Insurance Handbook - Alaska Department of Community and ...

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Captives and Other Risk-Financing Options
Captives and Other Risk-Financing Options
Traditionally, businesses and other organizations have handled risk by transfer-
ring it to an insurance company through the purchase of an insurance policy or,
alternatively, by retaining the risk and allocating funds to meet expected losses
through an arrangement known as “self insurance,” in which firms retain rather
than transfer risk.
During the liability crisis of the 1980s, when businesses had trouble obtaining
some types of commercial insurance coverage, new mechanisms for transferring
risk developed, facilitated by passage of the Product Liability Risk Retention
Act of 1981. These so-called alternative risk transfer (ART) arrangements blend
risk transfer and risk retention mechanisms and, together with self insurance,
form the alternative market.
Captives—a special type of insurance company set up by a parent company,
trade association or group of companies to insure the risks of its owner or owners—and
risk-retention groups—in which entities in a common industry join
together to provide members with liability insurance—were the first mechanisms
to appear. Other options, including risk retention pools and large deductible
plans, a form of self insurance, followed.
ART products, such as catastrophe bonds, weather derivatives and microinsurance
programs are also emerging as an alternative to traditional insurance
and reinsurance products.
Alternative Market Mechanisms
I. Captives
Wholly owned captives are companies set up by large corporations to finance or
administer their risk financing needs. If such a captive insures only the risks of
its parent or subsidiaries it is called a “pure” captive.
Captives may be established to provide insurance to more than one entity.
An association or group of companies may band together to form a captive to
provide insurance coverage. Professionals—doctors, lawyers, accountants—have
formed many captives over the years. Captives may, in turn, use a variety of
reinsurance mechanisms to provide the coverage. In particular, many offshore
captives use a “fronting” insurer to provide the basic insurance policy. Fronting
typically means that underwriting, claims and administrative functions are
handled in the United States by an experienced commercial insurance company,
since a captive generally will not want to get involved directly in running the
insurance operation. Also, fronting allows a company to show it has an insur-
I.I.I. Insurance Handbook www.iii.org/insurancehandbook 29