For over a decade, more and more financial services companies have used captive insurance companies as part of their overall risk management strategy. In its simplest sense, a captive insurance company is a wholly owned subsidiary of a policyholder’s parent company that underwrites and sells insurance to the parent and its subsidiary companies. Captive insurance arrangements are widely seen as offering benefits to policyholders in terms of improved loss control, access to insurance coverages and rates that might be hard to find in commercial insurance markets, control over and access to potential investment income earned on premiums between the date of insurance purchase and date of loss (especially on risks with excellent loss experience) as well as tax benefits in many circumstances.
Benchmarking studies in recent years have shown that companies in the financial services industry account for the largest number of captive insurance company formations. There are a number of reasons why captives appeal to financial institutions; some are fairly obvious and others less so.
As an initial matter, large financial institutions often have sophisticated and resourceful risk management departments that are up to date on the use, regulation and advantages of captive insurance. Furthermore, because large financial institutions usually purchase towers of coverage with large limits, captive insurance presents an attractive opportunity for hedging against traditional insurance purchases in the commercial market. For example, a bank with little or no losses will see a direct benefit in the form of the enhanced reserves if it places some of its risk in a captive, while still maintaining protection against large losses through its purchase of traditional commercial insurance policies.
Many financial institutions also often have very high retentions or deductibles on certain risks, and many choose to protect against losses within those deductibles via insurance purchased from a captive.
Furthermore, financial institutions obviously have excellent resources for managing and getting good returns on capital reserves, which is a key component of any insurance company’s performance. Not surprisingly, many financial institutions put such internal resources to use in the management and maximization of their captive insurance company’s assets, subject to applicable regulatory standards.
In recent years, some financial institutions have begun to consider the use of captives not only as a means to protect their own assets against risk of loss, but also as a clearinghouse to aggregate risk and offer insurance to customers who are not in a position to form their own individual captives or who otherwise might not have access to such insurance via traditional commercial insurance markets. For example, a number of hedge fund clients of a large financial institution can participate in a captive structure sponsored by such institution.
With good planning, attention to various rules and guidelines laid down by the IRS and analysis of structural options, there are numerous ways for financial institutions to enhance their risk management program through the use of captive insurance. Such strategies appear to be a growing trend in the industry, one that can be expected to continue its growth in the future.