IN131 - Case Studies - Potential and Commercial Benefits from the Use of Captive Insurance

A captive insurance company can be defined as an insurance company formed by an industrial or commercial group to insure some, or all, of the risks of its parent organisation. Traditionally captive insurance companies have been used by large firms paying substantial insurance premiums.

In 1997 Guernsey introduced the concept of a Protected Cell Insurance Company, which made the benefits of captive insurance available to much smaller entities. Dixcart formed its own protected cell company several years ago to provide the benefits of captive insurance to clients operating in a number of different industries.

An effective way to demonstrate the benefits that can be provided through Managed Risk Insurance PCC Limited (MRI) is through the example of case studies. This Information Note examines two such case studies:

• Captive insurance for a diversified property portfolio.
• Captive insurance for the construction industry.

CASE STUDY 1: Captive Insurance for a Diversified Property Portfolio

Background

This case study takes the example of a private equity property portfolio with a diverse range of commercial, industrial and residential properties with a total value of £250 million.

Traditional Insurance Cover

Average rates of insurance for such a portfolio of this size are in the region of £3.50 per £1,000 of cover. In this instance therefore the total premium would be £875,000 per annum.

The five-year claims history suggests average claims per annum at 40% of the premium (£350,000).

Using traditional third-party insurance the total cost to the portfolio per annum is £875,000, with the real cost being £525,000 [£875,000 - £350,000 (claims at 40%)].

Insuring Using Captive Insurance

A fronting insurer is prepared to issue policies and retain all risk above £175,000 for any one claim and £875,000 in the aggregate. The premium for this will be £175,000.

As the Profit and Loss Account and Balance Sheet detailed on the final pages show, the use of a cell in MRI PCC, in these circumstances, generates a net profit of £327,400 per annum and creation of sufficient interest income to offset the running costs of the cell.

CASE STUDY 2: Captive Insurance for the Construction Industry

Background

Many companies in the construction sector have experienced large increases in premiums paid for employer’s and public liability insurance. This is insurance that they must have by law, but which is a cost they cannot control. It would be advantageous for such companies to reduce their costs of insurance and, at the same time, gain some certainty in terms of obtaining cover.

Once action has been taken to minimise risk, and there is confidence in the risk management policies, captive insurance should be considered. In this way the company increases its share in some of the insurance risk, whilst simultaneously generally reducing its insurance cost and placing itself in a position to share in the profits currently enjoyed by the insurance industry.

This case study describes a family owned construction company which started to use captive insurance cover.

Traditional Insurance Cover

The company’s premiums for employer’s and public liability insurance increased by 300% from the previous year, to £650,000.

Average annual claims were £100,000, with one £250,000 claim three years ago.

The highest risk area of the company’s business, steel erection, had been sold off two years earlier.

Insuring Using Captive Insurance

The first £650,000 of any aggregated claims insured is to be met by the captive insurance company, which issued a policy to the construction company for this amount. A Lloyds Syndicate issued the statutory insurance policy and insurance certificate to the construction company, showing a £650,000 excess for aggregated claims. The premium charged by the captive to the construction business was £325,000, and the premium charged by the Lloyds Syndicate was £150,000.

- The captive was set up with share capital of £350,000, of which £100,000 was paid up, and £250,000 uncalled.
- The captive’s maximum exposure is £650,000, covered by the share capital and the first year’s premium.
- The captive provided a letter of credit* to the Lloyds Syndicate of £350,000.

*A letter of credit is required. This is because in the early years the captive might not have sufficient funds to meet the first £650,000 aggregate claims if, for example, the construction company ceased to trade. The letter of credit provided by a bank ensures that even in a worst case scenario the captive will be able to meet its £650,000 liabilities.

Risk

The captive is at risk for all claims in that year up to a maximum of £650,000. Based on the previous annual losses this was anticipated at £100,000, but, in fact, was less than this in the first year.

Financial Outcome

In addition to the cash retained within the captive, a premium saving of £175,000 in both year one and year two is enjoyed, in comparison to the more traditional insurance route (£650,000 - £475,000). A total profit of £350,000 is therefore generated per annum.

Risk Management

As with all captive insurance, this solution is only appropriate for a company with a good claims history, and which believes that its risk control is of a sufficiently high level to carry a reasonable level of risk itself.

Additional Considerations

An anticipated reduction in the overall cost of insurance through the use of a captive is not the only consideration. The use of a captive provides the opportunity to:

• Effectively share in the underwriter’s profit, often in a very tax effective way.
• Build a reserve, which can be used to assist in obtaining cover when the market hardens by effectively allowing a higher excess to be accepted, thereby decreasing the main insurer’s risk and making the client more attractive to the insurer.

Captive Insurance Case Study Comparison

Please find detailed below an illustration of the effects of the use of captive insurance, showing the potential profit in the above circumstances. Profit and loss accounts and balance sheets for the two case studies considered in this Information Note are illustrated.




*Expenses include: management fee, PCC capital access fee, cell licence fee, share of audit fee, sundry expenses, letter of credit fee.

In addition to the savings that the cell may generate, the surplus funds held within the cell will be earning interest. Rates currently available are in the region of 4.5% and bank interest is paid without deduction of tax by Guernsey banks. It is quite feasible that interest income will exceed the running costs of the cells in the examples shown above.

Additional Information

If you require additional information about Managed Risk Insurance PCC Limited please speak to Alan Corlett at our office in Guernsey, or your usual Dixcart contact.