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A Captivating Way of Controlling Insurance Costs

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Insurance, the equitable transfer of the risk of a loss from one entity to another in exchange for payment, has been around for centuries. Over 500 years ago, ship owners in London met in Lloyd’s coffee shop to write down their names and value of cargo. These were the first recorded private agreements to share risks associated with cargo. Now, the captive industry is the new kid on the block and in relative terms is still in its infancy. 

Essentially, captive insurance companies are established with the objective of insuring risks emanating from  their parent group or groups. Ultimately, a captive is a sophisticated way to reduce the amount of insurance paid to somebody else, control costs and losses and build a fund to properly manage inevitable risk.

In 1978, Bermuda became the first country to formalise the captive industry with comprehensive legislation to standardise licensing and oversight procedures. The Cayman Islands followed suit and established captive legislation, targeting the healthcare industry. Harvard’s medical hospital formed one of the first pure Cayman Islands captives to supplement and control professional and medical liability risks due to increasingly expensive commercial market insurance and to improve claims and loss control.

Captive insurance resembles an in-house benefits plan to cover the assets and risks of a company. It was initially intended as a cost-savings tool by which large corporations could get coverage for operations and liabilities that would have resulted in higher premiums had they sought coverage from traditional insurance companies. Captives accept the premiums that the company would have paid to a regular insurer and then cover any claims against the parent company. If the claims are less than the premium, the captive has made a profit in the same way a regular insurance company would. The difference is that the company that set it up benefits rather than the insurer.

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” The loss control and risk management benefits of captives insurance companies are the principal draw, and these lead to the more level management of related costs.”

 For example, if a business paid a premium of $1 million to a regular insurer and had only $600,000 in claims, it would lose $400,000. If, however, it put the same amount of money into a captive, it would keep the extra $400,000 in the captive less any costs of operation.  Large companies and non-profit organizations such as hospitals and medical schools have used captives for decades to self-insure against predictable risks.  Now, financial advisers are increasingly pitching captives to smaller businesses that want to cut the costs of health insurance for their employees. They are being sold as a way not only to save money on insurance premiums but also to reduce income taxes and transfer money to heirs free of estate tax.

The loss control and risk management benefits of captives insurance companies are the principal draw, and these lead to the more level management of related costs. Tax benefits, in most cases, are the icing on the cake. Although a company might get the same tax deduction for paying premiums to a captive as to a regular insurer, in the U.S. one real advantage accrues to people whose company profits flow through to their personal income tax.  A person setting up a captive can put up to $1.2 million a year into it, tax-free.  If the captive reports a positive return after meeting all claims and expenses, it can eventually start returning the surplus to the business owner in the form of dividends, which are taxed at a lower rate than income.

                                       

In recent years, smaller businesses have learned that the captive insurance entities can provide them with significant benefits.  A good captive insurance company could provide asset protection from the claims of business and personal creditors; access to the lower-cost reinsurance market; the insurance of risks that would otherwise be uninsurable; a tax deduction for the parent company for the insurance premium paid to the captive; gift and estate tax savings for the shareholders and income tax savings for both the captive and the parent.

There are some possible drawbacks to captives.  At least during the initial stages of a captive formation, the burden is on the parent company’s financial resources to fund the set-up costs and the capitalisation required by the domicile’s regulatory body.  The captive will be responsible for such items as claim administration, loss control and underwriting.  Inevitably, the successful operation of any captive will make demands on management, with increased emphasis on loss control and risk management, and it is often the success of this commitment that dictates the ultimate benefit of a captive to any parent organisation. In addition, as the reinsurance market tends to be experience rated (premiums closely reflect the loss history of the insured) a reinsured risk of a captive might face premium increases sooner than a commercially insured risk, but at the same time a captive offers opportunity for actual premium costs to be aligned to actual loss experience as against market average to include experience of industry where perhaps less attention is given to risk management.

The use of a captive should be considered by profitable business entities seeking heightened loss control and risk management. It also a good option for businesses with multiple entities or those that can create multiple operating subsidiaries or affiliates, businesses with $500,000 or more in sustainable operating profits and businesses with requisite risk currently uninsured or underinsured. Business owners interested in personal wealth accumulation and family wealth transfer strategies should also consider captives, as should businesses where owners looking for asset protection.

The Cayman Islands have emerged as a flourishing centre for the captive industry. Indeed, Cayman is a global financial hub, not merely because of favourable tax laws and a positive regulatory environment but also because of the global expertise of the professionals who chose to reside and do business there and the impact that business expertise has had on the decisions made by government officials. The Cayman Islands is home to 70% of the world’s Funds, and it has over 90,000 active registered companies.

Information technology and electronic banking advancements have increasingly blurred the lines between nations and where one should conduct business and invest capital.  By contrast to the strict insurance regulation in most industrialized countries, a domicile such as the Cayman Islands can provide a less bureaucratic but still prudent and responsible regulatory framework.  This has been described as a system of shared regulation, whereby the regulator cooperates to ensure   an  appropriate level of policyholder protection while at the same time permitting captives to grow and prosper.

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