Role of Captive Insurers in the Financial Market - Coursework Example

Role of captive insurers in the financial market Name Subject Instructor Institution Date Introduction Captive insurance is a form of insurance in which the insurer is fully insured by the insured’s. The main aim focuses at self funding at the risk of the owner as stipulated by Adams and David (2002, p.36). In its process, it involves a carrier who performs the role as a licensed insurance carrier that is controlled by the given parent corporation or an enterprise. Moreover, Kong and Manmohan (2005) states that, the policy holder can be another person, a business or a family who have an interest in insurance. It is operated so as to provide insurance cover to the owner as well as insuring businesses of the same type where they are required to pay premiums in exchange for insurance cover. According to Jaffee (2009, pp.11-12), in 2000, there were approximately 4500 captives who had been registered as indicated in fig 1. This contributed to the net gain of approximately 31.6%. The values of the premiums were estimated to be $20 billion in the same year. In the past, the risks were ranging from the coverage for property, the casualty for the workers compensation although it has no longer been remarkable for the company to re insure one or more of the benefits of an employee in a captive as itemized by Maeda Yoshihiko and Nicos (2010, 47). Even though the captive insures the parent companies risk only which includes the risks of those associated with it, it regularly functions like a normal regular insurer by issuing policies to its shareholders, disbursing claim payments, collecting premiums, preparing balance sheets and income statements and has to comply with the regulatory requirements of the domicile where that places jurisdiction applies. The difference is that, they are not regulated in the same manner as commercial insurance carriers as they are not to insure the general public. This paper gives a critical evaluation of the role of captive insurer’s in the financial market. Fig 1 Graph indicating number of captives vs. Time Source: (Jaffee 2009) Captive insurers Captive’s insurers play a very vital role in the insuring and risk financing market. There are different types of captive insurers who perform different roles. The cell captive for instance, is for providing insurance cover for the low income groups so that, they can offer insurance to their members or the clients. It offers an alternative for obtaining an underwriting where entities are allowed to build up the capital skills. This enables them to become potential insurers in their own right (Giarini, 2000; Sharma 2011). It has also allowed for the formalization of the illegal or informal provision of insurance. This can include the funeral parlors which have opted for the cell captive direction so as to extend their clients with insurance services. Their main functions may be stated as: Covering several risks of the affiliated companies. They deem as the profit centre in which they are in charge of the management of the companies which they are affiliated. They play a vital role in determining the prices and the decisions that relates to the underwritings investment and management process. They also manage the insured risks. Their centralized operations reduce the cost and the minimum capital required. Moreover, carrying the risk that is prudential, the insurer centralizes reporting and compliance which includes; pricing and other skills where the operational costs is reduced as well as the risk for the cell as noted by Sharma (2011). The capital holding for the individual cell is much lower than that for full insurers and is usually determined as part of the agreement by the shareholders based on the assessment of the internal risks. The captives have to diversify the risks that are related to the employees benefit programs so as to mitigate against the volatility that accompany has in the overall claim which has acted as a motivator to the employee captive transactions. For example, if the employees who are covered under a life insurance policy are in diverse regions and far apart, their deaths which fall under benefit claim are independent of each other and independent of the casualty risks which have been insured by the captive. Moreover, the amount payable to a single death is lower than that of the parent’s casualty claims that the captive is most likely to indemnify (MacMinn, 2005). When such cases occur, the result is that having the risks with the captive to be insured is likely to reduce the volatility from one year to another of the aggregate risk portfolio and this is related to the theory of portfolio in variance reduction where, the uncorrelated risks are combined. When a captive book is diversified, the enterprise can be able to add other enterprise risks to the captive so as to redress a situation where, the risk bearing capacity is lacking in the commercial markets. It may also happen so as to avoid paying current premium rates of the market which may be too high for the risk profile of the enterprise. The employer’s costs and benefits delivery are reduced by the reinsurance of the employee’s benefits to the captive and reduces the liability of the employers on the employees. As noted by Worley and Martha (2008, pp.19-20), many employers are achieving meaningful benefits in the form of meaningful delivery costs, even though the incremental economic costs are considered as well as the risk associated with including the risks of