Managing Risk: How Captives Are Helping Businesses Through a Hard Insurance Market

Macroeconomic challenges, inflation and higher reinsurance costs are driving significant increases in commercial insurance rates. On top of hard market conditions, businesses are facing less competition among insurance carriers and fewer options for coverage. This dynamic creates challenges for companies looking to control their premium costs and address coverage gaps in their insurance policies. As a result, many are reviewing their existing captive insurance company, or exploring the formation of a captive insurance company, to manage these headwinds.

You know your business better than anyone, which means you may be better equipped than a third party to identify, quantify, price and control your business risks. Using a captive can be an efficient tool to transfer risk and mitigate exposures. Similarly, if you have an existing captive, a periodic review is critical to ensure optimal use. Considering the feasibility of a captive or the effectiveness of a current captive can have numerous benefits, including lower costs, tailored coverage and increased profitability.

If your business is considering a captive formation or has not reviewed an existing captive in the past few years, it’s important to use a holistic approach in analyzing the potential opportunities and challenges presented by current market trends.

Growth of Captives and U.S. Domiciles

The steady growth in captive formations has been fueled by companies exploring options to help control insurance costs and mitigate risk. That trend is poised to extend throughout 2023 and likely beyond as factors contributing to the hardening insurance market persist.

From a regulatory standpoint, some U.S. states are more conducive to captive formations than others. In recent years, more states have also seen the benefits of facilitating captives. In total, the U.S. has at least 30 captive domiciles. Vermont is the largest U.S. domicile, although other domiciles have continued to experience growth. Utah, North Carolina, South Carolina and Tennessee saw particularly strong growth in captives during 2022, as did Delaware, Hawaii, Nevada, Arizona and Texas, among others.

Prior to selecting a domicile, it’s important to take into consideration the acceptance of coverage you are looking to write as well as potential tax implications. Established, leading domiciles may offer robust regulatory and service provider expertise to companies exploring captive formation. However, evaluating domiciles based on your primary business location can simplify the decision-making process, as long as the local domicile can meet your short-term and long-term needs.

Coverage Options and Undesirable Risk

The hard insurance market has impacted how organizations manage risk. Some insurance companies are looking to exit or limit certain exposures, and others are increasing premiums for unprofitable business lines. Since captives often provide coverage for traditional property and casualty (P&C) risks that insurers increasingly see as unwanted or uninsurable, this market volatility has prompted new ways to leverage captives and mitigate the economic impact.

Whether extreme weather events have become more common or our exposure to them has increased, the need to approach risk more creatively will continue for the foreseeable future. One way that captives are responding creatively is participating within the primary layers to blunt premium increases and selectively take positions within the program where it makes sense.

The pandemic also highlighted new risks for companies to consider as they seek to enhance resilience and strengthen enterprise risk management. Coverages can stem from a variety of growing risk exposures, including supply chain, cybersecurity and more.

Some insurance policies may also restrict coverage through low sub-limits for specific risk types, such as social engineering attacks covered under cyber insurance. Cyber threats have increased significantly, but limited insurance coverage may not be sufficient to fully protect a company from the associated risk. Insuring these gaps and exclusions is just one more example of how a captive can be a tool to proactively identify, quantify and mitigate risk.

A Holistic Approach to Captive Formations and Utilizations

While the challenges posed by a hard insurance market are clear, determining whether to form or participate in a captive insurance company involves several complex considerations.  Companies should look at the full risk landscape to identify both short- and long-term opportunities to ensure the captive achieves desired maturity. By maximizing captive benefits, companies can better manage today’s market headwinds and address important insurance coverage gaps. This includes considering not just straightforward and less complex coverages in initial years, but also outlining other long-term captive coverage options and the conditions in which they should be insured within the captive (i.e., market or loss conditions, etc.).

It’s critical to take a comprehensive approach to assessing the feasibility of such a formation and understanding the range of options and potential downstream effects. For instance, it is important to evaluate the possible impact on several areas of your business, especially the finance and tax functions. Engaging experienced advisors who are able to consider both the tax and non-tax impacts of forming a captive, or evaluating the utilization of an existing captive, maximizes the potential efficiency and benefits of operating a captive.

Written  by Lisa Martel. Copyright © 2023 BDO USA, LLP. All rights reserved.