Captive insurance is a foreign concept to people, even insurance agents. Understanding how captives work is already difficult. Then there’s understanding how they can financially influence clients.
Thankfully, Captive Coalition specializes in captive insurance companies, helping make the concept digestible to insurance agents and their best clients. While we could only talk about the financial advantages of captives, it is just as important to discuss and be transparent about their disadvantages.
This article will help you understand the disadvantages of captives, how they can financially impact your clients, and other aspects of captives to consider. That way, you can see which clients would be best suited for captive insurers and discuss it with them.
What are the Financial Disadvantages of Captive Insurance?
When discussing captive insurance, understanding its drawbacks is important for your clients to be aware of. Here are some financial disadvantages to consider.
- Capital investment
- Possibility of lost capital
- Reinsurance market volatility
- Short-term cash flow limitations
- Sub-standard ROI
- Runoff Expenses
- Collateral Reclaim Delays
- Insurance Accounting Issues
Why is Capital Investment Necessary?
In the beginning, businesses need to allocate significant capital to set up a captive. This involves initial setup costs and regulatory capitalization requirements.
You and your clients might wonder how your best client would do as a captive owner. That, and how much can be made in underwriting profit. Use the captive assessment tool to get those results.
Risk of Capital Loss
In captives, the business owner puts up collateral to make sure the captive can handle unexpected claims in the first few years. Think of collateral as a security deposit that is used if the captive lacks the funds needed to back up financial obligations.
If claims exceed expectations and collateral is used, additional capital may be required. While this risk is not common, it is something to consider.
In the initial years, businesses set aside substantial capital to establish and run a captive. Capital investment can be a deterrent for businesses when considering captives. Capital needs to be maintained so long as the captive operates, which can tie up funds otherwise used for the business.
Impact of Reinsurance Market Volatility
The reinsurance market reacts quickly to losses, often leading to premium increases sooner than traditional insurance. Captive owners could face higher premiums if their loss history worsens.
The reinsurance market’s volatility can directly impact the financial stability of a captive. Traditional insurance can absorb shocks over a broader base. Captives, especially smaller ones, are vulnerable to rate fluctuations. The volatility can lead to increased premiums, affecting financial planning and the stability of businesses in a captive.
Short-Term Cash Flow Challenges
Captive insurance affects cash flow differently than traditional insurance. In traditional insurance, you pay the premium, and you’re done from there. If you have a lot of losses in a captive, you could be forced to pay assessments for additional money up until your maximum premium. So you could pay more in premium compared to the traditional marketplace
This disadvantage is usually overshadowed by plenty of benefits. That said, it is still an issue to consider.
Evaluating Captives Based on ROI
Gauging a captive’s value primarily to earn minimum ROI is a flawed approach. Captive insurance is a long-term insurance strategy. Captive owners should plan for at least a five-year horizon to see significant returns. Immediate returns should not be the primary focus. Businesses wanting that might be disappointed.
The benefits of captives often accrue over the long term. It might be several years before a business sees a tangible ROI.
What Would Runoff Expenses Look Like?
A business change or merger might place the captive in runoff mode, meaning expenses are incurred without the economic benefits. If a business decides to exit a captive, the costs associated with running off the captive could be substantial. These expenses can include administrative costs, regulatory fees, and claims management.
Delays in Reclaiming Collateral
Exiting a captive can be complex and an absolute pain. Unlike traditional insurance, captives require collateral, which remains tied up until all policy years close (typically 5-7 years). This can delay the return on invested capital.
Challenges With Insurance Accounting
The IRS has specific criteria for what qualifies as “insurance” for federal tax purposes. If a captive cannot meet these criteria, it can jeopardize the deal before it starts. It’s vital to understand these regulations to avoid pitfalls.
Effective insurance accounting status is crucial for captives to receive favorable tax treatment. The IRS has stringent requirements. Not meeting them can result in the captive being disqualified as an insurance entity. The IRS wants to be sure your captive is a legitimate insurance company and not just a tax strategy.
The result of the IRS breathing down your client’s neck would result in unfavorable tax consequences and other financial burdens.
Other Considerations With Captive Insurance
Each client’s situation is unique. What works for one might not work for the other. While captives offer numerous benefits for businesses that reduce their claims through robust safety and risk management programs, they are not for everyone. Make sure a cost-benefit analysis is done and consult industry experts. That way, it can be determined whether or not captives align with the business’s long-term financial goals and risk management strategies.
Do Captives Align With Your Client’s Financial Needs?
Knowing the potential financial pitfalls of captives is crucial in being transparent and making informed decisions. That way, you and your client can determine whether captives align with their long-term goals. Remember: captives are a long-term insurance strategy.
While you are at it, read our article that covers both the financial advantages and disadvantages of captive insurance. That way, you have a better understanding of captives as a concept and see if they are a fit for your client.
For more detailed insights and personalized assessments, schedule a call with Captive Coalition to talk to an insurance advisor.
