What it means
A captive is a licensed insurance company, normally a subsidiary, whose policyholders are its parent and that parent's affiliates. It holds capital, sets premiums, keeps reserves and files accounts like any other insurer.
What makes it captive is simply that it does not sell cover to the general public. Businesses form captives when commercial cover is expensive, hard to find, or badly matched to the risks they actually run.
A group with a strong safety record is effectively subsidising weaker firms inside a commercial insurer's pool, and a captive lets it keep the benefit of that record instead. It also creates a funded, formal way to handle risks the market will not price sensibly, such as product recall or an unusual cyber exposure.
In practice a captive rarely takes on every risk. It retains the predictable layer of small, frequent claims and buys reinsurance to cover the rare large ones.
A fronting insurer is often used as well, issuing the paperwork a regulator or landlord demands while passing the underlying risk back to the captive. The main nuance is that a captive only makes sense at scale, because it needs capital, an actuary, an auditor and a regulator before a single claim is paid.
Tax authorities also watch captives closely, since premiums are deductible and an inflated premium can look like profit shifting. A captive that never bears real risk is likely to be challenged.
In practice
Real-world examples.
Example
A hospital group facing a 40% jump in medical liability premiums forms a captive to retain the first $500,000 of every claim. It keeps the underwriting profit in the good years and uses the reserve build to fund a clinical safety team.
Example
A national chain of driving schools cannot buy affordable cover for pupil damage to vehicles, so it writes that specific risk through its own captive. Premiums are set from ten years of internal claims data rather than from a broad market rate.
Example
A construction group uses a captive to insure its subcontractor default risk, a hazard commercial insurers price very conservatively. The captive charges each project a premium, and the accumulated fund pays for the two failures that occur over five years.
Formula
Calculation
Annual cost of the captive = expected claims + captive running costs + reinsurance premium. Annual saving = commercial premium given up - annual cost of the captive.
A hotel group currently pays $2,400,000 a year for property and general liability cover. Its own claims history points to expected annual losses of $1,300,000. Running the captive, covering management, actuarial work, audit and fronting fees, costs $250,000, and reinsurance above $1,000,000 per claim costs $300,000. Annual cost = $1,300,000 + $250,000 + $300,000 = $1,850,000. Annual saving = $2,400,000 - $1,850,000 = $550,000, which is about 23% of the old premium. The group funds the captive with $3,000,000 of capital, so that saving is a return of roughly 18% on the capital committed, before any investment income on reserves.Case study
Seen in the real world.
Kestrel Freight Group is a fictional, illustrative haulage business running 900 trucks across a regional network. Its commercial motor and liability premium had climbed to $2,400,000 despite an accident rate well below the industry average, so the finance director asked whether the group was paying for other fleets' bad driving.
Kestrel formed a captive, retained the first $250,000 of each claim, reinsured the layer above and invested part of the saving in in-cab cameras and driver coaching. Claims frequency fell by a fifth over three years, and because the captive kept the benefit, the improvement showed up directly in group profit rather than in a future renewal quote.
The illustrative point is that a captive changes the incentive. Once losses hit your own balance sheet rather than an insurer's, spending on prevention stops looking like a cost and starts looking like an investment.
Watch out
Common mistakes.
- Thinking a captive removes risk, when in reality it simply moves the risk from an insurer's balance sheet onto the group's own.
- Setting premiums by guesswork rather than by actuarial estimate, which leaves the captive under-reserved when a bad year arrives.
- Forgetting the fixed running costs, so a captive is formed for a risk far too small to justify the overhead.
Questions
People also ask.
How big does a business need to be for a captive to work?
As a rough guide it needs enough insurable spend that a saving of 15% to 25% comfortably outweighs several hundred thousand dollars of annual running costs.
Are premiums paid to a captive tax deductible?
Usually yes where genuine risk transfer and risk distribution exist, but authorities will disallow the deduction if the arrangement looks like a savings account in disguise.
What is a fronting insurer?
It is a licensed commercial insurer that issues the policy paperwork required locally and then reinsures almost all of the risk back to the captive for a fee.
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