Items to consider before forming a captive – a risk manager’s view

Captives are a robust risk financing tool and can deliver value in many ‘business case’ scenarios. At the same time, there are situations when captives might not be the best answer, and these are worth keeping in mind to make sure the captive fulfils its purpose. Below are some examples.

1. Low premium spend. Size matters as far as captives are concerned, and a certain minimum premium volume would be required to make a captive structure worthwhile economically. This threshold has been decreasing in recent years, and different professionals would probably give a different figure for a recommended minimum premium spend. Yet, even for solutions tailored to smaller accounts such as cell captives in Europe or group captives in the USA, a minimum premium volume in the low hundreds of thousands of dollars would likely be necessary.
2. High or fluctuating loss ratios. One of the goals of forming a captive is to reduce the Total Cost of Risk (TCOR). This is achieved through retaining more risk in-house, along with the corresponding premium and losses, whilst hopefully maintaining low claims figures with the help of loss control and loss prevention measures. The TCOR benefit of the captive is therefore realised if regular losses are low. It would not be achieved in a persistently high loss ratios scenario or where loss ratios are volatile year on year – unless risk management is implemented first to improve loss results.
3. Unwillingness or lack of resources to commit to risk management. Risk management requires a process and a structure, as well as a commitment of resources (personnel and financial) to execute it. For different reasons, a company may not be prepared or ready to invest in risk management, and without a minimum level of risk maturity and risk awareness, a captive structure would not be the best solution.
4. Low risk tolerance. A captive is a formalised way to retain and manage risk in-house. This means that within the defined risk tolerance level, losses that occur would be retained by the company via its captive. If this loss retention threshold is low, commercial markets would not provide sufficient discount for the risk portion which is being transferred. When considering the captive route, the company should therefore be willing and able (from a financial and conceptional perspective) to retain risk.
5. Lack of data or understanding of the risk to be insured. To manage risk, the company needs to collect, analyse and monitor the data around it. Without understanding the risk, it is not possible to effectively retain it through the captive. In fact, in some cases, captives are formed with the main purpose of facilitating the data collection and ‘incubating’ emerging risks. In the absence of the company data, industry data can sometimes be used instead for the initial modelling and programme set-up. However, there should be a commitment to improve data collection and analysis going forward if the captive is to succeed.
6. Unwillingness to tie in capital. A captive is a legal entity and the capitalisation of the captive is a statutory requirement. Captive structures demand a capital commitment from their owner(s) at the outset, which should be maintained throughout the captive’s life at a certain level, defined by the captive’s domicile and the risk it writes. This also means that if the captive would be unfortunate enough to incur losses beyond those predicted, the parent may be required to provide a capital injection. Its willingness or otherwise to commit capital long term, along with the lack of flexibility to withdraw it at will, is something that a company should evaluate before forming a captive.
7. Unwillingness to commit to a long-term structure. Following on from the above, a captive is a long-term commitment. Closing a captive might be easier in some structures (e.g. cells) than others, but it would still call for solutions to be found and formally implemented to address the liability, financing and practical handling related to the business being closed. Such solutions would entail a thorough legal review and an upfront cost, and might not permit a 100% exit for the captive owner.

These are not ‘hard and fast’ rules but items to keep in mind before forming a captive. Recognising the above points may help risk and insurance managers contemplating a captive to address some of these areas in advance and to account for them in their decision-making. Then, if the company decides to proceed with a captive, such decision could be better thought through and hopefully lead to the long-term success of the captive venture, beyond the hard market.

The views expressed are entirely and exclusively my own and do not represent those of my employer.