the employees (Petroni, 1998). The components of saving the cost are in the form of risk charge reductions, premiums based reductions and investment returns on service. The captives assist in the allowing for the flexibility in the risks share arrangements as well as, having the underwriting and administration separated where the enterprise can be able to negotiate for the matching of the services required to the administration fees and this will allow investment returns on reserves The employers obtain savings on cost by retaining benefit risks through reinsuring their employees to the captive which, have negative perception from the commercial insurance markets due to the exposure to the catastrophic harm. Some of the clients have the losses resulting from the preceding years and the wide geographic dispersion of the other employee populations where there has been doubt on whether cost reductions would be obtained through the reinsurance. The results of the claim experience are the aim of the arrangements where it is both favorable and unfavorable where the expectation of the reduction of the aggregate costs will reduce and this usually happens over a long period of time (Berwick, 2001). The risk charge reduces though the elimination of risk loading that comes about due to commercial insurance. The employer is able to retain some benefit risks of the employees through the arrangement to reinsurance. In this, the employer is able to remove the commercial carrier’s loadings that are associated with the risks that are retained where they act as fronting carriers in the reinsurance and are able to derive the revenues which emanate from the risk loadings. Role of captive’s insurers in financial matters The captives stabilize the insurance budgets by setting insurance reserves which are equal to the ultimate expected losses where, this will ensure that there is consistency in insurance reserve expense (Yoshizawa, 2006). This is used to avoid the expenses that come with the use of alternatives like the deductible programs which are large and the SIRs which although they reduce the insurance costs, they have swings which occur year to year in the budgets of the insurance companies that will depend on the claims experience. In this case, the captive brings in the year to year consistency in the insurance premiums because the retained earnings are used to assist in the worse years after the expected results are not achieved. The business owners have a concern of taking an additional risk and this has been as a fear among all the investors and has led others to being risk averse. However, it is a reality that most of the businesses self insure themselves without having the self knowledge. It has been a problem if the self insurance is without a captive as this is deemed as a non-tax deductible for the state federal income tax purposes as noted by Porat and Michael (1999, pp73-79). The reserves on the losses cannot be set aside for financing future lawsuits or the so called risk exposures and with the consideration of the current tax rates at their maximum, to self insure would cost as much as twice since they would be paid out of the profits whereas the business has already paid he tax on. The structured captive insurance if adopted can be able to prepay the risk using the pretax dollars. The risks have now a possibility of being addressed using the pretax nest egg. Where the claims fail to materialize, a substantial pretax sum will be captured by the captive which will secure the future business risks or for the distributions to the owners, or the family members or the business executives which will be done at favorable rates. Captive insurer’s in making key decisions The captive insurers bring in the aspect of savings on taxes levied. The company and the affiliates are able to get a reduction in the premiums paid it of which losses would have been inevitable if the captives were not to be there as they would be tax deductible. In addition to this, captives sometimes deduct its reserves and the incurred losses that have not been reported. The tax benefits that initially fueled offshore captive information have been removed and this has not had much effect to the premium tax as some benefits still exists. Large captives still obtain savings in the offshore where there is no premium tax as noted by Kong and Manmohan (2005). The offshore captive that are well designed provide income tax advantages to organizations that are tax exempt or otherwise assist the individuals in the endeavor to reduce double taxation in their profits. In addition to this, they offer advice to the investors who pay premiums due to the complexity of the captive insurance taxation. The captive have optimal risk sharing arrangements with the large corporations and insure and reinsures them. They sometimes carry out the role of self insurance and pool the risks together and then transfer them to the reinsurers and later allow the parent groups to extend the optimal coverage on the insurance to the business units using the frontiers or doing it directly. Through the captives, the holding company accumulates the gains from the lower costs of the frontiers and the optimality of the risk sharing of a bigger policy propelled by the retro cessionaries. The deductible insurance contracts are made possible through a frontier or an insurance captive which cedes its risks to the reinsurance captive Pressman and Cheddar (2006, p.196). In addition to this, the reinsurance in the captives may come from the local investors who