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TO THE EDITOR: Just like many dangerous products require warning labels, all future columns in Business Insurance about captives should have their own "insurance consumer protection" labels ("Property Captives' Greatest Risk is in First Three Years", BI Jan. 15). I think it's fair to assume that the vast majority of your readers work for publicly owned companies and are subject to FASB accounting and IRS tax rules; as such, they should be aware of the following:
While you may accumulate premiums in your captive by writing property "insurance," from a parental balance sheet perspective, you are not transferring risk. A captive's underwriting profits and retained losses flow through the company (by way of accounting consolidation) exactly as they would if you took a deductible or were self-insured. Unless a captive qualifies as a risk transfer vehicle, I suggest that the use of the word "insuring" be banned from future captive articles.
Any capital that accrues in the captive is money that would have remained in the parent company's coffers absent captive use. One would expect the parent to be better at utilizing its funds to generate a higher rate of return than can be had by captive investments. (Otherwise, why not liquidate the company's assets and mirror the captive investment portfolio, thus providing a better return for shareholders?) There is almost always a marginal cost associated with funds remaining in a captive.
No one year in a captive is more volatile than another. The underlying volatility of a property program has nothing to do with whether it is financed by a captive, retained on the parent company's balance sheet or funded with gold coins buried in a cave. The first years might be more risky (from a captive-centric funding perspective), but they are not more volatile.
A captive might be useful in accessing reinsurance and in allocating premiums to divisions, but it certainly doesn't provide any intrinsic risk management benefit. The author states that "if you are willing to assume a significant amount of risk (and volatility) in the early years, a property captive can bestow significant benefits downstream." I challenge him to name a single significant benefit that would accrete to the majority of captive owners under this scenario that wouldn't otherwise result from a well-planned deductible program.
Finally, I'm not sure how reducing the "number of coverage disputes" is useful. Disputes with whom? Is the risk management department going to argue with finance over whether a claim is covered or not? Either the company suffered a loss or it didn't; whether it's paid by the captive is moot (unless your broker has cleverly managed to obtain reinsurance that follows the captive's exotic primary policy, in which case I'd like their phone number and e-mail address.)
My proposed captive warning label would include, "Danger: Use of risk financing vehicles can be harmful to your career. Be sure you have a basic understanding of accounting and tax principles, or consult a professional before using. Side effects of captive use can include an irrational belief you are transferring risk, and potentially career-limiting decisions."
By the way, I have been an enthusiastic proponent and user of captives. Like any financial tool, they can be useful in the appropriate circumstances (such as accessing otherwise inaccessible reinsurance or accelerating tax deductions in certain cases). Please don't make them out, however, to be something they aren't.
and Risk Management
Union Bank of California