A Guide to Captives

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EXECUTIVE SUMMARY

Airmic is grateful to Chartis for producing this guide to captive insurance
companies. Airmic invited partners to select an area of expertise and produce
an introductory to intermediate level guide for the benefit of Airmic members.
The intention of this guide is to provide Airmic members with an overview of
the topic and provide information on the practical considerations when
managing this important insurance issue.
This guide has been written with a view to providing members of AIRMIC
with support when faced with such questions as...
“What alternatives are available to buying cover in the commercial market?”
“Can we save on premium spend and can we take more control of our risks?”
“What do we need to do and what will it cost?”
If you already have a captive you may be asked to explain why and what it
provides that the commercial market does not.
This is by no means a definitive guide; however we hope it will go some way
to answer these questions and to help in your understanding of the world of
captives and how they may work for your organisation.
This guide will take you through the life cycle of a captive from initial
concept through to the benefit and uses and finally to exit strategies.
The following topics will be covered:

1. What is a captive? 10. What would it cost to set up
2. Is it a legitimate insurance and manage?
company? 11. Who would manage it?
3. Why set up a captive? 12. How much would they charge?
4. What types of companies 13. Where to set up your captive?
consider captives? 14. Set up insurer or reinsurer?
5. How do you know if it is right for 15. Typical examples of
your organisation? captive structures
6. What risks can it insure? 16. What exit strategies
7. Advantages and disadvantages are available?
8. Types of captive 17. Case studies
9. When is a good time to set up
a captive?
2

1
WHAT IS A CAPTIVE?
The name “Captive” was coined in the 1950’s Captives can operate as either insurance or
when the concept was being brought into reinsurance companies and as such issue:
practice for a mining company. A mine producing
• insurance/reinsurance polices
output which was being kept solely for the
corporations own use was referred to as a • bill and collect premium
“captive” mine. When the mining company
Generally they have no employees so all typical
incorporated its own insurance company, it was
“insurance company” functions are outsourced to
referred to as “captive” insurance as it wrote
third parties.
insurance exclusively for the captive mines.
Today, a “captive” insurance company is
effectively an “in house” insurance provider
formed primarily to insure its owner and affiliated
companies and can be viewed as a form of
formalised self-insurance. They can write some
third party business but this is dependant on the
jurisdiction and its definition of a captive.

2
IS A CAPTIVE A LEGITIMATE INSURANCE COMPANY?
Yes, a captive insurance company is a risk • There are over 5,000 captives worldwide
management and financing vehicle that offers an
• Estimated annual premium flowing into
alternative to conventional insurance and also the
captives is US$55bn-US$60bn per annum
opportunity to combine with an existing risk
financing (insurance) programme. Captives are • Captive (re)insurance companies have been
regulated entities within the domicile in which established in over 70 jurisdictions worldwide
they operate. Captive insurance has become an
• Typically non rated
integral part of the global insurance market;

Switzerland 4% Malta 1%

Sweden 6%

Ireland 9%

Isle of Man 16%

Guernsey 41%

Luxembourg 23%

Active captives by European Domicile
Source: Crain Communications Inc Sept 2010

A GUIDE TO CAPTIVES 3

3
WHY SET UP A CAPTIVE?
Captives are set up for 4 main reasons:
Cost gear premium levels to own Capacity hard and soft market cycles dictate
group claims experience price and capacity
Cover uninsurable or difficult to insure risks Control long term company strategy

4
WHAT COMPANIES CONSIDER CREATING A
CAPTIVE TO MANAGE THEIR RISKS?
Companies that in the main want to control their They have been commonly established by the
own destiny with regard to their insurance Fortune 500 companies, large professional service
programme and have a strong commitment to loss firms, and other large organisations. However, with
control. They will also: the introduction of PCC’s and Rent-a-captives it is
quite possible for small to medium sized
1. Be willing to invest time and money to create a
enterprises to economically establish their own
captive i.e. have the financial ability to pay
captive programme.
captive premium and provide initial capitalisation
2. Have premium large enough to justify the
annual operating costs
3. Have a claims history that is better than other
companies in their class of business or have
improved risk management processes that are
expected to improve its risk profile

