Captives: Pros and Cons for Public Entity Pools

A captive is a registered insurance company that is a wholly owned subsidiary of another entity with the captive formed to provide insurance or reinsurance to its non-insurance parent company.ⁱ There are several types of captives with the most common being those with a single owner or those jointly owned by a group of entities.ⁱⁱ Captives are a legitimate method for risk transfer and are typically formed and utilized to meet certain unique risk management needs of the company or companies forming them. Traditionally, insureds have handled risk by transferring it to the commercial insurance market by purchasing insurance coverage. Some have retained the risk and become self-insured.  In the case of public entity pools, risks are shared among homogenous group members pursuant to a self-insurance pooling agreement, with reinsurance purchased from the commercial market as needed. 

Captive insurers have existed for over 70 years, dating back to the early 1950’s.ⁱⁱⁱ Originally, captives were used largely by Fortune 500 companies^iv due to their relatively high cost to form and because corporations using captives gained tax advantages from their ability to avoid corporate taxes on funds transferred to captive entities in the form of premiums if they meet certain IRS requirements.^v Subsequently, smaller closely held corporations began to form captives to meet their insurance needs because captives have some unique estate planning capabilities.^vi

In the public entity sector, initially captives gained popularity during the hard markets of the 1980’s when high premiums and coverage limits and exclusions did not meet the insureds’ needs. Recently, however, public entity pools have been aggressively exploring alternative risk management structures including captives. Today, while financial institutions dominate in captive formation, captive use in the public sector now totals 6.1% of the entire market, fifth among industries using captives to meet their insurance or reinsurance needs.^vii

Generally, captives have been successful financial partners with their parents.  According to A.M Best, in 2020, the operating performance of rated U.S. captives surpassed that of commercial market carriers insuring the same lines of business.^viii  According to Best, captives’ “inherent flexibility and control in managing risk drives profitability and retained earnings, while creating value for their policyholders and stakeholders, regardless of market conditions.” A.M. Best estimates that the total number of captives worldwide now totals approximately 7000, a substantial increase from the 1000 plus back in 1980.^x Total captives increased by more than 100 in 2021.^xi 

The pros and cons of public entity captives are complex and should be closely examined and analyzed by any public entity pool considering making such a move to form or join a captive to meet its risk management needs.

The Pros:
Public entity pools form captives for one or more of the following reasons:

• Cost Savings—Reduced reliance on third party involvement in placement of coverage in the traditional commercial market allowing pools to capture costs and profits normally flowing to a private insurer or broker. For example, with a captive a traditional insurer’s “loading costs” (acquisition costs, marketing expenses, administrative expenses, overhead and commissions) are excluded from the cost of the premium.
• Gain Control—Much as public entity pools gain control by pooling their risks and becoming self-insured, when they pool their reinsurance needs by creating a captive, they gain ownership and decision-making authority over that aspect of their risk management as well. Since each captive owner is represented on the captive Board of Directors, there is not only greater transparency regarding all aspects of the risk management operation, but members control the hiring of vendors such as accountants, actuaries, litigation attorneys and claims management specialists. In addition, captives allow pools to tailor coverages to address hard to insure, difficult to place and emerging risks.^xii 
• Increase Investment Opportunities—Because many state laws treat public entity pools as quasi-governmental bodies, they may exercise some degree of regulatory authority over the types of investments pools can make with their surplus funds. Forming a captive allows the pool to transfer some of its funds (in the form of premium payments) to an entity not commonly limited in the same way. As a result, the captive can participate in a wider array of investment vehicles, including equities, allowing for at least the possibility of greater returns.
• Advantage of Economies of Scale—Much like public entity pools’ combining of resources decreases the costs of professional fees and administrative expenses to its individual members, captives allow pool members to share startup costs and ongoing annual operating expenses, along with reinsurance risks. In addition, having other entities with like interests share reinsurance costs and risks will often lead to a sharing of methodologies, ideas and a spreading of risk that is not the case in the traditional commercial insurance market.