Businesses Turn to Captives to Control Insurance Costs

Captives comprised of similar companies, like general contractors, share best practices for safety and risk management because they have a common financial interest in avoiding losses.

In 2018, U.S. businesses paid $41.4 billion in insurance premiums for commercial peril coverage. Insurers paid $25.1 billion for direct losses in return.

Businesses also paid $62 billion in workers’ compensation premiums to cover $29.3 billion in direct losses, according to 2018 Market Share Reports from the National Association of Insurance Commissioners.

The companies that incurred the losses were likely grateful to have paid their premiums. But their insurers probably increased their premiums in 2019 to reflect the increased risk based on the losses.

Insurers also may have raised premiums for companies that didn’t file any claims to cover claims filed by other commercial clients that did. So, even if they avoided any claims themselves, businesses could have paid their premiums to insurers who kept all of their payments and raised their rates the next year regardless.

With their premiums often increasing regardless of their performance, many companies have taken control of their insurance by forming or joining captives. This is where companies become their own insurer or join a group of like-minded companies in self-paying claims incurred by members of their group. There were 6,454 captives in 2018, or 1.8% more than in 2017, according to commercial insurance statistics from the Insurance Information Institute. Captives typically provide workers’ compensation, general liability, or automobile liability insurance.

“If a company is traditionally making money for their insurance company, then the company owner has the opportunity to be that insurance company with a captive so that they’re profiting from their hard work,” said Patrick Johnson, Senior Sales Executive and Construction Practice Leader for business insurance at The Horton Group, an insurance, employee benefits, and risk advisory firm. “It’s a natural progression for those companies that take safety, claims management, and risk control seriously and a way for them to optimize their insurance purchase.”

Potential profit center

Unlike with traditional insurance, in which the insurer keeps the premiums that a company pays, the businesses in a captive divvy up any excess payments that weren’t used to cover losses incurred by members of the group. Companies also can deduct the premiums that they pay as a business expense, as they would if they were paying a traditional insurer.

Business owners can earn profits outside of their company because the shareholder of the captive doesn’t have to be the company that is insured, Johnson said. It could be the owner or an affiliated entity, like a trust that they may have formed, he said. “You can take a normal operating expense of buying insurance and make it a profit center outside of the business.”

A commercial plumber that Johnson helped join a captive 13 years ago has long since profited. The excess premiums that the client once paid to an insurer now come back to itself instead. The annual premiums also have decreased because the company has avoided losses.

Captives reported a pre-tax profit of $1.1 billion in 2018, according to a report on rated U.S. captives from global insurance rating agency A.M. Best. From 2014 to 2018, they:

• Added $3.1 billion to their year-end surplus
• Paid $1.6 billion in stockholder dividends
• Paid $1.9 billion in policyholder dividends

“Therefore, $6.6 billion during this period remained with the captives or was paid back to their policyholders and stockholders instead of going to the commercial market,” according to A.M. Best. Captives consistently perform well because they are closely aligned with the interests of their member companies and have a “deeply ingrained risk management culture,” the agency stated.

Shareholders in captives can typically get 65% of their annual insurance premium returned as a distribution, according to a blog post on captives and self-insurance from The Horton Group. “If you are dedicated to a safe workplace and have few insurance claims, a group captive could be a great long-term risk management approach for your company.”

Shared Risks

Minimizing losses is key to maximizing gains through a captive.

“If you’re already doing that, a captive should heighten that and make you better,” Johnson said.

Captives comprised of similar companies, like general contractors, share best practices for safety and risk management because they have a common financial interest in avoiding losses.

“There’s more accountability, and there’s more emphasis on, ‘I don’t want to have that loss, but if I do have that loss, then I want to mitigate it as much as possible,” Johnson said.

Companies can reduce their costs of risks by identifying exposures and implementing control measures, according to a blog post on how to manage the cost of risk, control price from The Horton Group.

“An estimated 75% of commercial insurance expenses are claims-driven. We look to control and reduce this percentage through pre- and post-loss control measures,” he said.

Companies also can control costs by covering at least part of their exposure through a captive. Even smaller companies can use captives when they commit to only self-paying claims that they can afford to pay while using traditional insurance to pay catastrophic claims.

“Risk managers are shifting more of their property exposures to captive insurers amid rising costs and tightening terms and conditions in the U.S. commercial property insurance market, particularly after the higher catastrophe activity of the past two years,” Business Insurance reported in an article on how the hardening property market shifts interest toward captives. Captives and traditional commercial insurance carriers are coordinating to help companies control costs and risks, according to the article.

“In a captive setting, your premium costs are more dependent on your performance year to year than in the traditional marketplace,” Johnson said. “If you control your losses, your premiums would trend down.”

That’s the kind of control that companies in captives want instead of paying insurers premiums for losses that they may never incur.