5
HOW DO YOU KNOW IF A CAPTIVE IS
RIGHT FOR YOUR ORGANISATION?
If a company can answer “yes” to points 1 - 3 above • Source of business e.g. country, subsidiary or
then the next step would be to have a feasibility third party
study undertaken. The study is one of the more
• The risk and circumstances of the client
important steps in determining the value of a
captive to its owners and provides a roadmap as • Identification of classes of business to
to how a captive can be specifically used to meet be written
the insurance needs of its owners and related • Details of existing reinsurance programme
parties. The study will evaluate whether the
captive is an optimal tool for business and will • Policy limits
therefore likely include: • Advice on the most suitable structure for
• Financial projections – estimated capital the captive
required to meet legal and cost requirements • Where relevant actuarial reports –
of the captive estimated loss experience
• Premium volume that will make the captive • Underwriting guidelines
financially viable, for example this should be in
• Domicile review
the region of £500,000
• Claims handling procedures

4

6
WHAT RISKS CAN IT INSURE?
In principal any risk can be covered through a • Operating risks, such as product recall
captive structure.
• Credit default
Popular types of risk covered within a captive
• Loss of key customers and suppliers
structure include professional indemnity and
other commercial insurance – property, • Exclusions in disability insurance policies e.g.
business interruption, employer’s liability pre-existing conditions
and environmental liability.
• Types of insurance unavailable in
Instead of looking at the usual business risks, commercial markets
potential captive owners could consider risks not
• Natural disaster
covered by their conventional insurance policies.
This raises the question of why a business would • Construction defects
want to insure additional risks that it wouldn’t Generally the cost of self-insurance outside of a
otherwise have to. Consider however, that those valid and qualifying captive structure is not tax-
additional risks were always there; they were deductible. A properly formed and operated
simply risks that were self-insured. In reality, most captive may, however, deduct insurance premiums
businesses knowingly or unknowingly self-insure a that are paid into a privately owned insurance
large amount of risk, including the following: company. Also claims are paid with pre-tax funds.
• Policy exclusions, such as mould and pollution If no claims are made, the captive retains the
premiums for future business risks or distributes
• High deductibles and self-insured retentions
as profits.


7
WHAT ARE THE ADVANTAGES AND
DISADVANTAGES OF OWNING A CAPTIVE?
ADVANTAGES: DISADVANTAGES:
• Cover for risks that are unavailable or expensive • Formation can be costly
in the commercial market
• Capitalisation is required creating an
• Ability to set aside separate fund for risks in a opportunity cost for the business
more tax efficient vehicle
• Ongoing expenses incurred for operation of
• Smooth insurance prices over time the captive i.e. governmental fees, legal fees,
accounting fees (audits) etc.
• Premium based on own experience
• Increased management involvement required.
• Incentive for loss control
Captive is not for the short term, there will be
• Increases senior management’s awareness of an ongoing time commitment from the
cost of risk and control management of the owner
• Can be a negotiation tool during renewal • Exposure to underwriting loss
discussions with the commercial market
• Insurance premium tax when insuring a
• Direct access to the reinsurance market previously uninsured risk
• Underwriting profits and investment
income retained

6

8
ARE THERE DIFFERENT TYPES OF CAPTIVE?
Yes, captives can take the following forms:

PURE CAPTIVE Is a wholly owned subsidiary of its parent company and insures primarily the risk of the
(also known as parent and its affiliates. In some circumstances it can extend cover to non owned third
single parent) parties. Least costly type of captive to operate, outside of a cell in a PCC and provides
most flexibility in terms of programme design, operating structure and lines of cover.

GROUP CAPTIVE Has many owners and insures the risks of these owners, and usually cannot extend
to third parties. These enable similar or diverse businesses to band together to share
the risk, cost and benefits of providing commercial insurance to their members.

TRADITIONAL This is set up by a sponsoring organisation such as an insurance company or a
RENT-A-CAPTIVE broker. This organisation provides the capital for the facility and then “rents” this
capital to participants who seek to establish their captive programmes as individual
“cells” within the Rent-a-captive facility. It has all the benefits of captive ownership
without the initial capital contribution and therefore can be more suitable for the
SMEs. Traditional Rent-a-captive operates on the same basis as a PCC (see below)
but risks are segregated on a contractual as opposed to a statutory basis.

PROTECTED CELL Similar to a Rent-a-captive but unlike a traditional Rent-a-captive it has
COMPANY (PCC) segregated cells for each user. The assets and liabilities of each user are
legally separated ("ring-fenced") from those of the other users.

INCORPORATED CELL Similar to a PCC, however each cell is a legal entity in its own right. Unlike
COMPANY (ICC) with a PCC cells can transact with each other. Allows greater flexibility in the
way segregated accounts are operated.

Captives can operate as insurers, providing insurance The drivers behind the decision whether to set up
directly to the captive parent or reinsurers providing an insurance captive or a reinsurance captive will
reinsurance to a direct writing insurer which in turn be discussed later under “Examples of captive
provides cover to the captive parent. structures”.

