John Talley, TAL Consulting
17 February 2021USA analysis

Risk management and captives

The insurance industry understands risk management because it is the epicentre of how the insurance business operates. Risk management encompasses the identification, analysis, and response to risk factors that affect the life and financial wellbeing of a business.

Effective risk management attempts to control future outcomes by proactive measures as well as mitigating the losses caused by the risk. Therefore, effective risk management offers the potential to reduce the possibility of a risk occurring and its impact.

“As the business risk management profile changes, the captive can quickly provide coverage needed to facilitate the programme.”

A good risk management structure can do more than just recognise existing risks. It should also determine unidentified risks and predict their influence on the business. The result of this exercise produces a choice between accepting the risk or rejecting it. The tolerance levels that a business has already defined for itself will aid management in this decision.

If the risk management programme is a disciplined and continuous process for the purpose of identifying and resolving risks, then the programme can be used to support other risk mitigation systems, such as planning, organisation, cost control and budgeting. A sound prospective risk management programme can reduce or eliminate many adverse surprises.

To aid in managing business risks, businesses can form a captive insurance companies to formulate a plan for risks, insuring the business while reducing costs. A captive is a subsidiary formed by a private company to insure losses due to insured risks. Captive insurance companies can solely insure risks or can supplement commercial insurance, allowing companies to save on their overall insurance costs.

A captive operates as any insurance company would by issuing policies, collecting premiums and paying claims. However, the system was conceived to offer insurance only to its owner, affiliates and other risk management controlled entities.

Captives allow businesses or groups to self-insure where owners can stabilise coverage for their specific exposures while participating in the potential underwriting profit and investment income.

A good plan

A well-run captive can provide additional focus on an established risk management plan. As the risk management programme identifies the key risks of your business, a captive adds the ingredient of estimating the amount of potential loss. This is done through:

  1. Preparing a detailed analysis of the risks that are optimal to retain in the captive;
  2. Providing annual reviews of your risk management performance to help you develop a risk strategy that better protects your assets; and
  3. Determining the reserves to hold in the captive. This produces an organisation that keeps the business’ risks management at the top of the minds of its owner.

A captive can insure many of the same risks as a commercial insurance company, such as general liability and property loss. When companies are unable to obtain necessary insurance coverage from traditional carriers, and where premium costs are rising significantly, they look for less expensive coverage.

Regardless of the reason for forming a captive insurance company, the goal is the formation of an entity that aids the business in managing its risks and mitigating the potential losses. As the business risk management profile changes, the captive can quickly provide coverage needed to facilitate the programme.

History has shown that commercial insurance companies are not capable of reacting to the rapid changes of the modern marketplace. Additionally, they have never been capable of insuring the many hidden risks many businesses face. A good risk management protocol would incorporate both commercial and captive insurance.

The core purpose of the captive will be the financing of its owner’s risk and become an essential part of the overall risk management plan. It gives more risk management and financial control to the captive owner/policyholder than the traditional commercial insurer-insured relationship. If the owner’s business has a good risk management programme and a low claims history, the cost of financing a particular risk can be much lower than a corresponding commercial coverage.

Additionally, the captive owner controls the operating expenses and the profit component of the premium, which factors into the development of premium cost. The captive owner can utilise a lower overhead expense ratio than most commercial insurers and lower or eliminate the profit component to the calculation.

Analytical approach

As with any business venture, the prospective captive owner must approach forming an insurance company analytically. An insurance company is very likely outside of the understanding and business acumen of the business owner. It will be necessary to obtain the services from individuals and organisations qualified to operate a captive insurance company.

The captive must also be funded to meet domicile requirements and actuarially sound finances. The initial cost of funding a captive insurance company could be prohibitive. Potential captive owners should gather enough information to make a well-informed decision on not only how to form a captive but also who should assist in its operation. A captive should be viewed as a long-term strategic risk management tool rather than a short-term fix.

Whatever the business owner decides on the formation of a captive, the captive’s place of domicile is also important. Although there are several good choices for a domicile, Missouri is the premier Midwest captive domicile.

Missouri’s captive insurance laws offer several options for businesses and are specifically designed to minimise the need for mandated regulation and oversight. The department has the experience and flexibility to provide the level of regulation needed for nearly any situation. The department also has significant experience and expertise relating to reinsurance.

We are here to help. With offices in St. Louis, Kansas City and Jefferson City, we’ll meet where it’s most convenient to you, or we will travel to your office. In any event, we are always just a phone call away.

John Talley is captive programme manager at the Missouri Department of Commerce & Insurance. He can be contacted at: