The periodic nature of insurance, coupled with both changing and emerging risks, will always influence the insurance and financial markets. New alternatives are being chased to address both unmet needs and a lack of capacity. Alongside these new alternatives are creative ways to employ developed solutions.
In the wake of the challenges caused by the hard market and the uncertainties and questions resulting from the experience of the COVID-19 pandemic, one solution that many companies are turning to or returning to—and expanding upon—is captive insurance.
What Is Captive Insurance?
A captive insurance is a subsidiary company formed by a private company to finance or cover its retained losses in a formal structure. Captive insurance companies are normally formed to supplement commercial insurance, allowing companies to retain the money that would otherwise be spent on insurance premiums.
eg: assume a small medical facility is paying AED 25,000 per year for medical malpractice insurance, an ordinary and compulsory business expense (medical liability federal law no.4 of 2016). The policyholder transfers the liability for claims to a third-party insurance provider, but assuming a claim-free practice – there is no recovery of the cash paid for coverage as premium, nor any return to the insured on the funds set aside in a reserve to pay any claims.
Why Form a Captive Insurance Company?
There are several key benefits to forming or becoming part of a captive insurance company. Captive insurance companies typically allow more risks to be covered than a traditional insurance carrier. These risks may be specific to an industry group. There are some risks that traditional insurance companies won’t cover for various reasons. It may be a risk they’re not comfortable insuring. These may include acts of God, such as a flood or earthquake etc. Also, an insurance company may not want to cover other catastrophic risks due to a risk of a large claim, including construction defects or environmental issues. If a carrier does offer coverage for some of these events, it can be prohibitively expensive. Captive insurance can be cheaper than going through traditional insurance companies. Captives don’t have the overhead that a traditional insurance company has, such as commissioned sales staff, advertising, etc. It also eliminates paying for insurance companies’ profit. In fact, premiums paid to the captive will be invested and earn money for the captive. Companies can even use a captive to post a surety bond on a project with the proper structuring.
Advantages/ Benefits of Captive Insurance
- Coverage tailored to meet your needs
- Reduced operating costs
- Improved cash flow
- Increased coverage and capacity
- Investment income to fund losses
- Direct access to wholesale reinsurance markets
- Funding and underwriting flexibility
- Greater control over claims
Potential Downsides to a Captive Insurance Company
In the long run, it can help save money on premiums. However, there can be substantial setup costs and capitalization required. In general, a company considering a captive should have a strong balance sheet. In addition, a captive insurance company can create additional administrative expenses. At the very least, you’ll want someone employed at the operating company who has ample knowledge of insurance so they can help manage the captive’s activity. Lastly, it could bring greater risk to a company because the risks aren’t spread like they are with a typical insurance carrier. To help with this, the population is typically protected by reinsurance, but if there’s a large claim, the cost of the reinsurance will typically increase faster than with a normal carrier. This could mean higher premiums to the captive at a quicker rate.
Being part of a captive insurance company structure can be a powerful tool to help companies with insurance and possibly cost savings. However, companies should thoroughly evaluate the benefits and risks before establishing a captive.
