Captives And The Middle Market

Not everyone has succumbed to the perfume of the premium. During the past 10 years, more and more businesses have joined captives, particularly middle market captives.

The most recent soft market dampened the captive movement somewhat, but the movement continues to grow. Captives have gone from small, risky offshore operations to large, well-capitalized U.S.-licensed insurers. Middle-market captives are viable because they address long-term costs instead of short-term expenses. Premiums and dividends are usually based on individual and collective expense losses; many businesses prefer to reap the long-term savings that captives offer instead of jumping at every 5% premium drop that the insurance companies are hawking. Captives allow businesses to reduce their insurance and loss expenditures through risk control.

Captives often spring up when there's no fairly priced coverage for exposures not covered by standard insurance lines, such as underground storage tanks. The industry understands that some exposures are best managed by a captive or other self-insurance arrangement.

Group-owned captives require a capital commitment from each owner, and usually only insure the risks of members and owners. For owners, these programs are equivalent to having insurance company subsidiaries. Rent-a-captives offer many of the benefits of ownership without the capital commitment. Years ago there was only a handful of rent-a-captive operations. Today Bermuda seems to have one on almost every street.

Middle-market group captives usually cover owners' and shareholders' loss exposures. They may be domiciled offshore in places like Bermuda, Cayman, and Barbados. Some write unrelated third-party business for firms that don't contribute capital and aren't owners or shareholders of the captive. All unrelated third-party captive business is domiciled offshore, because U.S. domiciles don't permit them. However, Vermont and Maine allow controlled third-party business in which at least one member has direct control over activities of the third-party member, such as business practices or loss control.

The most successful middle-market captives are very selective about membership - for good reason! Suppose a captive retains the first $250,000 of each loss and members are responsible for the first $150,000 of their own losses. The remaining $100,000 is shared among all members. That $100,000 can be distributed back to the members or allocated to the capital account if each member keeps losses below $150,000.

Over the years, there's been an increase in the number of successful middle-market captives with members who are in different businesses. Despite their differences, members should have similar loss payout characteristics. Even though ABC Co. and XYZ Co. have very similar premiums and claims, they might not warrant similar benefits, such as dividends and underwriting returns. XYZ's claims are more complex, taking five to seven years to close, allowing the captive to earn more investment income. In contrast, ABC's losses pay out in less than three years, with many closing in the first year.

Group captive members can deduct their premiums from their federal income taxes. In a group captive, the risk is shifted from the member to the captive. If the captive pays federal income taxes annually, there's no additional taxation on dividends. A captive is just as susceptible to an IRS challenge as any other loss-sensitive insurance plan.

Captives will continue to flourish regardless of the market cycle because they keep costs down. They also provide effective loss control, claims management, and risk management.