GIM11040 - Captive insurers: commercial reasons for establishing a captive

Establishing a captive is often not solely tax driven. There are commercial advantages to setting up a captive:

• Insurance involves the transfer and sharing of risks. Some policyholders will receive back more than they pay in premiums whilst others will receive less. A group with a good claims record may find itself subsidising, via its level of premiums, the risks of others with a poor claims record - possibly even its competitors. A captive deals only with the risks and risk record of its own group. Good group risk management will enable the business either to reduce its premiums to reflect its own claims record, or to retain, through the subsidiary, the underwriting profits on its own insurance business. Additionally, the knowledge that the group is responsible for the risk tends to concentrate the minds of the local risk managers, making them more safety or liability conscious.
• Some risks are very expensive or even impossible to insure on the open market. Professional indemnity, public liability and environmental damage fall into this category. A captive will insure what it is told to insure. Captive arrangements can also allow reserves to be built up against the risk of catastrophic events, at an economic price.
• Some low layers of risk are not worth insuring. The group may feel that it is as well to retain the funds to pay these losses. An offshore location gives an additional tax advantage to the retention of such funds.
• Some sectors of the insurance market experience substantial fluctuations in capacity. When capacity is limited perhaps due to heavy or persistent underwriting losses in the area concerned, premiums increase. Self-insuring through the use of a captive insurance company is one way for businesses to overcome the vagaries of the open market. Knowing that a company will accept the risk for a certain premium can even out the effect on the group profit and loss account.
• General insurers do not normally retain all of the risks that they initially write but they reduce their potential liability by getting other insurers to share the risks through reinsurance. Reinsurance companies do not deal direct with the public. This means that they do not incur the retail expenses of a branch network, claims handling etc., and they offer direct insurers substantially lower premiums than they will charge to their customers. Owning a captive insurance company gives businesses access to the reinsurance market, and thus to cheaper premiums, which would otherwise be denied to them.
• Territories that wish to encourage captive insurance companies may have a more relaxed regulatory regime than the UK. This may mean less capital tied up and fewer or less detailed information/returns required by regulatory authorities. But there is a limit to how far relaxed regulation is an advantage, as it may impact upon the sponsoring group in other ways. Captives themselves are often unrated, but the presence of a captive in a lightly regulated domicile may lead to pressure from Home State regulators or rating agencies to post collateral, affecting the sponsoring group or fronting insurer (see GIM11020 and GIM11030).