Here is an Acronym I came up with for remembering the reasons for setting up a captive Insurance company:
Access to Reinsurance
Profit loading and Acquisition costs
Tax and Regulatory optimization
Volatility in premium rates
Extension of coverage
Claims control - As the captive is directly controlled by the parent company, the parent company is free to establish the claims handling procedures. For example, they may wish the captive to operate a very liberal interpretation of what is covered under the policy, thereby reducing the possibility that the parent company will be exposed to a financial loss which they thought they were indemnified from. If the parent company were dealing with a commercial insurer instead then they would be at the mercy of the exact policy wording.
Access to Reinsurance - By self insuring, the parent company gives itself the option of then ceding the risk directly to a reinsurer rather than going through an insurance company. Reinsurers tend to enjoy greater economies of scale than direct writers, and incur lower acquisition and claims handling costs due to the smaller number of clients they deal with. Therefore the premiums charged by a reinsurer would be lower than that charged by a direct writer.
Profit loading and acquisition costs – Due to the fact that most insurers are run as limited liability companies, the premiums that are charged by the insurer will be loaded for profit. There will also be significant loadings for expenses and acquisition costs (the costs associated with acquiring new business). By setting up a captive the parent company can eliminate these loadings and instead just pay a pure risk premium. These loadings can be significant, sometimes as high as 50%.
Investment Income – The captive will be required to hold capital to cover the liabilities that it is taking on by accepting the risk from the parent company. This capital can be invested and the investment income retained in the captive. This investment income would otherwise be earned by the insurance company. (Admittedly the insurance company would be expected to reflect this fact in the premium that it charges however this may not always be the case)
Volatility in premiums rates - If the parent company uses a commercial insurer rather than a captive then the premium charged by the insurance company will be partly market driven. Premium rates vary over time in line with the underwriting cycle beyond how they would be expected to vary based on the pure risk premium. The underwriting cycle is related to the cost of capital and the level of profit and competition between insurance companies. This can add an additional level of volatility to the premiums paid by the parent company. By setting up a captive the parent company can help stabilize the premiums that it pays.
Extend coverage – Insurers may be unwilling to accept certain risks which they deem to large or too unique, or they may charge premiums that are excessively cautious when taking on these risks. The ability to dictate to a captive the risks that it should accept extends the coverage available to the parent company. This is one of the primary reasons for setting up a captive.
I work as a pricing actuary at a reinsurer in London.