In recent years, an increased interest in captive insurance across a broad spectrum of industries has led to significant growth in captive insurance company formation. Leading the surge in interest and demand are middle-market organizations who now see captives as an attractive option that can complement their existing commercial insurance programs.
Sharing of third-party risk
While setting up a captive can be an option for managing risks, particularly those that are not adequately addressed by commercial insurance products, it is also important for organizations to understand the structural requirements necessary for a company to be recognized as a bona fide insurance company.
One such requirement is the need for true risk distribution. This means that enough independent risks of unrelated parties must be pooled to invoke the actuarial law of large numbers. Thus, distribution of disparate risks is one of the requirements imposed by the IRS for the captive to be considered an insurance company for federal tax purposes.
As one might imagine, for small to middle-market companies, it can be difficult to satisfy this risk distribution requirement within their own insured programs. However, there are a number of options available to the captive owner. One of the more popular methods is to participate in a risk pool. In simple terms, a risk pool provides a reinsurance structure in which the risks of a sufficient number of captives are blended and shared.
Participants in a risk pool pay a portion of their direct written premium to the pool to buy reinsurance. In turn, they assume an equivalent amount of other risks from fellow pool participants. This concept has been underscored in IRS Revenue Ruling 2002-89, a safe harbor rule stating that a captive with at least 50% of its premiums derived from third parties satisfies the requirement for risk distribution.
Risk pool governance and control
In addition to risk distribution at the individual captive level, best practices dictate that a risk pool employs a number of governance and control protocols to ensure it is structurally stable and able to maintain its financial integrity. These protocols include: providing timely and accurate reporting, demonstrating underwriting control with new and renewing participants and maintaining the overall financial strength of the pool.
To this end, the risk pool must be independent, meaning it must be run separately from the members, including separate books and records. The overriding focus for the pool managers is to protect all participating members; no single member’s needs are permitted to take precedence.
Importantly, the risk pool also must demonstrate risk distribution. In other words, this requirement does not just fall on the individual member captive; the pool itself must meet the same risk distribution requirement by having a sufficient number of members and an even spread of risk among those members.
Guidance: the key to understanding
The demands of risk diversification can mean that individual participants may assume risks they do not fully understand or with which they are not totally familiar. Furthermore, it is likely that a participant may be unable to control the risk they are assuming.
There are strategies to mitigate this situation, including creating a pool of low frequency risks where loss activity is low or conversely a pool of high frequency risks in which the exposure is more easily identified and less volatile. The potential for misunderstanding the downside of risk pooling underscores the need for an experienced advisor. Confidence in the underwriter assumes a critical level of importance.
Members should have complete understanding of both the benefits and the obligations of participation, as well as the ways in which transactions to and from the pool are handled. These details are why consulting with a dedicated captive manager is not only important but also strongly encouraged.
As a captive insurance specialist, Atlas Insurance Management can prove instrumental in tailoring a program to a prospective client’s specific needs and managing the cost of the risks identified. As an experienced captive manager, Atlas can also help the client with the operation of the captive after formation, including possible risk pooling to achieve proper risk distribution and risk transfer.