Insurance premiums can make up a large portion of administrative expenses in certain industries, and small businesses can find themselves in a position where insurance is not readily affordable. Self insurance and captive insurance offer two alternatives to traditional insurance contracts, opening up additional possibilities for protecting your business from financial loss. They provide fundamentally different approaches to financial protection, and each has its own set of advantages and drawbacks.
Self insurance is the act of systematically setting aside money to insure against specific risks. Self insurance can take a variety of forms. A small business can establish a savings account specifically to cover cash shortages caused by nonpayment by credit customers, or a real-estate lessor can set aside cash each month to cover the cost of potential damages due to natural disasters. Almost anything covered by insurance can conceivably be covered by extensive savings, and that is the philosophy behind the self-insurance concept. Some states require employers to meet certain conditions before using self insurance to cover legal insurance requirements, such as workers' compensation. In these cases, the right to self insure is generally granted to larger, more financially stable companies.
The term captive insurance refers to insurance coverage provided by a carrier that is owned by one or several clients. Captive insurance operates according to principles similar to self insurance, but captive insurance is a bit more complicated and costly to maintain. A financial-services company, for example, can set up its own errors and omissions insurance carrier to serve itself exclusively, or a local group of farmers can create an insurance company to protect themselves from loss due to crop damage. In captive insurance contracts, owner companies pay regular premiums to the insurance carriers the same as a commercial insurance contract.
Self insurance is essentially a fancy term referring to age-old financial wisdom. Setting aside money for emergency situations is a solid strategy for both personal and business finances. Some types of insurance coverage, such as comprehensive automobile coverage, can easily be covered with cash after a period of diligent savings, rather than relying on a commercial insurance contract.
Captive insurance has the benefit of resembling a commercial insurance contract in almost every way, while providing policyholders with the power to set their own prices and determine their own benefits. Prices and benefits are still subject to the laws of economics, but captive insurance providers do not necessarily have to generate any profit, allowing them to charge minimum prices for large benefits.
Self insurance has distinct limitations. Some types of insurance, such as workers' compensation, can pay out benefits far exceeding a company's ability to put money aside, even after years of saving. Others, such as general liability, can be too unpredictable to rest assured that potential issues are covered by savings.
Captive insurance incurs a wide range of expenses not present in either commercial or self insurance. Costs such as business registration and licensure can make it challenging to justify the costs of maintaining a captive insurance carrier rather than simply buying a contract from a third party.
- Hemera Technologies/AbleStock.com/Getty Images