The captive insurance model has gained rapid recognition as a consistent risk management tool for multinationals and large corporations that desire better control over their insurance programs. Establishing a captive can help a parent company to ‘insure’ its unique business risks, possibly with reduced costs and improved coverage flexibility, as per Charles Spinelli. However, running a captive insurance company entails numerous risks and challenges that necessitate careful evaluation before proceeding.
Regulatory and Compliance Complexity
One of the leading challenges of managing a ‘captive’ is fulfilling its stringent regulatory requirements. Captives are made liable to stick to insurance laws relevant to their operational domicile. This may involve licensing, capitalization, reporting, and governing liabilities. Such regulations are also subject to change from time to time, requiring consistent reviewing and staying compliant with them.
Violating or failing to meet regulatory standards is likely to lead to high penalties, including fines, restrictions, and even cancellation of the captive’s license. Moreover, captives being operational across borders tend to encounter complex tax and audit authorities spread across several jurisdictions.
Capitalization and Financial Risk
Inadequate capitalization of a captive may affect the success of the entity. Moreover, if the capital requirements of the company are undervalued, the captive company may find itself incapable of settling claims. On the other hand, the company might end up with too much capital reserved, which could reduce its profitability.
The risks of the insurance company can sometimes lead to losses that surpass expectations, especially if the claims turn out to be more than the company anticipated. The company’s investment performance can worsen its financial stability, particularly in an unstable economy.
Operational and Management Challenges
Keeping a captive functional requires experts in insurance, risk management, accounting, and governance. Given that many establishments operate depending on third-party captive company managers, actuaries, and legal advisors, they face extra overhead and often face complexity in coordination.
Poor management, lack of expert supervision, or absence of appropriate internal controls may result in poor decision-making, financial misrepresentation, or inefficient operations. Running an effective board of directors with sound governance processes is considered an ongoing struggle.
Volatility of Claims and Risk Aggregation
According to Charles Spinelli, compared to traditional insurance that diversifies risk by maintaining a large pool of risks, insurance captive companies may cover a small set of risks on behalf of a single parent or group of associated entities. This may result in a captive being susceptible to a high degree of variation in possible claims. A single catastrophic loss or a set of high-value claims may pose a serious threat to the overall position of a captive.
Ineffective management oversight or inadequate internal controls can lead to poor decision-making, financial misstatements, or operational inefficiencies. Maintaining a competent board of directors and ensuring proper governance practices are ongoing challenges.
Taxation Matters /Transfer Pricing Issues
Tax aspects are prominent in captive insurance arrangements, and they also present a particular risk area. The taxation authorities might scrutinize captured entities quite closely to confirm that there is a valid reason for setting up a captive for its intended use rather than using it mainly for avoidance of tax. Aspects of risk allocation, premium charges, and claim payment should be as per the market standard. Failure in documentation or non-compliance might result in penalties, taxes due, and reputation loss.
Forming a Captive company can provide meaningful benefits, but it also involves certain risks, as stated above. Companies should carefully evaluate the challenges and risks and take proper steps to avoid them.
