The benefits of captive insurance

29 March 2017

Written by Charles Scott

In a world of corporate risk, ARM Managing Director Charles Scott looks at the benefits of insuring against parent liabilities.

Some of the earliest methods of transferring or distributing risk in a monetary economy were practiced by Chinese traders who, when making a treacherous river crossing, would distribute their wares across many vessels to limit the loss due to any single vessel’s capsizing.

In the millennia since, the methods used to transfer or distribute risk have become more numerous, diverse and sophisticated. The latest means of risk distribution is far more versatile than an extra vessel: the captive insurance company.

What is a captive?

A captive, in its purest form, is a company set up by its owners primarily to insure the risks of its parent. When an enterprise has a significant insurance spend and its claims are generally less than its premiums, it should consider setting up a captive.

A captive will typically insure the primary layer of its parent’s liabilities, covering the lower value/higher frequency claims, while using the insurance or reinsurance markets to provide cover for exceptionally large claims.

The monetary benefits of a captive insurance company include:

  • Reduced insurance costs: A captive can reduce the overall cost of the parent’s insurance programme by insuring anticipated losses. In doing so, it avoids the premium loading that a commercial insurer must apply to cover its own overheads and deliver a return to its investors. The total loading can equate to as much as 35% of the premium paid.
     
  • Tax efficiency: As a licenced insurer, a captive may benefit from many tax advantages not available to non-insurance companies: premiums paid to a captive are tax deductible, provided they are based on ‘arm’s length’ market prices. Further, a captive can establish loss reserves out of pre-tax income, and, also consider both ‘incurred but not reported’ (IBNR) and claims deterioration reserves, for treatment as a tax-deductible expense.
     
  • Investment income: Although investment returns are low at present, the reserves of the captive can be invested and the income or gains either retained in the captive or distributed to the parent.

The strategic benefits include:

  • Risk management: A captive is a powerful risk management tool, because it encourages the parent to focus on claims trends and exposures. A captive enables its parent to identify where and how losses are occurring and take steps to design more effective and efficient loss control and claims management systems.

  • Programme design: A captive provides opportunities to structure flexible, bespoke insurance programmes since the captive is not bound by the constraints and conventions that apply to traditional insurers.
     
  • Use of preferred claims handlers: A captive is at liberty to appoint its preferred loss adjusters and solicitors, rather than entrusting these important appointments to commercial insurers whose selection criteria may not reflect the insured’s best interests.
     
  • Independence from the commercial insurance market: A captive creates a facility which can accumulate underwriting profits over time, this ensuring not only that all claims are fully funded and promptly settled, but also that increasing amounts of risk can be retained and the outflow of premium to third-party carriers can be gradually reduced.

Why look to Guernsey for captive insurance?

Guernsey is Europe’s largest captive domicile, home to 835 licensed insurance entities as of 31 December 2016. Its success in attracting captives is a result of its tax neutrality, pragmatic regulatory and solvency requirements (suitable for self-insurance), and a wealth of expertise and experience.

The island’s industry has a long history and a reputation for innovation. This year, Guernsey is marking the 20th anniversary of the introduction of Protected Cell Company Ordinance, which provided the island’s captive insurance industry with the first cell company legislation anywhere in the world.

The original version of this article was first published by the British Chamber of Commerce in Hong Kong, March 2017.

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