9
WHEN IS A GOOD TIME TO SETUP?
Generally captives are set up in what is known as Usually market conditions will not be the only
a “hard” market i.e. when the premium rates are factor which would dictate the point at which a
so high that they are unaffordable and do not company should/might consider setting up a
make economic sense for the purchasing captive. The parent company would need to be of
company. Alternatively, cover may not be a sufficient size and at a point in its development
available in the market for particular risks, this that makes sense to establish a captive.
may be because of bad loss experience in the For example, as mentioned earlier its premium
past or the risks to be covered are new or spend should be in the region of £500,000 to be
speciality risks. able to justify the additional operating costs and
capitalisation of the captive. Most importantly it
will need to be willing to assume risk.


10
WHAT WOULD IT COST TO SET UP AND MANAGE?
These will vary from a standalone captive to a cell feasibility study, consulting fees, regulators and
within a PCC or Rent-a-captive. These costs are legal fees, and on-going costs such as auditors
split between initial start up costs such as; and directors fees and captive management fees.

11 12
WHO WOULD MANAGE IT? HOW MUCH WOULD THEY CHARGE?
The parent company itself could take the decision Captive Managers normally charge their fees on
to manage the captive if it has the time, resources a time and expense basis based on the number
and expertise to do so. More usually a Captive of hours to be spent on managing the captive.
Manager is employed. The company can benefit This will normally be estimated in advance and a
from the managers knowledge and expertise and fixed annual fee proposed to the client.
they will likely have an existing relationship with
Fees will therefore vary based on the complexity
the regulator, often crucial when setting up a
of the captive and the requirements of the
captive. In nearly all jurisdictions or domiciles the
captive sponsor.
local regulatory authorities require that captive
insurance companies are managed by experienced
and qualified insurance professionals.

8

13
WHERE TO SET UP YOUR CAPTIVE?
Captive insurance companies are typically formed When making this decision the factors to be
in countries that have laws allowing for the considered are numerous, these include:
establishment of a captive insurance company.
• Whether the captive is to write direct or
These locations are known as domiciles.
provide reinsurance
The choice of domicile for the incorporation of
• The regulatory environment including the
the captive insurance company will depend on
sophistication and reputation of the regulators
many practical considerations affecting the
for example – Solvency II, regulators
business concerned.
response time
Domiciles in the EU such as Ireland, Luxembourg,
• Costs of creating and running the captive
Gibraltar, Sweden and Malta or in the US such as
Vermont, South Carolina and Hawaii can have • Minimum capitalisation requirements –
very different benefits and drawbacks to “off- can vary widely from £100,000 to £3m
shore” domiciles such as Guernsey, Isle of Man,
• Taxes (local premium tax, federal excise tax,
Switzerland, Bermuda, Cayman and Barbados.
double tax treaties)
• Investment restrictions on the captive’s surplus
• Type of cover to be offered (whether a
particular domicile offers unique advantages
regarding a particular type of cover)
• Convenience – ease of travel, time zone
The ultimate decision should be based on the
parent company’s overall risk management
objectives and the direction it wishes the captive
to take and also how comfortable a parent feels
with respect to the overall regulatory approach of
a particular domicile.


14
WHAT INFLUENCES WHETHER A CAPTIVE
OPERATES AS AN INSURER OR A REINSURER?
We spoke about captives operating as either This is where a “Fronting” insurer is needed.
insurers or reinsurers earlier. What influences A fronting insurer is a licensed carrier that issues
this decision? the policies that a captive cannot issue with the
intent of passing all or most of the risk to the
Generally, a company must be licensed to do
captive by way of reinsurance. In that case the
business in the jurisdiction in which a policy is
captive will operate as a reinsurer.
issued. A captive licensed as such will most likely
therefore write insurance directly. In some cases
however, captives lack the required licenses to do
business and, therefore often must use a fronting
arrangement in order to do business in a country
in which its parent's risks are located.

A typical fronting arrangement

Fronting Carrier Retains:
CAPTIVE PARENT FRONTER Fronting Fee
(Insured) (Insurer) Taxes
XOL Cover Premium (optional)

REINSURANCE

Dividend payments CAPTIVE
CAPTIVE MANAGER
Captive retains: (Reinsurer)
Underwriting Profit
Inverstment Income

RETROCESSION

Premium

XOL Cover Claims
RETROCESSIONAIRE e.g. cat cover Collateral
e.g. LOC, Trust

The decision to operate as an insurer or reinsurer is not solely driven by licensing requirements but
can be driven by other factors such as administration requirements, readiness of the parent company
to be hands on and cost of fronting etc.