assume the role of the frontiers and therefore cede their risks up to a certain level. After this, the reinsurance captive transfers its risks to the market of reinsurance through a contract known as stop loss and thereby offers a bigger policy to the holding company. Financial concerns of the captive insurer’s Although there are tax benefits with respect to the formation of a captive, the main aim of its formation is purely non tax which should come first as the main business purpose. It plays a role in the reduction of long term risk costs as the costs of a captive insurance is lower than that of the ordinary conventional insurance markets. The captive company existence gives the parent company the advantage of having negotiation leverage with the commercial insurance market. This is an upper hand as far as the financial benefits of the captives is concerned for it and in itself as it portrays that the affiliates together with the parent market consist of expertise and much knowledge in the context of insurance companies and that the coverage way has room for expansion, development and alteration so as it will fit in the insurance overall needs. Moreover, the policy of an insurance captive can use market based premium quotes to lay down the set rates for a long period of time that is at arm’s length for the owner insured’s of the company as noted by (Sharma, 2011). As a general rule therefore, it means that a captive can accrue for loss expectancy for the uncertain or unknown liabilities for a basis of the same kind as an independent insurance company. Although this may happy, the insurance company that is a subsidiary might as well be able to provide insurance services to the parent company at a reduced cost. The surplus that comes from that as an additional benefit can be used for more investment or may be used in consistency with the practice of the insurance company. There are tax deduct abilities paid to the captive which involve the premiums and this occurs as a benefit of having a captive to the parent company which differs from the self insured arrangement, as a case where the insured party recognizes deduction on tax as a loss as losses are paid out over time when they are sustained. An example is the workers’ compensation losses which are triggered by an even in the underwriting time, although they are paid out over a number of years. It is only at such times that the losses are actually sustained. It is only at such times that the losses are paid out when the tax deductions are recognized but this happens only when the payment is made. The premiums under a captive arrangement are calculated using the accounting principles of the insurance companies where the prospective loss exposures are taken into account because the captive is noted to be a true insurance company rather than a substance of self reliance reserve. For a captive that is structured as true insurer and can therefore establish insurance loss reserve that is deductible in the period of assumed risk which had been reserved by the insured as well as the risks that are already insured and proposed to cover any subsequent events. The results of this are that, there will be enhanced cash flows and a reduced taxable income for the group under consolidation. A captive is used to fill in the gaps which the commercial insurance markets have failed to fill by not providing the necessary coverage or, in cases where the costs is deemed to be unattractive for them. The areas of risk are mostly included in the commercial insurance policies of which are either deductible or excluded. In this case, the business will have not assumed the risk that is additional for it was already aware of such risks before captives were established. There are industries like the manufacturing, construction, professional services and distribution services that regularly have to face the risks associated with the industry of which the general liability insurance does not include them as well as the errors and omissions policies. An example of this is the construction defect liability, the product liability, administrative actions and the distributor liabilities which are just but some of the common risks that the general commercial insurance policies have failed to cover (MacMinn, 2005). In addition, the captives can provide cover for the self insured risks which include pollution and other exposure types, loss of tenants, insurance deductibles, and breach of contract, loss of key customers or employees as well as natural disasters. The ultimate result is that even actuaries and the underwriters end up quantifying the self insured risk which is converted to premiums and later deducted from the insurance premium of the affiliates or the parent company. Later on the funds are invested by the captives and are later used to pay the claims. It is the choice of the captive to distribute the profits thereof as dividends to the shareholders at a later date or they may choose to take the profits and reinvest in other businesses. Methodological aspects employed by captive insurers The first step in the captive is to do an analysis of the existing insurance coverage and the risk management program so as, to coordinate the captive issued policies together with the existing insurance coverage. This is because, the business owners may decide to transfer the risks to a captive or the commercial insurer or, may choose to retain important business decisions and bear the real repercussions of that decision as stated by Fitch (2007). The captive issued