What is Captive Insurance?

I think most people have a fundamental belief that you can purchase any kind of insurance you want – that all you have to do is call your insurance agent and say, “I’m looking for “X” kind of insurance.” If he or she doesn’t know where to get that particular policy, you firmly believe that they know somebody who knows somebody who then knows somebody who can find you that policy. After all – someone must sell this, right?

This overlooks a little fact about the insurance business: insurers are in it for the money. That’s right – they usually have a constituency called shareholders who have the audacity to expect their investment to grow. If a particular line of coverage costs too much (read: claims are too high), insurers will simply stop writing that coverage. Don’t believe me? How many companies that are now involved with the newly legalized cannabis industry have access to coverage? Here’s another example: I live in Houston, Texas which has been hit by three hurricanes in the last twenty years. How many insurers are writing homeowners coverage? Not that many.

This is where captive insurance comes in. Some company’s basic line of business is simply too risky for insurers to touch. The market forces these companies to go into the insurance business. Here’s one of my favorite real-world examples: company X makes aerospace parts (please don’t ask what it is they do exactly; while they took great pains to explain it to me, their explanation sounded like the teacher from Charlie Brown). No insurer would sell them product liability coverage. Why? Well, have you ever seen the damage totals from a downed airplane? It’s in the hundreds of millions of dollars with litigation that lasts longer than a Phish jam. So, this company formed a captive that covers, among other things, product liability. Problem solved.

In fact, this is basically how captives started: businesses either couldn’t find coverage or could only find very expensive coverage, forcing them to act. Two of the earliest examples involved companies that owned property next to a river – one was in Kansas City and the other was in New Jersey. Because of recent flooding, neither company could find insurance. At this point you’re probably thinking, “why didn’t they just move their operations?” They couldn’t. If you go back to your U.S. history class from high school, you’ll remember that waterways are a great way to move goods from point A to point B. They still are. Anyway, neither company was going to move or shut down their operations, so both formed a captive. Problem solved.

And this gets to a key point about companies that form captives: they’re a really exclusive clique, kind of like the girls from Mean Girls (maybe not that snotty). But seriously, they’re really not for everybody. Most companies are just too small, or they don’t have the legitimate need. In my experience (Dear God, I’m old enough to actually use that phrase and mean it) only about 10%-15% of the companies out there could really use a captive. That’s still a lot, but it does limit the scope a bit.

At this point, the intrepid reader (who undoubtedly sells insurance) has probably noticed that this captive idea could be downright dangerous to their business model. “If my clients go into the insurance business themselves, I’ll be broke. I’ll be standing on the side of the road with a sign that says, “will analyze CGL policy for dinner.” No. First off, most companies that form a captive will still buy coverage from the larger insurers. They’ll just use larger deductibles and have the captive underwrite a deductible reimbursement policy (gee – guess what that policy does?). Second, your client will still need your services to coordinate the policy language of third party insurers and the captive. Third, your client will need your help to mitigate their risks and manage claims. You’ve probably realized that you will be changing how you charge for your services. Instead of using a straight commission model, you’ll have a mixture of commission and fees. However, you won’t go broke.

So, that’s it for this introduction to captives. Assuming the editors of Insurance Nerds publish it (did I mention how much I love the title to the website and think it’s utterly brilliant) I’ll be back in a bit to delve a bit more into captives.

About Hale Stewart

Hale Stewart is a tax attorney, in Houston, Texas, which you’d think would make him boring and dull.  However, his wife assures people that he’s really very funny. Their dogs aren’t quite so sure. He is truly a tax nerd – he has a masters in U.S. and international tax, has actually read the entire tax code multiple times along with more cases than should be allowed by law.  He’s written a few books on Captive Insurance and has been working in this area of the law for over a decade. Please help him make Captive Insurance in Plain English a NY Times bestseller by buying it.

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