How Can a Captive Help You?

Our previous article, What is a captive and why do you need one, outlined how a captive works as a form of alternative risk transfer, and if one would be suitable for your company.  Here we examine in further detail, the benefits that a captive provide businesses, which are essentially threefold: Financial benefits; Risk management benefits; and Organisational benefits.

1. Financial benefits

Cash flow considerations

When a company pays premiums to commercial insurers, cash leaves the organisation and claims payments are often made long after the premiums are paid. However, if premiums are paid to a captive, the cash remains inside the organisation and generates investment income. This substantially improves the organisation’s cash flow flexibility and contributes towards reducing the total cost of risk.

Cost of capital reduction

While an organisation can retain risks without utilising a captive, it creates inefficiency due to the high degree of uncertainty at the business unit level. It is conceivable that each business unit would set aside capital up to its self-retained worst case scenario. Since a captive bundles the business unit’s risks collectively, the retained risks are shared amongst the business units and financed only once. This will free up capital for the organisation’s core business.

Speed of claims payment/settlement

Commercial insurers can be relatively slow in claims payment and settlement depending on the complexity and the nature of the claim. Under a self-insured program, a company can manage the claims process much more efficiently, which can mitigate financial problems for its subsidiary if faced with a major cash outflow issue due to an insured loss, proactively helping the business get back to normal trading conditions quicker.

Stabilising risk financing cost over time

Market premium and capacity vary substantially over the long term. Optimising an organisations risk retention through a captive shields the parent from insurance market volatility. While the market has been soft over the last few years, it would be prudent to plan ahead by taking measures against this exposure.

Portfolio effect

Risk retention programs can often involve making retention decisions by line of coverage, business unit, year or geography. Combining retentions in a captive creates a ‘portfolio’ of retentions that collectively are more predictable and allows you to make more informed decisions about risk retention generally.

2. Risk management benefits

Direct access to the reinsurance market

The captive is a legitimate insurance company with access to the reinsurance market. This provides clients with additional choices. Reinsurance carriers may offer better rates, coverage and/or services. Additionally this can help should a specific type of risk become uninsurable or overtly expensive.

Improving insurer purchasing power

In addition to reducing cost of capital, bundling the organisation’s risk through one entity may improve its purchasing power. The organisation can retain more risk than the sum of its individual subsidiaries without endangering its overall financial position. Increased retention positively impacts the organisation’s attitude to claims prevention and shows the market that management is committed to and confident of its risk management practice. It also avoids the expense of taking too much risk as is possible in a decentralised approach.

Cycle management and independence

The ability to retain more risk provides the organisation with greater independence from capacity available in the insurance market. Through the captive, the organisation can choose to retain more or less risk depending on market cycles. With a good program in place, the captive can accumulate substantial shareholder equity, which further increases the organisation’s capacity to retain risk.

Funding of non-insurable risks

The parent can protect its subsidiaries for risks that the insurance market is not willing to accept or that are too expensive to buy by incubating the risk in the captive as premium and loss information is developed over time in the captive, the parent is better positioned to approach the insurance or reinsurance market place for protection.

Control over claims settlement

Brand and reputation is highly crucial for many companies, especially those in the consumer goods and services sectors. Through a captive, the organisation may exert significantly more influence over how a claim is handled.

Setting of claims reserve

The risk management team is in a position to set reserves for the captive’s insurance liabilities. This involves substantial professional judgment as the reserves can be more or less conservative, reflecting the organisation’s attitude to risk.

3. Organisational benefits

Formal mechanism of risk retention

The captive’s premium and loss data are centralised. This provides a formal measure of the organisation’s overall risk management performance. Where appropriate and desirable, the organisation can turn its risk management department into a profit centre.

Appropriate funding of risk retention

The captive also provides feedback on the effectiveness of the organisation’s risk financing strategy. As the organisation acquires more experience, it can adjust the captive’s retention limits and use of available capital.

Corporate governance considerations

The captive structure creates a strong governance environment to manage risk across the organisation by centralising the collection of risk data in a regulated environment and promoting better risk management behaviours.

Creation of an additional revenue stream

Captives primarily insure the risk of its parent, however, there are many examples of captives that have expanded beyond their parent’s risk to provide insurance solutions to other parties. These strategies can be extremely successful when an insurance product is linked to the company’s overall marketing strategy to benefit core revenue lines (by creating differentiation in the marketplace) as well as earning profits from insurance products.

Contact Aon today to discuss how a captive can help your business.