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Disadvantages of Captives

We've already discussed some of the costs and risks of captive insurance programs (see Types of Captives and How They Work).  Here is a summary of the most frequently identified disadvantages.

General Captive Disadvantages

Captive programs: 

  • present the risk of financial loss to owners as well as financial gain;
  • require an up-front capital investment;
  • in some circumstances, may present uncertainty as to the federal tax treatment of premiums and captive profits;
  • are not as easy to enter and exist compared to purchasing insurance from the commercial market;
  • may decrease an insured's purchasing power for other coverage in the commercial market, and
  • requires management time to participate on the captive's board and manage captive investments.

Pure Captive Disadvantages

In addition to general disadvantages, pure captives:

  • may have fewer insureds to pool and spread risk resulting in more variable year-to-year captive financial results (this risk can be addressed through reinsurance); and
  • issue certificates of insurance that may not be acceptable to some third parties.

Group Captive Disadvantages (Association, Risk Retention Group)

In addition to general disadvantages, group captives:

  • take longer to form; 
  • may not offer the best policy form for each and every insured;
  • may utilize service providers that offer less than optimal services;
  • offer much less control over claims handling than do pure captives;
  • may required insureds to share in the poor loss experience of others;
  • require higher overall levels of capital than do pure captives;
  • tend to be more reliant on the availability and cost of reinsurance;
  • tend to be more political and subject to decision-making problems as respects captive governance;
  • may present conflicts regarding profit and earnings distributions;
  • offer less confidentiality;
  • are subject to greater regulatory requirements;
  • are more complex and at-risk regarding taxation and ownership;
  • are at a high risk of losing members (and their capital) to competing programs; and
  • insureds may not be able to easily exit a group captive program.

Sponsored / Protected Cell Captive Disadvantages

While insureds do not need to provide up-front capital to participate in a sponsored / protected cell captive, the following disadvantages are present with these programs:

  • policy forms may be dictated by the sponsor;
  • insureds do not have a choice of whom their service providers are;
  • sponsors usually require that each cell be fully funded or collateralized up to the aggregate limit of liability, with such collateral being held for a number of years;
  • the IRS may not deem the arrangement as insurance for federal tax purposes;
  • excess funds in a cell may not be released by the sponsor for a number of years; and
  • conflicts of interest between the sponsor and insured are more likely.

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