The captive insurance industry has enjoyed tremendous growth in recent years. First begun as a means of providing specialty insurance for hard-to-place risks and meeting the needs of companies that could not secure traditional insurance coverage, captives now stand as a valuable risk management tool. Unfortunately, all that growth has also come with significant pitfalls; captive insurers have many factors that can negatively impact business and eventually cause a firm to fail. In this guide, we’ll explore some of the common factors that lead to captive failure, and address ways that these important insurance options can set the stage for continued success.
Worldwide growth in the captives market has seen a steady rise over the past three decades. According to the Insurance Information Institute, a leading industry information resource, in 1991, there were nearly 2900 captive insurance companies. By the end of 2013, the number approached 6600 individual firms. In 2010, captives accounted for 10% of direct written premiums in commercial insurance, or about $60 billion of a $600 billion market. Changing global regulations and a growing need for unique insurance solutions has driven this growth. With all the money and potential to be found in the captives market, why are some companies nearing failure? The answer is complex and requires a careful understanding of risk factors.
The leading factor that has caused captives to fail is the current insurance market. Captives were originally designed to provide insurance protection for unique business risks and did so in a cost-effective manner as compared to traditional business insurers. The open insurance market is softening, however, erasing much of the value inherent in the captive model. If the open market charges less for insurance services, how can a captive compete?
Another factor that has led to the failure of many captives is the concept of over-diversification. Insurance brokers, dizzy with the financial possibilities to be found in the captives market, pushed companies to diversify beyond their knowledge and capabilities. The result was nothing less than disaster; poor quality in service and in coverage drove many over-diversified captive insurers under. The key to continued success is for captives to remain within their own knowledge base, even as tempting as diversification may be.
The goal of a captive insurer is to provide cost-effective coverage for hard-to-place business risks. In many cases, these captives are created without careful research into the regulatory and financial restrictions that go into a successful operation. Some captives simply cannot afford to pay out for a major claim, despite collecting premiums from members and pooling those premiums into a reinsurance fund. To avoid this potential pitfall, it may be useful to employ the services of a specialized captives management firm that handles regulatory and financial compliance issues on behalf of the member partners.
Increased regulatory scrutiny has also led to a significant number of captive insurers exiting the market. The U.S. Internal Revenue Service (IRS) has focused on small captives for their potential to run afoul of taxes. In some cases, microcaptives were established to avoid paying taxes, and in the current regulatory environment, a captive must demonstrate that it operates legitimately for the purpose of providing insurance coverage, not as a front for tax avoidance.
Tax issues also arise when a captive does business in a state other than the one it is domiciled in. In certain situations, a captive must pay taxes in all states where business is conducted, contrary to common misconceptions within the industry. To help prevent from running afoul of state tax laws, it is important that a captive employ a competent manager who is prepared to perform his or her due diligence in meeting taxation requirements.
Captives remain a viable and cost-effective option for many unique business interests. In order to ensure the success and growth of a captive, it is critical that managers understand the prevailing markets, regulations, and tax/financial factors before moving toward the captive model. Following the regulatory guidelines and setting aside the funds needed to pay out major claims help captives to thrive, even in a softening insurance market.
Caitlin Morgan Captive Services provides clients with captive insurance solutions supported by years of experience in establishing the successful formation and implementation of a wide range of captives. To learn more about how we can help you, please contact us at (317) 575-4440.