The Six Cs of Captive Value: Focus on Capacity
Companies often face the question of “how much risk should my organization retain versus transfer?” The determination is made by weighing the costs of retaining losses up to a certain threshold versus the cost of transferring the risk to a commercial insurer. And you need to consider the investment income that can accrue on cash flow put aside to pay retained losses, which would be captured by the commercial insurer if the risk were transferred.
Once the determination to capture premium savings by assuming a higher retention is made, the next question becomes whether to fund for such additional retained losses at the parent level or remit the premium savings to a wholly-owned captive insurance company.
Reasons for Forming a Captive Insurance Vehicle — The Six Cs
By formally remitting premium savings into a wholly owned captive —which is formally regulated— the funds set aside are dedicated to supporting potential losses. If the parent took such premium savings, there is no guarantee a formal reserve account would be established. Future losses may have to be paid out of retained earnings, which may not be a favorable outcome for public companies looking to stabilize earnings.
For example, consider company XYZ, which has a large product liability exposure with an existing US$1 million deductible. They determine that they can raise their deductible to $2 million and receive a $1.5 million premium credit. Company XYZ has not had any product liability losses in excess of $1 million in the past ten years, so they decide to assume the higher deductible of $2 million. They then decide to remit the $1.5 million premium savings into a captive, which will insure the $1 million excess /$1 million layer.
The captive does not incur any losses until year five, when it inherits a claim of $5 million. Luckily, the captive has built up surplus of $7.5 million from paid premium over the past five years to cover the loss, so no unexpected further funding is required from the parent.
In this scenario, XYZ recouped $2.5 million in net premium savings over five years by obtaining capacity from the captive instead of the commercial insurance market. In addition, by formally putting aside premium into the captive each year, the parent had proper reserves accrued, which ultimately stabilizes earnings for the consolidated organization.
The above approach is taken by many companies looking to assume capacity from the commercial market and capture premium savings (or because no commercial capacity may be available), but that want a disciplined approach for funding future losses for high severity risks such as product liability, product recall, property, environmental, cyber, and terrorism.
The path to a captive insurance vehicle starts with a feasibility study to access the business case, including the financial, strategic, and operational benefits and limitations of alternative risk financing methodologies. If it is determined that a captive vehicle would benefit your organization, Marsh Captive Solutions, with your tax and accounting teams, can help you to determine the setup that meets the unique needs of your organization.