Captives made their debut in the U.S. in the late 1950s. States regulated them like insurance companies so establishing and operating a captive in the U.S. was very expensive. The few businesses that used captives created them offshore (in a foreign country) to save money.
The number of captives increased substantially in the 1980s, when product liability, medical malpractice, and other liability coverages became difficult or impossible to obtain. Nowadays, businesses use captives in hard and soft markets to obtain a wide range of property/casualty coverages. According to the NAIC, the industries with the most captives are finance, real estate, construction, and manufacturing.
Reasons to Create a Captive
Many Fortune 500 companies have established a captive. Here are some reasons why a company might create one:
- To obtain better control over its cash flow
- To secure a type of coverage that isn't available in the marketplace
- To obtain broader coverage than insurers will provide
- To save money on risk management costs
- To obtain stable insurance pricing
What's a Domicile?
A captive is subject to the rules and regulations of its domicile, the place from which it operates. A U.S. company may domicile its captive offshore or in one of 39 states or territories in the U.S. that have passed captive legislation. Common offshore domiciles include Bermuda, the Cayman Islands, Barbados, and Ireland. Some U.S. states have passed captive-friendly laws to encourage captives to form there. Examples are Vermont, Utah, Delaware, Hawaii, and North Carolina.
Choosing a Domicile
When a business opts to create a captive, it must choose its domicile carefully. Here are some factors to consider:
- Regulations. Laws and regulations vary widely from one jurisdiction to another.
- Capital requirement. The amount of money a company needs to establish a captive varies widely from a low of about $250,000 to over $1 million.
- Costs. The fees charged for creating and operating a captive vary from one domicile to another.
- Approval Process. The time and effort required to obtain approval for a captive vary from place to place.
- Types of Insurance Permitted. Many domiciles restrict the lines of insurance that may be written by a captive. For instance, some prohibit captives from insuring workers compensation unless the insurance is "fronted" by a licensed insurer. In a fronting arrangement, the insurer issues the policy forms but the captive assumes the risk of losses by reinsuring the insurer.
- Support services. A captive needs access to various types of professional services (actuarial, legal, management etc.)
- Financial reporting. Most domiciles require captives to submit audited financial statements at least once a year but the standards vary from place to place.
Types of Captives
Most captives created by businesses are single-parent (also called pure) captives, which are owned by one company. Other types of captives include group captives, association captives, and rent-a-captives. A group captive is created by a collection of companies that operate similar businesses and have similar loss exposures. An association captive is established by a trade or professional association or industry group to insure similar types of businesses.
A micro-captive is a small captive with an annual written premium of $2.3 million or less. The annual monetary cap is set by the U.S. Internal Revenue Service. Micro-captives have some tax advantages. They are taxed under IRS code 831 and pay tax only on the income they generate from investments. They do not pay tax on underwriting income.
A rent-a-captive may be used by non-owner companies for a fee. The companies gain access to the captive without making a capital commitment. The benefits of using a rent-a-captive include lower insurance costs, stable premiums, and better control over a company's insurance program.
How to Create a Captive
There are five basic steps to creating a captive according to Captive.com, a website dedicated to captives and the professionals that operate them.
- Choose the structure. The first step is to decide which type of captive will suit your needs (single-parent captive, association captive, rent-a-captive etc.).
- Do a feasibility study. A feasibility study will help you determine whether the type of captive you have elected will meet your risk management goals. Some regulators may require you to submit a feasibility study with your application.
- Select a Captive Manager. Most captives require a full-time manager. You should interview several companies and select the best candidate. To be effective, a captive manager should be knowledgeable in accounting, taxes, local regulations, claims management, and insurance pricing. Some captive managers perform feasibility studies.
- Choose a domicile. This is a major decision that needs to be made carefully. Changing the domicile of an existing captive can be very difficult.
- Submit an application. The application process varies from one jurisdiction to another. Your captive manager can help you prepare the required data and submit it in the proper format.