By LeStrange, Kenneth J.
Risk Management , Vol. 40, No. 8
The increasing use of captive insurance companies as a risk management technique has transformed and enhanced the role of the risk manager within the parent organization. As a repository of assets and liabilities, captives may become a significant part of the parent's financial structure and contribute substantially to the corporation's capital needs. The presence of a captive creates an opportunity for the development of flexible and responsive risk transfer programs that reflect areas of exposure particular to the parent company's operations. As the number and sophistication of risk management challenges have grown over the past 25 years, so have the opportunities for the risk manager to contribute significantly to the viability and profitability of his or her company. In many ways, risk managers with captives must meet many of the challenges faced by the executive management of insurance companies. Against this backdrop, it is not surprising that during this same period of time, relationships between risk managers and professional reinsurers have flourished.
Impetuses for the creation of captive insurance companies have varied over the years. In the early days of the captive movement, the quest for tax advantages led to the creation of many single-parent captives, particularly in offshore domiciles. As scrutiny increased and regulations tightened, many captive owners began to assume unrelated business to bolster the perception of their captive as a bona fide insurance company and to facilitate the tax deductibility of premiums paid by the parent to the captive. For many companies, this strategy backfired, with unrelated business creating exposure and losses greatly out of proportion to the benefits of potential tax deductibility of their premiums.
The insurance market cycle has also contributed to the need for captive insurers. Wild swings in pricing and capacity have been common for major corporations with difficult exposures. Often, an insured's own experience or exposure had little to do with the cost of insurance, as it was priced by a market driven primanly by supply and demand. Coverage forms and contracts tended to reflect industry standards or underwriter's concerns, rather than provide protection for exposures that threatened the insured. It became increasingly possible that substantial premiums could be paid to an insurer over a period of years, only to find that company insolvent when the time came to fulfill its obligations.
Over time, the nature of relationships between insurers and insureds began to deteriorate, driven by the legal climate in the United States. An explosion in the concepts of negligence, liability and appropriate compensation has revolutionized the nature of virtually every relationship in this country, and imposed, sometimes retroactively, new duties, obligations and standards. Asbestos, environmental impairment, products liability, workers' compensation and employers' liability have been the causes of huge, mostly unforeseeable costs of compensation and litigation created by the expanding concepts of liability. With economic survival sometimes at risk, disputes between insurers and insureds began to magnify and multiply.
The absolute cost of risk transfer and related services through traditional insurer and brokerage relationships began to bear more scrutiny. Risk managers began searching for ways to deliver more of the premium dollar as claim payments, and sought to gain more influence over the cost and quality of key services such as loss prevention and claims payments. Unbundling of services and risk transfer became common.
Captives became a key tool for risk managers to influence and control insurance issues affecting their companies. The captive provides a vehicle for the structuring of price, capacity, coverage and security necessary for risk transfer transactions. A risk manager can mitigate the impact of the insurance market cycle by expanding the use of a captive during a hard market. …