10

15
WHAT ARE SOME TYPICAL EXAMPLES
OF CAPTIVE STRUCTURES?
The most typical and simplest example of a GROSS LINE PROGRAMME
captive structure is that of insuring with the We have discussed how a captive generally
captive the deductible or self-insured retention would reinsure 100% of the risk of the fronting
(SIR) of the parent company. The insured parent insurer. The captive may decide that it will retain
company transfers the liabilities related to the only part of this risk and therefore it will cede
deductible layer from itself to the captive insurer the “excess” to a reinsurer - this is known as
up to the limits of the deductible or SIR. “Gross line”.
This ensures that funds are built up evenly over The benefit of a Gross Line programme is that
time and are available to pay claims when needed. the captive has more flexibility in its insurance
Also claims within the deductible may not be tax programme and it controls the primary rates and
deductible, from a parent company perspective, reinsurance rates it pays.
until actually paid. However, the disadvantage is that it is more
If the deductible claims are “transferred” to a labour intensive. Also the fronting fees and
captive, the captive will be able to deduct both security requirements may increase as the
the paid claims and the accrued unpaid claims for Fronter has no control over the reinsurance
tax purposes. bought by the captive and therefore may view
this as an additional risk. This would be more
suitable for a captive that has been running for
many years and has built up the expertise to take
more control over the captive programme.

An example of a Gross Line programme

CAPTIVE PARENT
(Insured)

Pays premium Issues policy for £50m
in the aggregate

FRONTER
(Insurer)

Premium less fronting fee
(e.g. between 4% - 10% of Issues policy for £50m in the
premium) and taxes aggregate and indemnifies for
all loss payments and provides
collateral (LOC, Trusts)

Issues policy
£30m xs £20m

RETROCESSIONAIRE CAPTIVE
Pays reinsurance
(Reinsurer)
premium


NET LINE PROGRAMME
An alternative to the Gross Line programme is a It has the benefit of being much less labour
“Net Line” programme which is more suitable for intensive then the Gross line programme with
a company in a start up situation. fewer security issues. However the captives
control of the programme is reduced and the cost
In this case the captive only insures that portion
of reinsurance is often higher as the captive, in
of the risk it wishes to keep net. The fronter will
this scenario, does not have the option to
determine with the captive the level of risk the
approach the market itself.
fronter itself will retain, if any, and what is to be
reinsured in the commercial market. Cessions to
the captive are net of all costs and expenses to
the fronting company i.e. fronting fees, taxes,
any other overrides and cost of cover above the
captive layer.

An example of a Net Line programme
CAPTIVE PARENT
(Insured)

Pays premium Issues policy for £50m
in the aggregate
Issues policy excess of
£800k up to £50m limit

REINSURER
FRONTER
(Insurer)
Pays reinsurance
premium
Issues policy for £800k in the
aggregate and indemnifies for
Pays premium less fronting fee, all loss payments and provides
reinsurance costs and all collateral (LOC, Trusts)
other costs

CAPTIVE
(Reinsurer)

12

16
WHAT EXIT STRATEGIES ARE AVAILABLE?
Captives are typically long term vehicles and The options available to owners seeking to exit
many are around for decades. However for a captives are:
variety of reasons, including merger & acquisition
• Commutation (with the fronting insurer)
activity or changes in risk management
philosophy, some owners may wish to close down • Portfolio transfer or novation
or sell their captive vehicles. (with another insurer)
• Restructuring of liabilities (through a PCC)
• Selling the captive to a third party
(as a going concern or as a run-off vehicle)
All of the above options require consultation with
and/or approval from claimants, regulators,
auditors and actuaries in order to achieve a
satisfactory exit solution.

COMMUTATION On fronted policies, fronting insurers are often happy to commute captive
reinsurance reserves for a reasonable margin that should compare favourably
with the full costs of run-off to expiry of all liabilities where the captive is to
close down completely.

NOVATION This involves replacing the captive with another organisation as party to the
insurance contracts. Typically this would be another insurance company. The
main drawback to such arrangements is the need to obtain full agreement of any
fronting insurers. However, where the fronting insurer is unwilling or unable to
commute, this can be an effective solution.

PORTFOLIO In cases where a fronting insurer is not amenable to a novation of the subject
TRANSFER business to another insurer, the captive can reinsure its liabilities with an insurer
through a portfolio transfer. The captive will retain credit risk against the insurer
providing the portfolio transfer reinsurance, and collateral supporting the
liabilities to the fronting insurer may not be released. However, this mechanism
will largely achieve the objective of removing the insurance liabilities from a
captive and will potentially enable a release of any excess capital.

