There are many new and different types of arrangements that are used in the reinsurance industry. Captive insurance is one such unique arrangement. Captive insurance is actually a part of an elaborate corporate strategy for many companies.
It has also spawned different arrangements such as fronting. It is important to understand what captive insurance is and how does it work.
This article provides further details about captive reinsurance.
Why are Captive Insurance Companies Created?
Many large corporate groups control hundreds of companies. It is quite common for a large group to purchase several types of policies for each company. There is property insurance, casualty insurance, workman’s compensation, insurance against natural disasters, etc.
A lot of these companies have realized that they pay a lot of premiums in the long run.
However, the amount of money that they receive in the form of claims is very less.
As a result, a lot of these companies realize that they are better off insuring themselves.
As a result, group holding companies often obtain insurance licenses with the sole purpose of providing insurance to their subsidiaries. This process of obtaining licenses may be complex because of regulatory reasons.
However, large corporations still decide to undertake this process since it provides certain benefits. The two of the most important benefits are listed below.
- Cost Effective: If empirical data shows that the company pays out much more in premiums, then they recoup in the form of claims, the company is just giving out money. If they do have the financial strength required to support a big loss, the company would be better off insuring the risk generated by its own group companies.
- Tax Efficient: It is also important to realize that insurance companies get preferential tax treatment. Insurance companies do not have to pay taxes on premiums received minus claims paid. This is because their claims may not have to be paid immediately. Some claims can arise years later.
Hence, the money is not really earned for a long time. As a result, insurance companies do not have to immediately pay taxes.
Instead, they can pay taxes after a long period of time and can compound their money in the meanwhile.
Captive Insurance Company Vs Captive Reinsurance Company
It is important to note that the group company can create its own corporation at different points on the insurance value chain. This means that they could either create their own insurance company and then may or may not use a third-party reinsurance company.
Alternatively, they could also create their own captive reinsurance company while taking the services of a commercial insurer to be an intermediary. The second arrangement is called fronting and has been explained in detail in the forthcoming articles.
Reinsurance Attachment Points
An analysis of empirical data shows that under normal circumstances, the company would be better off insuring its own risks.
However, empirical data does not take into account catastrophes.
A single catastrophe may lead to a disproportionate loss for the captive insurance company. It has the potential to wipe out the entire surplus which has been generated by the captive over a period of many years. In order to overcome this situation, it is common for captive insurance companies to purchase reinsurance.
The purpose of this reinsurance is not to pay out small claims on behalf of the captive insurance company.
The captive company wants to bear that risk itself. This reinsurance is designed to prevent the captive reinsurer from going bankrupt in the event of a crisis.
Hence, it is triggered only after a certain amount of losses have been reached.
For example, it is possible that the reinsurance company may only start paying out money for losses that have occurred beyond $1 million. This $1 million is known as the reinsurance attachment point. This is the point from which the reinsurance company starts paying. Up till this amount, the losses are absorbed by the captive company itself.
Since the combination of reinsurance premiums as well as actual claims is much less as compared to premiums paid out by many large companies, they prefer this approach to insurance.
Types of Captive Insurance Companies
Lastly, we need to understand the type of captive insurance companies which are present in the market to get a better understanding of the current situation.
- Single Group: A single group captive insurance company is one that exclusively insures the insurance exposure of the companies belonging to that particular group. This captive insurance company is not authorized to underwrite any other exposures.
- Association of Companies: A lot of times, many small companies belonging to a particular industry also pool their resources together so that they can also access the same benefits as large group companies. In this case, the business being underwritten belongs to all the companies which belong to that particular association.
The fact of the matter is that captive insurance and reinsurance companies have started mushrooming across the marketplace. In a way, it can be seen as a failure of underwriting that companies find it cost-effective to insure their own risks.
If improvements in underwriting are able to more accurately match the premium charged to the risk, such captive insurance companies will become unviable over a period of time.
