The 10 questions of captive insurance, Pt. 2

By F Hale Stewart, JD, LLM, CAM, CWM, CTEP

The Law Office of Hale Stewart

This is the second in a three part series of articles on the 10 questions all prospective captive owners should ask themselves (or that their financial representatives should ask them). I wrote the 10 questions to help in the captive formation decision making process. If you have further questions, please comment below or send me a message.

Forming a captive insurance company is an incredibly big decision. To help decide if you should form a captive, please answer the 10 questions, the second three of which are presented below.

Have I seen my insurance prices increase?

Sometimes, simply being in a certain line of business can mean you see insurance costs increase despite your individual loss experience. For example, OB/GYNs have incredibly high insurance costs, simply because of the nature of their work.

And some individuals — depending on their geographic location and despite having an excellent loss history — have seen sharp increases in their premiums for certain types of coverage. For example, after Hurricane Ike in Houston property owners saw their property premiums increase.

For people in this situation a captive makes tremendous financial sense. Remember that most large insurance companies spend between 20 percent and 30 percent of their gross revenue on selling, general and administration expenses. Captives, in contrast, are much leaner and have far lower overhead, thereby lowering the overall cost of insurance.

As a corollary to the above point, captives can also provide stable pricing. When the public’s premium for a particular line of insurance increases, a captive’s may not, depending on the experience of the parent company.

Captives focus on a smaller number of insureds. Therefore, if the insureds also control their risk they can work to prevent premiums from increasing, thereby creating a more stable pricing environment.

Have I started an asset protection or estate plan?

Asset protection is the legal discipline of mitigating, or attempting to mitigate, the negative impact of various financially and legally catastrophic events, while estate planning is the process by which the client plans for the disposal and dispersion of his estate on death. A captive insurance company, while primarily a risk mitigation tool, also has ancillary benefits.

Primary among these ancillary benefits are the facts they also provide some degree of asset protection (by segregating assets into a separate business entity) and estate planning (operating in a manner similar to a family limited partnership). However, these are not and should never be the main reason for forming a captive.

Am I committed to a long-term business plan?

That is, am I willing to see this through for at least 3-5 years? Captives require a long-term commitment; you can’t simply start one and then end it a year later.

There are many reasons for this. First, because a captive is an insurance company – and therefore what an economist would call a financial intermediary – it takes at least several years for the captive to build up capital and reserves to become a truly independent company.

However, the owners have to let the captive actually go through the process to get there, which takes time (and the time value of money).

Second, a captive should also be part of an overall risk-mitigation plan, meaning that the company is probably going to engage in certain policies and practices to lower their long-term cost of risk. But, again, it will probably take several years for these plans to take effect.

Third, starting and then ending a captive after only a few years will probably draw unwanted regulatory scrutiny.

The above reasons – considered alone – are all good reasons for form a captive. But we’ll add to the list in the next installment.