and in markets characterized by uncertainties, where adaptability is paramount.

Strategic Practices and Case Studies  

When designing a captive insurance program, establish competitive premiums and claims management frameworks while learning from proven captive strategies, which are pivotal to your success.

Setting Competitive Arm's Length Premium Rates

Dan confirms that to set competitive Arm's Length Premium Rates, corporations can consider and deploy a variety of approaches. The actuarial pricing approach is the most widely used approach. This method accounts for your unique risks, ensuring that premiums accurately reflect your actual loss exposure. You can also apply tailored calculations using market-based methods to align rates competitively with commercial insurers. Additionally, contract comparison methods can benchmark against similar agreements to ensure fairness and market relevance. Incorporating expected profit methods also ensures that your captive remains profitable and viable.

Captive Insurance Success Stories

Look to the success stories of captive insurance programs for best practices and strategies. Dan’s case studies reveal a trend where captives provide not just risk mitigation but also financial efficiency. Many multinational corporations realigned their risk management strategy post-COVID-19, leading to superior outcomes, reduced insurance costs and improved claims control with their captive. By adopting a comprehensive actuarial pricing approach, they achieved a balanced premium that encouraged risk management and satisfied regulatory requirements.

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Frequently Asked Questions

This section addresses key aspects of captive insurance programs, including their structure, the potential benefits they offer to corporations, and the importance of precise premium valuation.

What constitutes a captive insurance program, and how does it function?

A captive insurance program is a form of self-insurance in which a parent group or groups create a licensed insurance company to provide coverage for itself. The key function of a captive insurance industry is to manage the risks of its owners, allowing them to retain a significant portion of the value of venture capital and the profits from underwriting activities, given their diverse risk appetites.

What are the driving factors behind the rise in popularity of captive insurance since the pandemic outbreak?

Captives have become increasingly popular since the COVID-19 pandemic, as businesses seek to mitigate risk exposures and gain greater control over their insurance coverage in response to market disruptions. They offer more predictable costs and tailored coverage options in a time when traditional insurance may not adequately address all emerging risks.

Can you describe the organizational structure and management of a typical captive insurance program?

Typically, a captive insurance program is structured as a separate entity owned by the parent company or companies. It's overseen by a board of directors and managed by insurance professionals. Captives can be domiciled either onshore or offshore, based on the regulatory framework followed and tax considerations.

What type of corporations stand to benefit most from implementing a captive insurance program?

Corporations with significant uninsured or underinsured risks in the commercial marketplace or those paying high premiums for commercial insurance are best suited for captive insurance programs. These often include large multinational companies or those operating in industries with unique or complex risk profiles.

What range of risks and coverage can captive insurance programs encompass?

Captive insurance programs have a broad scope, often covering property damage, public and product liability, professional indemnity, employee benefits, and even some non-traditional risks, such as cyber threats, supply chain disruptions, commercial market disruptions, risk financing, and business interruption.

How does the valuation of premiums using an actuarial approach contribute to the integrity of captive insurance programs, and why is it vital?

Valuing premiums using an actuarial approach ensures that rates are competitive and reflect captive managers’ actual risk. This is essential, as is investment income, which helps maintain the captive's financial health by ensuring adequate reserve levels and preventing potential insolvency, while also satisfying regulatory requirements.