Basics of Captive Insurance Companies: An Alternative Risk Financing Tool

For almost 20 years, risk managers have enjoyed a soft insurance market where transferring risk to the insurance market through traditional insurance was inexpensive. In this low rate environment, many insureds chose to insure below their risk-bearing capacity, as insurance was an efficient spend and use of capital. While captive insurance company usage was active during the soft market, widespread interest in captives is most prevalent during a hard market.

In today’s hardening insurance market, there is no shortage of news about captive insurance companies and their ability to subsidize or even replace traditional insurance. Many articles assume the reader has a basic understanding of captive insurance company utilization and operation, but that is not always the case. 

A captive is not a silver finance bullet that allows a company to avoid the financial impact of self-insured losses or smooth loss volatility over multiple years. Forming a captive does deliver certain benefits to an organization, but it also comes with some costs. Determining whether a captive makes sense for a particular company is clearly not a one-size-fits-all analysis. The answer to that question is, “it depends.”

The key to successful risk financing, especially with captives, is to accurately compare the expected benefits with the riskiest elements that would apply to each potential owner

The entities forming captives range from major multi-national corporations to non-profit and public entity organizations. Once deployed, the captive largely operates like any commercial insurance company and is subject to state regulatory requirements for reporting, capitalization, and reserves.

While a captive may or may not be appropriate for your company, risk professionals should have a basic understanding of the benefits and downsides of captive utilization. At a minimum, they should conduct a self-examination of how a captive might contribute to their company’s risk management strategy. 

Certainly, talking with peers about their captive usage is helpful, but it is important to remember that each company is different and what is considered a benefit for one company, may be a burden for another. While some companies may view the ability to retain and build loss reserves in the captive favorably, others may feel that “trapped” cash is an opportunity cost. 

Exploring, establishing, and effectively utilizing a captive is an investment of time and resources. It is a decision that requires input from senior leaders within the organization, particularly within the finance department. Realistically, 6 to 12 months of lead time should be allowed prior to forming a captive to allow adequate time to complete an actuarial analysis and feasibility study, select a domicile, and secure professional business services. And, the organization needs to be committed to the captive for the long haul, particularly if longer tail lines or coverage are to be placed within the captive. 

Selecting the right partners for captive exploration, establishment, and management is essential. It is important to consider partner relationships early in the due diligence and feasibility processes. These selected partners will be able to guide the organization in the development of strategies and tactics necessary to prevent and manage losses over the long term. This will ultimately drive captive sustainability and success.

By K. Max Koonce, David Stills, and Chris Mandel

K. Max Koonce is chief Claims officer at Sedgwick. He is regarded as one of America’s foremost experts on workers’ compensation and risk management. He was previously the senior director of risk management of the nation’s largest private sector employer, administrative law judge for the Arkansas Workers’ Compensation Commission and appellate court justice for the Arkansas Court of Appeals.

David Stills is an SVP of Carrier and Risk Practice at Sedgwick. His experience includes serving vice president of global risk management the nation’s largest private sector employer, a role he held for 18 years. He has managed all lines of global insurance, captive insurance company management and U.S.-based casualty claims.

Chris Mandel is founder, president and managing consultant of Excellence in Risk Management, LLC. He has more than 30 years of experience in the insurance and risk field, having served in various leadership roles at large companies. He also served as a Risk and insurance Management Society (RIMS) president and chief risk officer. Mandel is currently serving on several boards spanning the education, workers’ compensation and insurance sectors.

The three recently collaborated on a White Paper about captive insurance companies. 

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