What is captive insurance?

If the last few years have taught us anything, it’s to expect the unexpected and the unpredictable.

Companies have had to add the impact of runaway inflation, war, disrupted supply chains, a pandemic and the increasingly evident impacts of climate change to their risk portfolio. Now they’re also facing a weak economic outlook that threatens to erode bottom lines.

What does all this mean for insurance costs? The outlook is tough – the market is already at its hardest in two decades and commercial insurance premiums are forecast to rise over the next two years. That’s why more companies are turning to captive insurance to reduce the cost of risk and to fill any gaps in their coverage.

Captives are a form of self-insurance where a company sets up its own in-house insurer or reinsurer and manages a portion of its own risk. They have saved a number of businesses since the pandemic began – some paid out on claims related to COVID-19, while others used reserves they had built up to keep their parent company afloat.

Thomas Keist, Global Captive Solutions Leader at Swiss Re, says increased uncertainty has prompted a rise in the use of captive insurance in recent years. Large corporates and mid-sized companies are either setting up such vehicles or ramping up their use of existing captives, while some are making use of innovative new products such as virtual captives to get started in this field.

A captive is a self-insurance vehicle that can help companies keep a lid on rising insurance costs. It can also plug gaps in any risk cover left by today’s difficult insurance market – where premiums and deductibles are rising and companies retain more risk on their balance sheet. And it can work as a way to build up reserves to cover risks that may be difficult to insure otherwise.

To create one, a company has to set up a wholly owned licensed insurance or reinsurance company. It’s generally easier to obtain a reinsurance rather than an insurance licence, so a large majority of companies opt for that model, Keist says.

For reinsurance captives, Swiss Re can act as a fronting insurance company, issuing the policy and then ceding the risk into the captive.

A captive bundles the risks of diverse business units and “uses internal risk diversification effects as a way to bring down the total cost of risk”, Keist says.

Setting one up makes most sense financially if the actuarially calculated expected loss is materially lower than the premium set by a traditional insurer implies. Keist suggests a company may start to benefit from setting up a captive structure if it pays between USD 3 million and USD 5 million annually for the commercial insurance of the contemplated captive layer.

There’s a limit though, and a captive won’t replace a traditional insurer. It’s a suitable option to cover losses of USD 25 million-50 million, but not catastrophic events such as natural catastrophes or an exceptional accumulation of smaller losses.

So why not just increase deductibles? That can seem “a cheap and easy fix for the problem”, Keist says. However, “it increases potential balance sheet volatility, particularly for smaller companies,’’ if they suffer from large losses and have not been able to build up respective reserves.

He cites the example of a company with a number of manufacturing operations in different countries. What happens if its factory in Malaysia burns down and the subsidiary there needs to be recapitalised to rebuild the factory? “You can’t just send a cheque,” Keist says. Having a captive allows the business to “pay for losses quickly and in the right place”.

Captives have been around since the 1950s, but they only came to prominence in the 1980s, when they were often used as tax-efficiency vehicles. Regulatory crackdowns have since seen them return to their roots as risk management tools for the parent companies.

Rising premiums and shrinking insurance capacity have fuelled growth in the USD 100 billion captive market and there are now more captive insurance companies than traditional insurers globally, estimated at more than 7,000 captives domiciled in more than 70 jurisdictions.

Captives are no longer just an option for large corporates, as new and more innovative products – such as virtual captives and protected cell captives – help mid-sized businesses to self-insure.

A virtual captive is a multiyear agreement with a licensed insurance company like Swiss Re Corporate Solutions, usually running for three to five years. It replicates the financial mechanics of a traditional captive without the need to set up a regulated (re)insurance company.

The customer will self-finance most of the risk while the remaining peak and tail risk is transferred to the insurer. The insurer, in turn, collects a risk premium and a fee to cover the cost of providing the balance sheet and running the programme.

Another option is a protected cell captive (PCC), which is essentially a rental captive set up by a third party, like large brokers. They are currently only available in a small number of domiciles, mostly offshore. Insureds are protected by special provision that legally separates the assets and liabilities in each insured's account, or “cell”, from those of every other participant's “cell”. The structure is essentially the same as that of a rental captive, with no risk sharing, but PCCs have the additional benefit of statutory protection.

Today’s world may have taught us to expect the unexpected, but it seems we can expect the use of captive insurance vehicles to continue increasing. The collision of rising economic and geopolitical risks with a hard commercial insurance market will leave companies needing to finance and manage more risk themselves.

So what’s the best advice for those looking at this form of self-insurance? Swiss Re’s Keist says businesses should ask themselves just one question: ‘’Does it make sense to keep the risk in the company?’’