A Captive Insurance Company: Is It Right for You?

A reprint of an article Brendon Hunt, that originally appeared in the Cornwall Business Magazine

As a business expands and grows, so too, do the various risks associated with operating that business. Recent trends towards globalization of commerce have resulted in significant mergers and acquisitions both abroad and right here in Canada. Larger and more far reaching companies take on considerable amount of expanded physical, liability and political risks in periods of expansion. Ultimately most controllers or vice-presidents of finance, review their insurance costs associated with containment of these various risks, and give thought to self-insurance.

There are numerous methods of self-insurance, the most familiar being a deductible. Most of us are very accustomed to deductibles on our home and car insurance policies. Deductibles, some times referred to as Self-insured Retention, reduce the overall premiums by eliminating the smaller, nuisance type claims which are expensive to administer and adjust. This way, the insured can keep the premium reduced and the still have adequate coverage for catastrophic loss.

One of the fastest growing areas of self-insurance, is the formation of a captive insurance company. By way of background, a "captive" can be defined as a closely-held insurance company whose insurance business is derived from, and controlled by its non-insurance owners, and in which the original insured are the beneficiaries.

There are literally thousands of captives world-wide, and it is estimated that they account for approximately 20% of world-wide gross premiums! They are now at the core of many business' risk financing programs, and a valuable way for owners to control a significant expense and participate in the profit that historically was taken by another business (insurance companies), and to develop their own in house risk management.

The majority of captives are not managed by their own full-time staff; it is estimated that there are over 250 management companies in the approximately 23 domiciles around the world. Consequently, the traditional, but understandable fear of many business persons, namely that they lack the experience to run an insurance company, is in reality redundant, using the combined talents of professional insurance managers and brokers.

The qualified insurance broker can play a crucial role in the ongoing operation of a captive, and may be involved in the brokering of fronting insurance, claims-handling, reinsurance issues, and in the capacity as a general consultant to the captive.

Captives typically are in one of four potential size scenarios:

• open market, i.e. an insurance company doing business with third parties, but which is able, because of its market to operate from within captive legislation, probably at a cost savings;
• full scale, or being of sufficient size to warrant having a self-supporting staff;
• small scale, managed by a professional manager, thereby saving operating costs without sacrificing efficiencies;
• rent-a-captive, where the insured utilizes another captive without necessarily funding the capital requirement. This is most advantageous to the (comparatively) small business, in offering the benefits of a captive with reduced expenses and less commitment in longer term.

In the late 1980's many Caribbean countries elected to amend their Exempt Insurance Amendments and Acts, in a effort to attract the flow of monies (in this case, premiums and investment income), thereby reducing their dependency on tourism. Most notably, Bermuda, Bahamas the Cayman Islands and Barbados, have aggressively solicited the growth development of this sector of their economies, by this type of investment into their respective countries, by reducing the amount of paid up capital and premium requirements necessary to establish the captive, as well as offering local tax incentives which effectively eliminate any income tax in the domiciled country. There are also essential regulatory controls to safeguard the integrity of those countries to prevent money laundering, thus, there is constant review of the applicable legislation within these Caribbean countries. Because the captive is not located within North America, they are sometimes referred to as "offshore" captives.

Very recently, Revenue Canada too, has become more aggressive in seeking and obtaining what are known as double-taxation treaties with various Caribbean countries, which fundamentally apply income taxation in Canada, based on profits of the offshore captive, however in many cases, the repatriation of dividend income back to the Canadian owners is treated in a favourable tax climate.

A captive should never be established solely for tax avoidance purposes, but rather should encompass additional objectives including the reduction or containment of existing costs; improvement of existing coverages, terms or conditions; cumulative investment income; the implementation of newer risk management procedures; improvement of cash-flow by establishing favourable premium payment timing; subsidiary loans (in some cases it may be possible to make loans to subsidiary companies from free reserves), and overall diversification by inherently creating a new profit center for the Canadian owner.

Ultimately, a captive is answerable to its owners and thus may offer more flexibility than traditional domestic insurers. It should be cautioned however, that these may not be the right risk transfer vehicle for all businesses, and regardless of the fundamentals for the captive formation, thought should be given to the significant financial commitment involved in managing the captive , as well as the premium volume, and the spread of the captive's risk amongst other insurers known as re-insurers.

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