Magazine article Risk Management

Factors to Consider When Forming a Captive

Magazine article Risk Management

Factors to Consider When Forming a Captive

Article excerpt

The benefits that a captive will bring to an organization must be outlined in a feasibility study before the captive is formed. Whether the company is considering a pure, group, association or industrial insured captive, senior management must first determine what the benefits of captive formation will be for the organization. Answering this question is crucial because captives can be expensive to manage and administer, and require the captive manager to spend significant time on regulatory matters and reporting to senior management.

Corporations find numerous advantages for the use of captives in their insurance programs. Essentially, these advantages can be regarded as either "soft" or "hard" - "soft" meaning structural improvements that use of the captive provides to the parent's insurance program, and "hard" referring to actual ways in which the captive can save the parent money.

There are several "soft" reasons for forming captives. First, a captive is an actual insurance company that requires its parent organization to continually monitor its financial status. As a result, the captive allows its parent to take a formal, rigorous approach to risk retention, including the use of actuarial reviews and annual audits.

Thus, the captive provides the parent organization with a disciplined method for risk retention. Some companies that do not have a captive develop risk retention programs that are little more than collections of money set aside for when a loss occurs. In this approach, the risk manager does not keep track of projecting losses on an incurred basis, match revenues with expenses or attempt to ensure that no surprise or unexpected losses occur. Such an undisciplined risk retention program will not allow the company to maximize value. A captive, then, can be a valuable tool that greatly aids its parent in its risk

A captive can also often provide more control over budgeting for losses than a risk retention program. One reason is that since the captive is an actual subsidiary of the parent organization, its very existence causes senior management to take a greater interest in the company's risk management program, which necessarily leads to greater corporate control of risks. For example, if the captive suffers losses and its solvency is threatened, the captive manager can directly discuss the losses with senior management, and what the company must do to remedy the situation. For example, when a large loss occurs, the captive manager will meet with the parent company's chief financial officer to examine the captive's balance sheet, its income statements and look at the reasons why the captive is a losing operation.

The second soft reason for captive formation is that captives allow for the rationalization of large, corporate-wide deductibles versus smaller deductibles at business unit levels. As an example, consider a large organization that has several smaller subsidiaries. While the parent itself can often afford large deductibles for various insurance programs, the subsidiaries taken individually might not be comfortable with deductibles that are as high as the parent's. The parent can then use the captive to pool the subsidiary's deductibles.

For example, Subsidiary A of a parent organization may be able to function comfortably with a much lower deductible than the parent's overall deductible. Subsidiary 13, however, may be comfortable with a slightly higher deductible, but one that is still lower than the parent's. In this case, the captive can be used to sell insurance to the subsidiaries. By doing this, the corporation is essentially harnessing the overall economic strength of the corporate entity and at the same time recognizing the different economic needs of each subsidiary. And, depending on the situation, there may be potential for taking tax deductions for premiums paid to the captives by the subsidiaries.

Another reason for captive formation is that captives can provide the parent organization with greater control over its insurance program. …

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