There are several ways that an organization can transfer its risks through commercial insurance in the insurance market. This includes catastrophe bonds, collateralized reinsurance, large deductible plans, weather-based derivatives, risk retention groups, sidecars, and captives. Traditionally, many companies and business organizations manage risk by transferring it to the insurance company. This was attained through insurance policy purchases or fund allocations to meet the expected loss. Currently, many large organizations prefer using captive insurance as a risk management tool. Captive insurance is a type of insurance where the insurer fully owns the company, which provides services to the parent company, majorly risk mitigation. This form of insurance is formed when the parent company cannot find an external organization that will handle the business risks.
Commercial insurance is an effective method through which business organizations relocate their risks. Despite this insurance being an efficient way of diverting unsystematic risks, it has changed the handling of systematic risks (Nguyen & Vo, 2020). It can handle the risks that antedate from unsystematic risk as per the traditional loss history and law of large numbers. It evaluates the relationship between premiums and risk through actuarial calculation (Bickley & Michel, 2018). Systematic risk is challenging to estimate, making it impossible for commercial insurance companies to have difficulties mitigating them (Bickley & Michel, 2018). However, many companies are prepared to pay for the huge premiums that concur with the price of risk in the market. Parent firms have opted for captive insurance to mitigate the inevitable systematic risk because of its benefits in risk transfer and retention.
Benefits
The organization’s benefits from setting up captive insurance rather than commercial insurance force large organizations to opt for this type. It enables the organization to reduce or stabilize its insurance prices by lowering personal and marketing costs, reducing the financing expenses, and the likelihood of the insurance owners’ to consent to the least underwriting profit (Pierpaolo & Michele, 2017). This program is crucial as it provides the owners with an upper hand during the regulation of the policy, such as shielding the profits of its underwriting policy (Pierpaolo & Michele, 2017). The company using this insurance policy can retain risk so long as they have an excellent loss ratio in the captive. Through the captive, the organization’s insurance premium is dependent only on its loss-making it less vulnerable to the loss generated by other insured parties. Captive insurance is significant as it can cater to the organization’s hard-to-insure or emerging risks. Furthermore, the organization can access the reinsurance market wholesale, thereby decreasing the overheads of the reinsurance to the parent.
The parent organization can access improved risk management and loss control through captives since the company has significant insight into risk control. Reinsures enjoy the benefit of having the insured company involved financially in the risk through the captive (AICPA, 2018). Additionally, certain risks, such as sensitive product liability and environmental impairment, are difficult to handle in the traditional market, irrespective of the claim history (AICPA, 2018). In such events, captive insurance creates a potential solution to boost the financial cash flow linked to risk management. From a broad perspective, captive insurance is a significant source of extended financial strength, attractiveness, and competitiveness for the parent organization (Pierpaolo & Michele, 2017). This insurance has placed risk management on a higher level in most multinational organizations by aligning the support of company boards and their interests. This is vital as it helps the parent company manage and review all the risks presented, incorporating those the organization decided to retain.
Captive Insurance Challenges
However, the development of captive insurance for an organization poses various challenges to the parent company. Its setup requires a significant capital outlay and maximum commitment of resources and time from the parent organization (Kossovsky, 2017). This leads to an increment in the cost of the captive, which leads to a substantial reduction in the premium savings the parent company expected compared to traditional insurance organizations. Additionally, it requires substantial expertise that will help maintain its quality. Achieving this quality requires service providers such as qualified insurance experts.
However, the selected managers need to have varying degrees that align with the parent company’s culture. There is also a challenge in the way insurance companies operate based on the concept of risk pooling. The room for risk spreading may be restricted, leading to fluctuations in the cost. Whenever the parent company’s business plan changes, the captive may not be useful in managing the organization’s risk (Kossovsky, 2017). During such events, the captive’s only way is a run-off, which triggers additional expenses that are not beneficial to the economy and the parent company. Captive insurance has also been associated with illicit activities such as tax evasion, fraud, and money laundering in the insurance market scope. This has made policymakers and regulators mitigate these activities by setting up strong policies such as appointing anti-money laundering officers and including independent directors that are not on the organization’s board. The insurance manager strictly maintains supervisory on the captive insurance because of the illicit activities above.
Conclusion
In conclusion, captive insurance has gained momentum in the current period because of its multiple benefits to large firms. Commercial insurance has a significant problem in mitigating systematic risks despite companies paying enormously to handle the market risk. This has made most organizations shift to captive insurance. The benefits of captive insurance include reducing insurance prices, marketing costs, and financial expenses. Its regulation gives the parent company the upper hand as it can shield its underwriting policy’s profits. The company becomes less vulnerable to losses that other firms have garnered. The company has easy access to the wholesale reinsurance market. However, it has various drawbacks that affect the parent company. It requires significant funds to set up, requires substantial expertise to align with the company’s culture, and is subjected to stringent regulations. Furthermore, it is linked with illicit activities, making policymakers implement tight policies.
References
American Institute of Certified Public Accountants (AICPA). (2018). Captive insurance entities. Audit and Accounting Guide, 471-480. Web.
Bickley, H., & Michel, G. (2018). Insurance pricing and portfolio management using catastrophe models. Risk Modeling For Hazards and Disasters, 235-246. Web.
Kossovsky, N. (2017). Private equity firms must ensure that captive insurance companies meet stringent government requirements. The Journal of Private Equity, 20(4), 34-35. Web.
Nguyen, D., & Vo, D. (2020). Enterprise risk management and solvency: The case of the listed EU insurers. Journal of Business Research, 113, 360-369. Web.
Pierpaolo, M., & Michele, S. (2017). Embracing change: the regulatory evolution of captive insurance companies. Insurance Regulation in the European Union, 377-397. Web.