There are many reasons why companies typically use captives.
Reduction in the Total Cost of Risk
This is generally the overarching reason why companies establish captives. The insurance market can be an inefficient solution for many companies, especially for companies with minimal risk exposure that end up paying for the claims of others. Captives offer control over pricing, risk retention and claims management.
An alternative to trading Dollars with Insurance Companies
Where the level of claims are relatively easy to predict over a period of time it can be financially inefficient to pay money to a third party insurer only for them to sit on your funds and then pay them back to you as claims less their administrative costs and profit margin.
A typical captive programme structure would seek to purchase insurance protection at a level above the expected level of losses both in terms of frequency and severity plus a small buffer.
Access to the wholesale reinsurance markets
Because reinsurers generally deal with insurance companies, a captive affords direct access to the international reinsurance markets. In bypassing conventional insurers, and going directly to the ultimate risk taker, insurer mark-up costs can be avoided and greater competitive tension can be created.
The savings associated with eliminating these costs will frequently outweigh the incorporation and other start-up costs of a captive.
Tailored retentions for different profit centres and operations
Whilst at a group level an entity may be comfortable in retaining a high level of risk, the volatility that this can create with smaller operating units may not be palatable. A captive can be used as the vehicle to retain this level of risk allowing the operating unit to have a retention level they feel more comfortable with.
Cover tailored to your needs
A captive has the ability to insure any risk it chooses and to customise the terms and conditions of its policies to its specific needs.
Threat to Insurers
The fact that a company has a captive and considers using it for a line of cover can invariably drive much lower pricing from the insurance market who wish to retain the risk themselves. The creation of much greater competitive tension can help drive significant savings.
It’s also a clear signal to the market that you are confident in your risk management and so they should be too.
Profit centre for customer or supplier insurances
Captives have been used to make money by offering insurance to their customer or supplier base. Typical examples include warranties, guaranties and credit risk.
Enhance flexibility in terms of programme design.
This includes being able to provide a risk finance solution for uninsurable risks. Few restrictions are placed on captives formed in offshore jurisdictions, therefore, they can write policies which the conventional market is unable to offer.
Generally, if risk transfer needs could not be fully met by the market, a captive / cell could facilitate by co-insuring to meet the shortfall and preserve ‘best terms’.
Expansion through capital accumulation
Over time, as a captive generates profits and builds its reserves from underwriting profits and investment income, it can increase its capacity to underwrite larger risks or expand its coverage offerings to its parent company or external clients. Alternatively, surplus funds can be dividend or loaned back to the parent company.