Introduction to CaptiveInsurance Companies

The purpose of this paper is to summarise what is a captive insurance company,why one might be formed, the advantages and disadvantages and the various riskcarrying options available.People forming their own insurance companies to insure the risks of the owners dates back to the dawn of themodern insurance industry. From the 1920’s more and more larger corporations established their owninsurance companies, but the term “captive” (as we know it today) was first used by Frederic Reiss, who coinedthe term while he was bringing his concept into practice for an industrial client in Ohio in the 1950’s.

The Youngstown Sheet & Tube Company had a series of mining operations and its management referred tothe mines whose output was put solely to the corporation’s use as captive mines. When Reiss helped themincorporate their own insurance subsidiaries, they were referred to as captive insurance companies becausethey wrote insurance exclusively for the captive mines. The term also made sense as the policyholder ownsthe insurance company i.e. the insurer is captive to the policyholder.

Today the captive insurance industry is still growing with over 5,500 captives established in excess of 60jurisdictions around the world. The rate of captives traditionally develops in response to “hard” insurancemarkets, although they are to be regarded as part of a longer term risk management strategy, rather than shortterm cost saving vehicles.

Vantage Limited are Jersey’s first resident specialist insurance management company who can advise on andprovide management services for captive insurance companies and alternative risk transfer vehicles.

Introduction

2

Why Offshore?

Historically captives were often established inoffshore jurisdictions for favourable taxationtreatment, however these days the tax benefits havebeen largely eroded. The major benefits of anoffshore located captive now are the reduced capitalrequirements (when compared with an onshoreinsurance company) and the more accessible, andgenerally more flexible, regulatory bodies.

In short, a captive is a special purpose insurancecompany established to insure specific risks. Itallows an entity (a company or individual) to form itsown insurance company to “self-insure” and thusobtain greater control over the insurance purchase.In most cases a captive insurer’s owner and itscustomers (the Insureds) are one and the same,which results in captives being different fromcommercial insurance companies. Captives canhowever also write “third party” risks. Contrary tothe understanding of many, captives are not purelyfor the benefit of PLCs or multi-nationals.

A captive is a registered and authorised insurancecompany established to write all or part of the risksof a company, its affiliates, or for the members of agroup. Traditionally they are subsidiary companiesof their parents (whose risks they underwrite)however there are now numerous additional uses forsuch vehicles - including the writing of third-partyrisks. Captives are used by PLC’s, privatecompanies, the public sector, trade associations,not-for-profit organisations and high net worthindividuals, as well as by insurance brokers (for theirclient insurance risks).

Commonly located in an offshore domicile, thecaptive will be licensed by the local regulator tooperate either as an insurance or reinsurancecompany (or perhaps both).

Generally an insurance company must be licencedto write risks in the country in which it issues itspolicies. In such circumstances, the captive willwrite insurance directly. In some jurisdictionshowever the parent company or its subsidiaries maynot be permitted (by local legislation) to insurecertain classes of business directly with the captiveand in these circumstances the risk is often initiallyinsured with a local commercial insurance company.That commercial insurer will then reinsure the risksinto the captive. (see Fronting)

A captive may also transfer some or all of the risk tocommercial reinsurers. (see Reinsurance)

A captive can write a wide variety of risks, includingProperty and Business Interruption, Liability, Transit,Professional indemnity, Credit and Warranties, aswell as Employee Benefits (such as healthcare ordeath-in-service).

What is a Captive?

3

Reinsurance

Invariably the premium level paid into the captive isinsufficient to cover the overall aggregate amount ofrisk exposure insured within it (for example, largeindividual losses, such as property damage orliability claims, or perhaps the accumulative effectof a large number of smaller losses). A reinsuranceprogramme is therefore assembled to protect thesolvency of the captive.

Reinsurance provides a number of beneficial factorsfor a captive. Primarily it increases the underwritingcapacity of the captive by allowing it to insure risksin excess of the premium paid in. In addition,reinsurance stabilises the underwriting results andprovides protection from catastrophic losses.

Reinsurance is purchased on a wholesale basis andis therefore generally cheaper than buying primary,or direct, insurance. A reinsurance company doesnot have the same overheads, staff, or marketingcosts as an insurance company.

Generally captives will be formed under thefollowing situations:

The insured loss record is better than averageand a desire exists to reduce premiumexpenditure and / or participate in theunderwriting profits, or

The insured loss record is particularly poor andinsurance coverage in the conventionalmarketplace is either considered too costly or isnot available.

The object of a captive is to provide a self-insuranceprogramme that will fund predictable losses andboth reduce and stabilise the cost of the insuranceto the Insured. In addition, in a carefully managedprogramme, profits will be earned and a return oncapital will be achieved.

