A captive insurance vehicle provides a legal basis for subsidiaries to pool retained risk across borders and different regulatory and tax regimes. The accounting, tax, and legal treatments are well known and understood. Conversely, regulators and tax authorities worldwide might subject transactions with less formal risk-retention vehicles to greater scrutiny.
In many industries, organizations are required to show evidence of insurance, but prefer to self-insure the risk rather than place insurance through the commercial market. In those cases, a true policy is needed to demonstrate evidence of coverage to the third parties with which they work. As a formally regulated insurance company, a captive may be able to produce a policy that meets that standard. In other cases, an organization may choose to set up or use a captive specifically for the compliance it facilitates.
What if a Captive Cannot Produce a Policy That Meets Regulations?
In some cases, a captive will not be able to produce a policy that meets regulatory requirements. For example, a captive cannot directly write a policy covering third-party automobile exposures. Or, an insured may require that the policy be issued on “rated” paper to satisfy regulatory requirements. In these instances, a captive can achieve compliance through “fronting,” which involves a licensed, admitted insurance carrier issuing a policy to the insured and reinsuring the risk to the captive.
Typically, the cost of fronting is a fee paid to the insurance carrier, called a ceding commission, as well as satisfying the carriers’ collateralization requirements. Ultimately, the insured receives rated paper from a licensed, admitted insurance carrier, which satisfies regulatory requirements, and the captive still retains most, if not all, of the data and risk.