Captive insurance refers to an arrangement in which an entity chooses to provide insurance for its members by using its own assets, rather than purchasing it on the open market. Captive insurance often is used in at attempt to reduce costs or gain more control over benefits administration. Despite these advantages, a captive arrangement has potential disadvantages as well.
Because the entity is essentially self-insured, it needs to raise a substantial amount of capital to keep in reserve to pay for claims. If the entity underestimates its need for protection, or experiences a catastrophic loss, it may not have the funds on hand to provide adequate coverage. This could have a severe impact on the company's bottom line if it needs to draw from other assets.
Quality of Service
When choosing captive insurance, an entity may not have the expertise in selecting third-party service providers or may choose discounted providers as a way to save money. As a result, it may receive inconsistent or inadequate service in return.
No Tax Benefits
According to Captive Insurance Alternatives LLC, the Internal Revenue Service has gradually reduced some of the tax benefits once enjoyed by captive insurers, such as low taxation of any plan profits. This can make captive insurance cost prohibitive, eliminating one of the main advantages of "going captive."
Inability to Spread Risk
Insurance is based on spreading the risk among large numbers of individuals as a way to keep costs down. With a captive arrangement, the pool of insured individuals is often small, which means the actual costs can vary greatly from year to year. This can make it difficult for the entity to properly plan for its insurance needs. It may have to rely on reinsurance, a form of secondary or excess insurance, to cover unanticipated needs.
A captive arrangement requires additional time and resources for the entity to manage, which contributes to its cost. The entity may need to bring on additional personnel to manage the day-to-day operation.
Difficulty of Entrance and Exit
Captive insurance arrangements are often more difficult for the entity regarding entrance and exit than is purchasing insurance on the open market. Depending on the arrangement, it also may be difficult for insured individuals to join the captive plan or leave to obtain coverage elsewhere.
Chris Joseph writes for websites and online publications, covering business and technology. He holds a Bachelor of Science in marketing from York College of Pennsylvania.