RESTRUCTURING Typically this involves the novation of liabilities into a PCC cell, financed through
OF LIABILITIES a combination of reinsurance and non-cash capital. This has the advantage of
segregating the captive liabilities in another vehicle and has reduced operational
costs and management commitment. Again it will need the agreement of
fronting insurers.

SALE OF CAPTIVE An alternative to closing down a captive is to sell it to an insurer or a third party
which can either continue to use the captive as an ongoing vehicle or can put it
into run-off.


CASE STUDIES

Property Cover in
an Irish Captive
PROBLEM:
Deductible too large for individual affiliates

ABC Company, a large global manufacturing The captive was set up in Ireland based primarily
company insured its property and business on its proximity to Europe and US, its ability to
interruption risks in the commercial market. access the EU on a direct basis and the favourable
However, the policy has a deductible feature for corporate tax rate of 12.5%. Minimum capital
the first £500k for each claim. The affiliates were required under the EU Insurance Directive
too small to absorb a single large claim so the is €2.3m.
company established an insurance captive to
indemnify and reimburse the affiliates for any
losses within the deductible. Premium of £5m
was paid based on actuarial analysis of the
exposure; this cost was spread over
approx. 40 affiliates according to turnover.

Liability risks
PROBLEM:
Premium rate increase

A large drinks company set up a reinsurance Following a bad loss year the fronting company
captive in a soft market cycle to retain a portion sought a sizable increase in premium and higher
of its own risk. A fronting company was used to attachment point for the excess layers.
provide cover from ground up to £550m. The Quotations from alternative insurers also
primary layer £800k per occurrence and £4m in indicated a general hardening of the market.
the aggregate was ceded 100% to the captive.
Due to the surplus built up in the captive it was in
Layers in excess of the captive’s layer were
a position to take on this greater risk by increasing
retained net by the fronting company.
the captives aggregate and per occurrence limits -
The captive loss experience over a number of allowing the fronting company to attach higher in
years was good with loss ratios in the low 40’s the programme with a resultant reduction in
leading to profits which were retained within the premium for the excess layers.
captive. As a result a large surplus above the
required solvency margin was built up.

14

Motor Collision
Damage Waiver (CDW)
PROBLEM:
Take over of another car hire company meant fee income
from CDW cover was substantially increased.

Following the take over of another hire company By establishing the cell the company now has the
the owner of the company recognised that it was advantage of not paying VAT on the CDW fee
an appropriate point in time to formalise the fees income, fees are now converted to premium and
received in relation to CDW using an insurance therefore tax deductible, any claims paid would
structure. In doing so the company would have therefore be funded from pre-taxed funds and
various tax advantages and would be able to build there is no requirement to release the surplus
up a fund to finance future losses. funds as profit each year.
The structure utilised had to be as simple and low
cost as possible and be set up swiftly to meet
other company commitments. The structure
chosen was that of a cell in an existing PCC in
Guernsey. This meant no capital had to be
deposited above that required to meet the cell
solvency requirement. Cost of running the cell
is lower than a standalone captive and the
timeframe to set up the cell was a matter
of weeks.


ce.com
u ran
t isins
har
w.c
ww

ROBERT M. GAGLIARDI
Senior Vice President & Worldwide Director
Tel: +001 802 419 1234
robert.gagliardi@chartisinsurance.com

IVY JERMYN-BUCKLEY
Insurance/Underwriting Manager – Europe
Tel: +353 1 802 8791
ivy.jermyn-buckley@chartisinsurance.com

Chartis is a world leading property-casualty and general insurance organisation serving more than 70 million clients
around the world. With one of the industry’s most extensive ranges of products and services, deep claims expertise
and excellent financial strength, Chartis enables its commercial and personal insurance clients alike to manage risk
with confidence.

Chartis Europe Limited is authorised and regulated by the Financial Services Authority (FSA number 202628).
This information can be checked by visiting the FSA website www.fsa.gov.uk/Pages/register. Registered in England:
company number 1486260. Registered address: The Chartis Building, 58 Fenchurch Street, London, EC3M 4AB.

Chartis Europe Limited (“Chartis”) disclaims all warranties, expressed or implied, relating to the information
provided. Chartis does not warrant or make any representations regarding the information provided in terms of
its correctness, accuracy, usefulness, completeness, reliability, or otherwise. Neither Chartis nor any member
companies of American International Group, Inc. accept any liability of any kind for any direct or indirect
loss arising from the use of this information.

This brochure is intended as general information only and is not intended to provide specific professional advice.
It is strongly recommended that you seek your own professional advice from suitably qualified professional advisers.

AI427653 12/11

A Guide to Captives

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