Captives and Other Risk-Financing Options

Traditionally, businesses and other organizations have handled risk by transferring it to an insurance company through the purchase of an insurance policy or, alternatively, by retaining the risk and allocating funds to meet expected losses through an arrangement known as “self insurance,” in which firms retain rather than transfer risk.

During the liability crisis of the 1980s, when businesses had trouble obtaining some types of commercial insurance coverage, new mechanisms for transferring risk developed, facilitated by passage of the Product Liability Risk Retention Act of 1981.

These so-called alternative risk transfer (ART) arrangements blend risk transfer and risk retention mechanisms and, together with self insurance, form the alternative market.

Captives a special type of insurance company set up by a parent company, trade association or group of companies to insure the risks of its owner or owners and risk-retention groups in which entities in a common industry join together to provide members with liability insurance were the first mechanisms to appear.

Other options, including risk retention pools and large deductible plans, a form of self insurance, followed. ART products, such as catastrophe bonds, weather derivatives and microinsurance programs are also emerging as an alternative to traditional insurance and reinsurance products.

Alternative Market Mechanisms

I. Captives

Wholly owned captives are companies set up by large corporations to finance or administer their risk financing needs. If such a captive insures only the risks of its parent or subsidiaries it is called a “pure” captive. Captives may be established to provide insurance to more than one entity.

An association or group of companies may band together to form a captive to provide insurance coverage. Professionals doctors, lawyers, accountants have formed many captives over the years. Captives may, in turn, use a variety of reinsurance mechanisms to provide the coverage.

In particular, many offshore captives use a “fronting” insurer to provide the basic insurance policy. Fronting typically means that underwriting, claims and administrative functions are handled in the United States by an experienced commercial insurance company, since a captive generally will not want to get involved directly in running the insurance operation.

Also, fronting allows a company to show it has an insurance policy with a U.S.-licensed insurance company, which it may need to do for legal and business reasons. The rent-a-captive concept was introduced in Bermuda 20 years ago and remains a popular alternative market mechanism.

Rent-a-captives serve businesses that are unable to capitalize a captive but are willing to assume a portion of their own risk and share in the underwriting profits and investment income.

Generally sponsored by insurers or reinsurers, which essentially “rent out” their capital for a fee, the mechanism allows users to obtain some of the advantages of a captive without having the expense of setting up a single parent captive and meeting minimum capital and surplus requirements.

Captives have been expanding into the employee benefits arena since 2003, the year in which the Department of Labor gave final approval to Archer Daniels Midland Co.’s plan to use its Vermont captive to reinsure group life insurance benefits.

While the leading domicile for captives in the U.S. is Vermont, offshore captives covering U.S. risks are predominantly located in Bermuda, where they enjoy tax advantages and relative freedom from regulation. The Cayman Islands, Guernsey, the British Virgin Islands, Luxembourg and Barbados are also significant centers for captives. Vermont is the leading domicile for captives in the United States.

II. Self Insurance

Self insurance can be undertaken by single companies wishing to retain risk or by entities in similar industries or geographic locations that pool resources to insure each other’s risks. The use of higher retentions/deductibles is increasing in most lines of insurance.

In workers compensation many companies are opting to retain a larger portion of their exposure through policies with large deductible amounts of $100,000 or higher. Large deductible programs, which were first introduced in 1989, now account for a sizable portion of the market.

III. Risk Retention Groups

A risk retention group (RRG) is a corporation owned and operated by its members. It must be chartered and licensed as a liability insurance company under the laws of at least one state. The group can then write insurance in all other states. It need not obtain a license in a state other than its chartering states.

IV. Risk Purchasing Groups

Like risk retention groups (RRGs), purchasing groups must be made up of persons or entities with like exposures and in a common business. However, whereas RRGs are liability insurance companies owned by their members, purchasing groups purchase liability coverage for their members from admitted insurers, surplus lines carriers or RRGs.

Laws in some states prohibit insurers from giving groups formed to purchase insurance advantages over individuals.

However, purchasing groups are not subject to so-called “fictitious group” laws, which require a group to have been in existence for a certain period of time or require a group to have a certain minimum number of members.

The Risk Retention Act of 1986 specifically provided for purchasing groups to be created to purchase liability insurance for members of the sponsoring groups.

V. Catastrophe Bonds and other Alternative Risk Transfer (ART) Products

A number of alternative risk transfer (ART) products, such as insurance-linked securities and weather derivatives have developed to meet the financial risk transfer needs of businesses.

One such product, catastrophe (cat) bonds, riskbased securities sold via the capital markets, developed in the wake of hurricanes Andrew and Iniki in 1992 and the Northridge earthquake in 1994 megacatastrophes that resulted in a global shortage of reinsurance (insurance for insurers) for such disasters.

Tapping into the capital markets allowed insurers to diversify their risk and expand the amount of insurance available in catastrophe-prone areas. Zurich Financial’s Kamp Re was the first major catastrophe bond to be triggered.

The $190 million bond was triggered by 2005’s Hurricane Katrina, and resulted in a total loss of principal. Catastrophe bonds are now a multibillion dollar industry.

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