Is a Captive for Workers’ Compensation Right for You?

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A captive, a type of self-insurance mechanism, is an insurance company created to provide multiple lines of business coverages or one coverage, such as workers’ compensation, to its owner(s). A captive, when operated successfully, typically will generate profit that belongs to its owner(s) while also providing potential tax benefits.

There are several types of captives, including single-parent, group, segregated cell, and others.

The most common structure, a single-parent captive, is owned and controlled by one owner and insures the risks of the parent company. This structure allows for the most autonomy in the operation of a captive. A group captive is owned by a group of related or unrelated companies. It allows the group to share the risk and insure each other. This is more of a one-size-fits-all approach. The lines of coverage and risk shared has little or no flexibility, but well-run group captives can provide a very cost-effective alternative. A segregated cell captive insures the risk of multiple insureds with individual captive “cells” that are part of a captive. The individual cells are legally segregated from each other. Insureds get the benefit of some of the autonomy of a single-parent captive, with lower startup and ongoing expenses. Individual cell owners may, in some cases, be able to share in some third-party risk if they choose.

Utilizing a Captive for Workers’ Compensation

Businesses turn to captives for workers’ compensation insurance for several reasons.

  • In transferring its retained risk to a captive for an appropriate premium, an insured is able to fund its expected workers’ comp losses for a large-deductible or self-insurance program. This reduces the risk of having to use future earnings to pay for past claims expenses. The difference between using a captive for a self-funded program is that with a captive the cost of claims is covered by premiums paid to the captive. This is as opposed to simply paying the medical and indemnity costs as these bills come due in future years, which can cause financial problems or strain on the operating company’s finances. The captive helps avoids those concerns.
  • If the captive qualifies as an insurance company under IRS rules, the premiums paid by the insured into their captive are tax-deductible expenses. With a traditional self-insurance program, the insured can take a tax deduction only for medical or indemnity bills when paid, which may be years in the future. With a captive, the losses are pre-funded, so the insured can take a tax deduction in the year in which the coverage was provided. Basically, from a tax standpoint, a captive simply allows the insured to take the tax deduction for claims expenses sooner.
  • The insured has greater control over all aspects of risk management, insurance costs, and planning for the future. A captive should provide profits for the owners and/or reduced insurance costs for the owners’ operating company. It can be another asset or profit center for owners.

There are drawbacks, however, in setting up a captive, of which insureds should be made aware.    These include:

  • Captives require a fair amount of upfront investment and expense.
  • Annual maintenance costs must be taken into consideration.
  • Workers’ compensation claims can take years to settle, and the captive must be maintained to meet its long-term obligations.
  • The potential for additional funding due to adverse loss development is a possibility.
  • The costs associated with closing a captive should also be taken into account.

Who Should Consider Forming a Captive?

Companies with the following attributes should consider forming a captive as part of their overall risk strategy:

  • Strong financial balance sheet: An organization should have the ability to invest in the captive as needed and meet both its short-term (costs for feasibility study, legal advice, actuarial and accounting, required collateral, captive management, claims management, etc.) and long-term (ongoing captive management and maintenance, annual fees, taxes, etc.) obligations.
  • Commitment to a long-term, proactive approach to robust risk management: This includes implementing good safety training for new employees and periodic retraining, loss evaluation, good hiring practices (i.e., background checks, fit-for-duty testing, and/or pre-employment medical questionnaires and applications, etc.), and other loss-control and risk management measures related to the work environment.
  • Adopting a risk approach aligned with overall business objectives: Starting or joining a captive should be contemplated with five- and 10-year financial objectives in mind. These objectives vary from company to company, based on what lines of coverage are in the captive, if the captive is being formed as another profit center, or simply to reduce insurance costs for the operating company.

Setting Up a Captive

The first step in establishing a captive is to determine whether it’s both viable and feasible for the organization:

  • Establish the primary motive for forming the captive and identify the exposures to insure. The insured should determine what lines of business to include in the captive and the amount of risk the organization is willing to retain. Is the insured, for example, looking for the captive to retain the first $100,000 or $1 million of each workers’ comp claim?
  • Conduct a feasibility study. This involves evaluating the company’s risk profile through the utilization of actuarial reports; investment models; insurance market conditions; and an assessment of regulatory, legal, and tax issues. Take a historical look at the company’s premiums and losses, along with projected growth plans and expected operational and environmental changes to calculate expected premium needs to fund losses within the retained limits of the captive. This gives the business a good idea of how much premium needs to be paid into the captive, the amount of losses to cover, the captive maintenance costs involved, and the bottom line.
  • Develop a business plan. If the feasibility study makes sense, a business plan should be developed with the intent of applying for a captive in the chosen domicile. Include actuarial support for loss assumptions, structuring requirements (fronting arrangements and reinsurance), an explanation of how the capital requirements will be met, board of directors’ selection, and continuing development of the captive, etc.

Ensuring the Success of a Captive

Once the captive is up and running, ensuring its success involves having a committed and dedicated board of directors who either possess or are willing to develop a good understanding of the exposures being insured, the workings of actuarial models and how to utilize them, and the operational structure of a captive insurance company and its financial needs. The board’s directors should be invested in their membership and learn all facets of running an insurance company.

In addition, a good captive manager – in essence, the quarterback of the captive – is critical in the success of the captive. The captive manager ensures that the captive continuously evolves to meet the organization’s needs throughout its lifecycle. He or she coordinates the accounting and actuarial services, produces reports for the board and regulators to review, and advises the board on a variety of issues that may affect the captive in the short and long term.

It is also critical to select strong and experienced claims management and risk management service providers, who work well with the captive’s staff. Not only does the insured entity have to be involved with risk management, but it also needs a good partner.

Again, keep the captive properly funded to make sure it can meet its short- and long-term obligations.

While the primary role of a captive is to insure the parent company, it is also an ideal mechanism to establish a centralized risk framework for tailored coverage; improve claims handling and monitoring; and potentially reduce the overall cost of risk through better risk control. Making the decision to form a captive is strategic and requires a detailed assessment of the organizations’ risk profile and financial standing, as well as a long-term commitment to optimize the balance between self-insurance and commercial insurance.

About Prescient National

Workers’ compensation specialist Prescient National Insurance Services provides fronting paper and excess coverage as well as third-party administration (TPA) services to captives. We bundle these services. In turn, this helps to lower costs and is also a convenient and more efficient model for captive managers. Additionally, we bring to the table a history of above-average workers’ comp claims results. In the last 10 years, our average claims payments have been 39% below the industry average. This reflects our strong claims’ management, medical bill review, PPO network, loss control and risk management.

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