policies are coordinated together with the existing insurance coverage. An example of this I that most of the businesses have their risk property insurance coverage not partly transferred which may include the risk of fire. The captives carry out the overview of the businesses and analysis of the risks involved as well as, carrying out the review of the actual loss that is experienced. The captive purchases reinsurance in cases where there are large claims to protect against these claims. This is a way in which the insurer transfers part or all of the risk under an insurance policy to another insurance company or the insurer. The parent companies can to this effect respond quickly to the changes in the commercial insurance markets in times when the market is soft or when it has firmed up. With the help of a captive, the parent company can respond quickly to the changes in the commercial insurance market for it has the capability of funding higher levels of retention (Sharma, 2011). In addition, the captives fill the void when there are needs in the parent company or an affiliate and it is costly or has proved unattainable in the commercial insurance market. In this regard therefore, the existence of a captive creates awareness on the loss potential throughout an organization and can develop a program that will be for the efficiency in the loss prevention among the members of the group that has been insured by the captive. It is well known that there is superb management when the captives are involved as they also offer high frequency and severity risks which are low. The captive analyses the cost versus the benefit in the undertaking f reinsurance policy. As stipulated by Birds and Norma (2001), the captive assists in the stabilization of the losses and the capacity of increasing the risks as well as limiting the liability on certain risks. In this instance, the captive transfers the premiums which the customers have forwarded to a reinsurer. The reinsurer accepts part of the risk which the insurer has assumed. The benefit of the captive to the owner is that he can insure the risks and also that he can reinsure the risks which spread them over different insurers and reinsurers which are done at a lower cost than commercial insurance. The captive therefore provides a direct access to the reinsurance market which would have not have been possible to an owner of a business owner if the captive was missing. The captive also helps the companies to be able to shift risks over time which were covered through the commercial insurance markets. The captive partakes in the protection of the capital through reinsuring the risks to minimize the losses attached to the risks. Conclusion In conclusion, these captive companies present a component of the alternative risk market. Considering their growth and utility, they have no longer been considered as alternatives of the insurance companies but core insurance providers as they have been an integral part of the performance of the businesses in the business and the financial risk management. As earlier mentioned, the tax advantages are not the major reasons for the formation of the captives as there are benefits that are available. A properly planned captive will bring about the tax advantages and have the businesses have tax reductions through them. The formation of their captives have played a very vital role as discussed earlier and shown in the summary below. Coverage can be obtained in cases where the commercial insurers are unwilling and this may happen due to the large costs that are associated with it and others which involve the environmental issues like the nuclear risk, the nuclear waste and the pollution. The reduction of the payment of premiums by the businesses especially the parent and the affiliates by reducing certain costs which the commercial insurer adds but the parent can be able to get the same at a lower price. The costs may include the general overheads, taxes, administration and settlement fees and brokerage fees The captive can be able to control the risks through the effective risk management and control the subsequent losses and therefore attain the cost effective risks. The captive insurance companies’ takes advantage of the principle amounts because even the investment income may be tax free in accordance to the domicile whereas the commercial insurance companies may depend on the primary sources of energy The captives have access to reinsurance markets unlike the commercial insurers including the international one. They are able to obtain reinsurance which is cheaper that the one available to the businesses in the commercial market and will therefore reduce their costs as they are licensed insurers. They sometimes hold third party risks that allow them to extend policies. The captive can be able to offer insurance services as well diversify the risks to the third partied who are separate as well as operate as a profit center. This will allow the captive to generate more income and be able to provide more risk distribution and this is achieved through the sale of warranties Finally, the captives offer balanced coverage as they are less affected by external factors like the poor underwriting and economic fluctuations which would have otherwise lead to increased premiums. The constant and steady premiums allow the captives to be included in the budget of the parent and therefore make it to have a better financial budget. References Adams, M. and David, H., 2002. 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