If you've been around captives for a while you've undoubtedlyheard someone say “if you've seen one captive, you've seen onecaptive.”

Captive insurance companies (those that are wholly owned andcontrolled by the insureds) are varied, and there are a thousanddifferent paths any one entity can go down when looking at forminga captive. Just think of all the permutations that are possiblewhen it comes to coverages, retentions, limits, reinsurance, typeof captive, type of ownership structure, domicile, service providerselection, stated goal of the captive, related or unrelatedbusiness and so on.

These are “micro” decisions, and it's best to have qualifiedcaptive professionals engaged to assist you when walking throughthe decision processes. But there are also macro decisions entitiesshould be making when contemplating a captive. When consideringthese macro decisions, engaging a captive professional can beuseful but not always necessary.

Senior management buy-in

Probably one of the most important aspects when forming acaptive is to have senior management buy-in; without it, thecaptive will be short-lived. A captive arrangement is a long-termplay, not something your entity should be popping in and outof.

There are costs associated with forming a captive entity, withcapitalizing the captive entity and with the ongoing operations ofthe captive entity. The capital commitment can be significant, andwithout senior management involvement and buy-in, that funding canbe denied or even worse, pulled down the road when the funds couldbe needed the most.

Corporate risk profile

What is the risk profile of the entity to be insured by thecaptive? Are there sufficient exposures that can be placed in thecaptive to make financial sense in regard to cutting overall riskcosts? Is the entity risk averse or a risk taker? Even when theentity is risk averse, a captive could be a good solution forlimited applications; however, you'll probably find more seniormanagement buy-in if the entity is somewhat a risk taker.

In the grand scheme of things, there are three dispositions to arisk exposure:

1. Self-funding or financing through a captive arrangement,
2. Purchasing insurance on the open market to cover any potentiallosses, or
3. Avoidance.

The third option can be limiting because it affects theoperations of the company. To avoid all risk exposures would beequivalent to ceasing operations of the entity and shutting down.There are many risk exposures that can't be avoided and need to behandled through options one or two, or some combination.

History shows us that if an entity is paying out at least$500,000 for its insurance costs, a captive cell arrangement isworth investigating. If the payout is at least $1million, awholly-owned captive is worth investigating. Anything below$500,000 would need to be an exception to the rule for a cell orwholly-owned captive, but it could be a good candidate for a groupcaptive.

The 3 C's

Control, cost and coverage represent the three C's of captiveformation. With a captive arrangement you gain better control overyour insurance-buying and risk-financing mechanisms, which shouldlower your costs. You're able to select the various serviceproviders who will assist you in operating the captive and in doingso, lower the cost of services. You have the ability to coverexposures that are uninsurable or too expensive to cover in theopen market along with having the ability to manuscript policies ifyou so desire to plug any holes in your current coverage from thetraditional carriers.

From a claims standpoint, you become more involved in themanagement of claims. This gives you better control over thedecision process of whether to deny a claim, fight a claim, adjusta claim in due course or to settle.

Related: Could macro-insurance become a reality? Theone-policy-covers-all-risk approach

Before deciding on whether to use a captive, an organizationhas several factors to consider, including frequence and severityof losses as well as tax implications. (Photo:Shutterstock)

Loss experience

When looking at loss experience in determining whether to use acaptive, there are two categories of losses to analyze: frequencyand severity. Frequency refers to the number of claims that occurover a given time frame whether that be over the policy period orcalendar year. Severity refers to the total dollar value of anyparticular claim over the measurement period.

In the captive arena, we typically look at frequency losses inthe first $100,000 to $250,000, depending on the nature of thebusiness and the size of the entity. There are obviously entitiesthat have formed captives for which this range is too high, andthey would need a lower attachment point. Still other entities areso large that this range is insignificant, and they would belooking to put an even larger loss through their captive.

With frequency type losses, the entity needs to see whetherthere is a predictability to the losses from year to year. Thisfrequency layer is well suited to be run through a captivearrangement. By buying insurance from the traditional market forthe frequency layer the entity is trading dollars with theinsurance company at a cost that is typically higher than coveringthe exposures through its own captive arrangement.

As for the severity type losses, these are much harder topredict and are best left to the traditional market with a fewexceptions. From a captive perspective, these losses should belimited to the captive with excess coverage purchased from atraditional carrier. This is typically done for severity lossesthat don't occur every year. For example, windstorm and earthquake coverage is written through captiveswith a low layer limit that is expanded each year as funds arebuilt up in the captive during the years when no losses occur. Thisis the classic, “saving for a rainy day” scenario. If by doing thisthe entity can reap the benefits of a tax election such as theSection 831(b) election where the underwriting income is taxexempt, all the better.

Related: Insurers face $3 billion payout for severe weatherin May

Tax issues

Is there ever a time that you enter into an arrangement to forma company requiring capital and resources to operate for aparticular purpose when the tax ramifications of such an endeavorwouldn't even be contemplated? Of course not. However, given someof the preferential tax elections available to insurance companies,there is potential for some abuse, which has triggered addedinterest and scrutiny from the IRS.

When it comes to forming a captive, it should be formed for riskmanagement purposes not for tax purposes. Analyzing how the newlyformed captive will affect the overall tax position of thecorporate entity is simply prudent business activity and should beone of the determining factors in moving forward. It should neverbe the only reason for moving forward.

Typically, one of the benefits of forming a captive is costsavings. Part of that cost savings can be the deferral of federalincome tax if the captive can be treated as an insurance companyfor tax purposes (the requirements of which are beyond the scope ofthis article). Corporate entities that have a net operating lossmay see limited benefits from a captive in regard to the loweringof costs. In these circumstances, an entity needs to weigh the manyother benefits that a captive can bestow on its parent companyversus the cost of formation and ongoing operations. Those benefitscan best be uncovered with the assistance of a qualified captiveinsurance professional.

Related: Is using a captive the right move for yourorganization?

Jeff Kenneson is president of R&QQuest Captive Management LLC. He can be reached at [email protected]