Fronting

Fronting is a term that describes a particular form ofreinsurance frequently employed by captiveinsurers. Commonly, a commercial insurer licensedin the jurisdiction from which the risk emanatesissues a policy to the Insured. Subsequently, the riskis transferred to a captive insurance company byway of a reinsurance contract, also known as afronting agreement. The insured (policyholder)receives a policy written by the licensed commercialinsurer, but the economic risk of that policy transfersinto the captive insurance company. In somejurisdictions, it is a legal requirement for either all orcertain classes of business to be written by a localinsurer. Hence, if the captive is established in adomicile other than that where the risk resides, thenfronting arrangements are mandatory.

Fronting insurers, who are fully regulated andsupervised in their home jurisdictions, may retain anelement of the primary risk they insure, or may cede100% of the risk into the captive (re)insurancecompany.

Why Form a Captive?

4

Principal advantages

Potential underwriting profit

Premium costs related to own loss experienceas opposed to the insurance market’s view of theindustry segment in question

Access to reinsurance markets not available inthe retail insurance market

Investment income on premium and lossreserves

Cash flow benefits

Possible improvements in policy wording /coverage not available in the conventionalmarket

Possible disadvantages

Exposure to potential losses which can erodecapital

Capital and solvency requirements

Running costs / Management time

It is well known that the conventional insurancemarket can frequently fail to adequately meet theneeds of the buyer. Criticism usually falls into one,or more, of three categories – price, cover, andservice.

The primary motives for creating a captive are to:

Help match insurance costs to the experience ofthe company (or group) such that a good lossexperience is rewarded;

Retain more risk and thereby reduce externalinsurance costs: At the lowest level this takes theform of retaining, financing and managingpredictable losses in a cost effective manner.However most captives assume a greater levelof risk;

Pricing stability: Provide a degree of insulationfrom the insurance market cycle which is oftenunconnected to the performance of thecompany or group;

Enhance risk management strategy: greatercorporate awareness of the overall cost of risk

Market leverage: A mechanism to providepressure on traditional insurance markets;

Drivers for forming a Captive

5

A cell within a PCC or ICC

The use of a cell within a cell company can providea means of entry into the captive insurance marketto entities for which it was previously uneconomic.The overheads of a protected cell captive can beshared between the owners of each of the cells,making the captive cheaper to run from the point ofview of the insured. Each cell has its own separateportion of the PCC’s overall share capital, allowingshareholders to maintain sole ownership of an entirecell while owning only a small proportion of the PCCas a whole. A number of insurance managers andbrokers sponsor their own cell company to permitaccess to self insurance vehicles for use by theirclients.

All of these vehicles can achieve specific riskfinancing and / or risk sharing objectives dependingon the needs of the sponsor and specific structuringrequirements.

Essentially there are three main types of formalinsurance vehicle through which self-insurance orreinsurance can be conducted:-

Captive Insurance Company

Referred to as “pure” captives, these are invariablywholly owned subsidiaries of their non-insuranceparent company. When first formed, a pure captivefor a large organisation will usually begin byparticipating in the high frequency/low severityelement of an overall insurance programme. As thecaptive becomes more established, with a strongerbalance sheet, it may look to write a wider range ofrisks, ie, those with medium frequency / manageable(or high) severity.

Protected Cell Company (‘PCC’) / IncorporatedCell Company (‘ICC’)

A cell company can be described as a standardlimited company (referred to as “the core”) that hasbeen separated into legally distinct portions (orcells). The assets and liabilities of each cell are keptseparate from all other cells. An ICC involves theformation of separate, legally recognised cells withinthe overall structure, with each cell established as aseparate incorporated company. This is in contrastto the traditional PCC where all the cells combine tocreate one legal entity and each cell is not treatedas a separate legal personality. Some largerorganisations have sponsored their own cellcompany (as opposed to a pure captive) andsegregate their different classes of risk in separatecells.

Types of Risk Carrying Vehicles

6

Key Contacts

Company Registration Number: 94048Vantage Limited is regulated by the Jersey Financial Services Commission for the conduct of Trust Company, Investment and General Insurance Mediation Business. Version: 4 (June 2014)

Vantage Limited PO Box 420, No.3 The Forum, Grenville Street, St Helier, Jersey, JE4 0WQ Tel: +44 (0) 1534 758875 Email: info@vantage.je www.vantage.je

Richard PackmanManaging Director

Direct Dial: +44 (0)1534 706503Email: richard.packman@vantage.je

Giles DalbyClient Insurance Manager

Direct Dial: +44 (0)1534 706523Email: giles.dalby@vantage.je