If a company requires alternative risk financing, its owners may choose to form a captive insurance company. The captive insurance industry was created to ensure a company or group of companies in the same or a similar industry against a specific company- or industry-related risk. For example, medical groups may create captives to supplement their malpractice insurance.
Although these companies pay themselves when they pay their premiums, they also risk their own capital because they must invest their own capital to start the captive and they are required by law to keep a specific amount of assets in case of an emergency or claim on the insurance policy. Although captives require a significantly lower capital infusion, their parent companies are not protected by the same regulations that traditional commercial insurers must abide by.
Captives are rewarded for reducing capital losses. Therefore, when a captive loses money, its underwriting profits are affected, but when these losses are reduced, the company’s underwriting profits increase. Therefore, these insurance companies carefully watch and address loss control through spreading or distributing risk effectively.
In addition, company cash flow increases as premiums that would otherwise go to an outside insurance company are distributed to the company-owned captive. Therefore, high levels of cash are held in these companies in case of an emergency. Captives also have much lower expenses (15-30% of their incomes) compared to traditional insurers (up to 40%).
Because captives are paid by their parent companies, their prices are typically stable. In addition, as they mature, their risk is further diversified or spread, increasing the captive’s ability to retain greater risk. These insurance companies are then able to protect themselves and are somewhat insulated from commercial insurance volatility. Coverage availability is also stable because the policy is written to address specific risks.
Captives have both financial risks and benefits. A well-planned captive will effectively moderate risk while earning a hefty profit for itself and its parent company.