Introduction

Although many people think captive insurance companies are a relatively new phenomenon, the “captive” concept can trace its origins back to the beginning of formalized trade. One of the first captives was formed in the late 1800s, and was designed to write more cost effective fire insurance policies for New England textile manufacturers that were hit hard by increasing market rates. However, growth of the captive market was slow, and only about 100 captives were formed until the 1950s. The real growth of captives began in the 1960s in the Bermuda market. The 1970s and 1980s represented a period of tremendous growth in captives in response to a hard insurance market and difficulty obtaining product liability coverage.

Today, there are over 7,000 captives in existence that typically represent commercial, economic and tax advantages to their sponsors due to the cost reductions they help create, the ease for insurance risk management and the flexibility for cash flows they generate. Additionally, they provide coverage for risks that are neither available nor offered in the traditional insurance market at reasonable prices, and, if necessary, allow the relevant group direct access to reinsurance markets.

What is a captive?

A captive insurance company is a closely held insurance company whose business is primarily supplied by and controlled by its owners. Captives are insurers owned by the insureds and organized for the main purpose of self-funding the owners’ risks. The shareholders/insureds actively participate in decisions influencing the underwriting, operations, and investments of a captive insurer.

Part of the mystery surrounding captives undoubtedly arises from the broad range of insurance institutions that are organized under the heading of “captive insurers”. Some captives, for example, are owned by a single parent, and write business only for that parent, while others may be owned by and underwrite risks for an association or an industry group. In some cases, the captives are owned by a party unrelated to the insured, but who “rents” the captive’s surplus to a firm wishing to set up a self-insurance program. The services provided by a captive can also vary depending on the needs of the insureds. Some captives engage in active underwriting through risk classification and pooling, while others may serve simply as a conduit through which the assumed risks are transferred to the international reinsurance markets.

The advantages conferred by a captive insurer can be substantial. The control that ownership of the captive affords the parent company can be useful by permitting the tailoring of insurance products and underwriting standards to the specific circumstances of the insured, particularly in cases where coverage might otherwise be unavailable or prohibitively expensive. Ownership also permits the parent an exceptional degree of control in the determination of appropriate litigation and claims settlement strategies, which then necessarily reflect the needs of the parent rather than only those of the indemnifying insurer. In other settings, the direct access to reinsurance markets that a captive permits may reduce the cost of laying off risks, and ownership of the captive allows the parent to reap the benefits of favorable loss experiences enjoyed by the captive.

Finally, the captive form of insurance may provide a tax benefit to the parent firm. Contributions to a self-insurance pool are not recognized by the IRS to be tax deductible business expenses, although the actual losses are deductible as they are paid. Premium payments to an insurer are, however, permissible business expenses that may used as an offset to taxable corporate profits.