Captives for SMEs: More Independence through Greater Ownership

• Companies gain a certain independence from the conventional insurance market – captive-related prices are more stable.
• Captives offer more risk structuring options – e.g., an extension of cover, the bundling of risks, as well as cover for conventionally uninsurable risks.
• Captives can compensate for capacity bottlenecks in conventional insurance programs.
• In comparison to a deductible, captives allow the volatility of the company's balance sheet to be smoothed in the event of a claim by creating a liquidity buffer (reserves for future claims).
• Captive owners benefit from underwriting profits if the claim history remains positive.
• A captive can act as a separate profit center that underwrites the risks of third parties, e.g., customers of the core business. An example would be insuring an extended warranty program for capital goods, including in the context of equipment-as-a-service business models. Such a strategy can be useful for retaining customers and generating additional revenue.

• First of all: the costs – have a look at: “When Does a Captive Solution Pay Off?”
• The limits of captive solutions are broad, but there are certain restrictions due to conflicts of interest in the area of D&O insurance. If shareholders claim damages from the company's managers, the company would also have to pay these damages in the case of captive participation in the D&O cover.
   

There are essentially three forms of captive solutions. They differ in terms of who bears the risk or provides the infrastructure. Captives can also be operated in the form of a primary insurer or reinsurer. As a primary insurer, the captive directly underwrites the company's risks. As a reinsurer, the captive assumes a certain portion of the risk from the corporation in return for a premium from the primary insurer. It therefore acts as a reinsurer of a primary insurer and can in turn purchase reinsurance cover.

Virtual captive/rent-a-captive

An insurer operates a solution that simulates the function of the captive for the client. It is implemented as an insurance contract so that a risk transfer component must remain. As a result, the company does not fully finance the liability line of the virtual captive, but sufficiently so that the first or a second major loss is covered by the financing. This is particularly advantageous when starting out with captive models, as the captive is already fully effective at the beginning. In the event of low loss ratios, the surplus is paid out to the client. This captive solution offers medium-sized companies in particular an excellent opportunity to optimize their risk structure. As an entry-level captive model, the virtual variant is easy to implement. Virtual captive solutions can be worthwhile for a transferred premium volume of €1 million per year and upwards.

Protected Cell Captive (PCC)

The company receives a legally independent shell (cell) as a subsidiary via a service provider, the so-called captive manager. These shells are legally separate from each other and there are no dependencies. The company can therefore use existing infrastructures for a fee and does not have to create the legal framework itself by establishing and operating an insurance company. In contrast to the virtual captive, the captive is fully capitalized by the company; part of the necessary capitalization can also be replaced by guarantees, for example. The captive managers are usually based in Malta or the UK (British Channel Islands).

Pure/real captive

This captive is wholly owned by the company. It is established by the company and operated independently. However, due to the expertise and costs required to fulfil all regulatory requirements at the captive's domicile (e.g. in Malta, Luxembourg or the UK), there are certain obstacles to overcome. Around 85 percent of all captives are domiciled in the USA, the Caribbean Islands or Bermuda. Genuine captives offer a very high degree of flexibility, but are also associated with high operating costs. They are therefore usually only worthwhile from a transferred premium volume of more than €5 million per year.

An effective management system in the area of risk and business continuity management should already be implemented and established in the company. This prevents avoidable losses and minimizes the loss burden on the captive. In addition, there must be sufficient financial strength in the form of retained earnings or free cash flow to be able to raise the necessary funds for capitalization or risk financing.

In Austria, the Financial Market Authority (FMA) is responsible for insurance supervision; captives are subject to the provisions of the Insurance Supervision Act. Within the EU, captives and insurance companies are generally subject to the (capitalization) requirements of Solvency II.

Outside the EU, the requirements regarding capitalization and supervision are usually more liberal. Many companies therefore set up their captives in Anglo-American and related jurisdictions on the basis of a limited liability company (Ltd.).

There are currently almost 7,000 captives worldwide. In addition, there are around 3,000 mini-captives and cell captives or captive-like special purpose vehicles worldwide. According to our own estimates, around 100 to 120 of these are used by German companies.

Funk assists companies in delving deeper into this complex but rewarding subject through personal consultations. We provide expert advice on your individual captive solution. The goal is to optimally structure your risks and achieve a long-term reduction in overall risk costs. We develop the details of the prevailing conditions within the company and the potential implementation of a captive for you as part of a feasibility study. This includes, among other things, an analysis of risk information, the requirements for the captive, a financial analysis of the captive's viability, and further recommendations for action. This ensures that companies are well-prepared for the implementation and operation of the captive.

The goal of captives is to reduce the overall cost of risk by adjusting premiums to the actual loss experience of the company, regardless of developments in the insurance market. To achieve this, the costs of the captive solution must be lower than the costs of traditional insurance premiums in the insurance market.

The costs for captive solutions depend on the chosen implementation method and domicile, as well as the scope of the risks carried into them. Additionally, there is a distinction between set-up costs and annual operating costs. The necessary capitalization of the captive should also be considered, which is significantly influenced by the type of risk and the liability scope of the captive in the insurance solutions. Opportunity costs must be taken into account here, as capitalization amounts are unavailable to the company for other investments.

Since insurers earn their margin by taking on claims-related volatility, it is plausible that captive solutions offer the greatest cost advantage in the high-excess segment or in the upper layers of a protection structure. However, this leads to a high entry of volatility into the balance sheet and contradicts the limited risk appetite of many companies. Therefore, it is important to carefully analyze the initial situation. "Together with our clients, we determine the sensible risk level in a feasibility study, for example using a value-at-risk-based approach," says Fabian Konopka, consultant for ART solutions at Funk. "We also examine which risks or insurance programs can be optimized with a captive solution, such as in the areas of property, liability, cyber, and transport."