Companies looking to achieve greater financial and administrative control over their risk profile are increasingly turning to captive risk financing.
The self-insurance upward trend may be a strategic response to challenging commercial insurance market conditions, which feature rising rates and stricter underwriting. Other reasons include the need to top up larger or excess limits on existing coverages and funding hard-to-insure risks.
Here’s what you should know as you consider whether captive risk financing is right for your organization.
Understanding the captive mechanism
Captive risk financing involves a company establishing its own licensed insurance subsidiary, referred to as the captive, to insure its own risks or those of its affiliates.
- Single-parent captives: Typically set up by companies large enough to be considered a Fortune 500 candidate. ›
- Group and cell captives: Offer a pathway for smaller companies to access similar benefits through shared or segregated accounts.
A captive functions as a formalized self-insurance program, allowing the parent company to structure its risk retention. The parent finances the more predictable, frequent, lower-severity portion of its risk through the captive, while continuing to purchase traditional insurance for high-severity, catastrophic losses.
A company may also use a captive to achieve greater coverage on existing insurance programs. This approach offers organizations greater ability to control the terms, conditions, and pricing of their program.
Strategic benefits of captive risk financing
An optimal captive is a solution for greater autonomy over risk financing. It offers:
- Customized coverage: A captive allows the company to fill gaps in coverage or address unique and hard-to-insure risks, such as cyber or environmental liability or product recalls, that are difficult to place in the commercial market. This flexibility translates into stronger risk management and strategic value.
- Stabilized pricing: Insureds participate directly in the profitability of their own insurance programs. This helps stabilize insurance costs, as pricing reflects the company’s actual loss experience rather than general market fluctuations.
- Claims and data control: The parent company gains greater oversight of claims situations, which is crucial where claimants may be existing or future customers. Managing a captive also naturally enhances the quality and impact of risk management techniques within the organization.
- Cash flow and investment income: Funds that would otherwise be paid as premium to a commercial carrier remain within the parent company’s structure. This can enhance a company’s EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) and add to the bottom line. The captive can generate investment income and potentially make funds available for internal financing or dividend distribution.
- Direct access to reinsurance: A captive provides direct access to the global reinsurance markets, often achieved through a “fronting” carrier arrangement.
- Another profit centre: A captive can evolve into a revenue-generating entity. For example, it may eventually write coverage for affiliated or even thirdparty businesses, creating a new stream of income for the company. Public companies can use captives to smooth earnings and protect shareholder value; private companies often use them to isolate risks and improve operational transparency.
- Contribute to financial health: Captive reserves are held in a regulated insurance entity—not booked on a corporate balance sheet. CFOs can leverage this structure to better reflect the company’s actual financial health, especially when preparing for financing or transactions.
What businesses should consider captive risk financing?
Companies best suited for captives are typically those that demonstrate a strong risk management philosophy and have stable and profitable earnings. While any industry can benefit, companies that fit this profile often seek to make their premium spend more efficient. For instance, a captive can be used as a funding mechanism for future, uncertain events, such as a costly mine reclamation.
This may also bring challenges that are best discussed and developed with tax counsel—it’s not without risk. Most companies use their captive for financing frequent, low severity claims to eliminate that from the pricing of traditional insurance. That may be auto claims or moderate product claims that become too expensive to budget for through normal operations.
Why should risk managers consider captive solutions?
For the risk manager, establishing a captive elevates their role beyond being solely an “insurance buyer” responsible for an expense line. They become responsible for a financial subsidiary that can have a greater impact on the organization’s financial profile, bringing them into higher-level management discussions about capital and financial budgeting.
Risk managers with a finance background may understand that accounting rules are different for an insurance company than for other types of companies. This approach requires a close discussion with the company’s tax experts to ensure that the strategy is what the company expects.
Aviva’s captive solutions
Aviva offers an integrated approach to captive fronting, including:
- Designing (limits and coverage) and pricing of international and domestic insurance programs in close cooperation with underwriters and actuaries.
- Managing collateral and cession efficiently, including timely reporting to the captive manager.
- Addressing compliance of insurance programs through multinational insurance propositions and stringent internal governance.
To learn more about integrating a captive into your risk financing strategy, please contact your insurance broker.
