Aon | Professional Services Practice
The risk retention series:
Retaining Risks in a Captive – Considerations for Professional Service Firms
Release Date: July 2022
The Professional Services Practice at Aon shares further insights to help firms make better decisions about risk retention and which risks to cover in a captive.
A captive insurance company is established to insure the risks of its owners. When determining the appropriateness of a captive, a company must identify the role the captive will play within their risk strategy, and importantly, understand their overall tolerance for risk retention. This is even more relevant with the recent hard market conditions and COVID uncertainties that have increased both appetite and desire for greater use of a captive. Therefore, a detailed captive feasibility analysis is needed. A major task in that analysis is a review of an organization’s goals around the retention of risk and the type and level of risk that the organization is willing to insure in a captive.
Some important criteria should be considered:
- Actuarial Forecasting
- Strategic Planning
- Self-insuring risk/reward
- Internal and External Structural Obstacles
Actuarial analysis plays a key role in the formation and the continuing solvency of a captive. Results from loss forecasts and the projections of future premiums vary greatly between lines of coverage – the unique risk factors of each coverage must be considered. Such robust quantification is necessary to allow captive owners to maintain the levels of capital required to satisfy regulators, pay claims and cover operational expenses. Accurate data is essential for this level of actuarial forecasting for any risk that could potentially be included in a captive.
Captives are long term investments and the lines of coverage that are insured in a captive should support the long term strategy and objectives of the owner. A captive may be established to reduce insurance premiums, fund increased retentions, smooth funding to assist with intergenerational equity within partnerships, better control an insurance program, or more recently, for new and emerging risks. But whatever the reason, the opportunity costs of the decision to form a captive must be considered within the strategic plan of the prospective captive owner. A firm should always consider, among other factors, their risk appetite, capital adequacy and the availability of commercial insurance when considering coverages for a captive. This process can help a firm identify the appropriate amount of risk to retain when aligning their use of a captive with long term goals.
The risks and rewards of self-insuring through a captive must also be considered when reviewing lines of coverage for a captive. While retaining some risk in a line of coverage may align with a company’s strategy, there should also be operational and financial benefits to incorporate it into a captive. A company must weigh the pros and cons of insuring the risk in the captive, examining its cost of capital and the opportunity costs of self-insurance. This also includes identifying volatile risks that might be more appropriately transferred or distributed outside of the company. Aon maintains a pulse on the commercial insurance market and can help organizations analyze the risks and rewards associated with different lines of coverage.
Internal and External Structural Obstacles
There are regulatory, financial, operational, and administrative obstacles to retaining certain risks within a captive. When establishing a captive, it is important to assess the challenges and hurdles across all lines being considered. Certain coverages may require higher initial capital contributions. Other lines, based on actuarial modeling, have higher probabilities of severe loss. The type, location and tax treatment of the captive are also major factors to consider. All these issues must be examined prior to the formation of a captive.
Below are examples of lines of coverage that could be insured by captives of professional service firms:
Line of Coverage
- Professional Liability
- Employment Practices Liability
- Management Liability
- Employee Benefit Programs
- Property & Casualty
- Strategic coverage
- Increasingly difficult coverage in the market
- Sensitive and potentially volatile risk for professional services
- e.g., D&O, Fidelity, Fiduciary
- Medical Stop Loss, Long Term Disability, Other Coverages
- Property, Primary and Excess Liability
Single parent captives are typically formed to cover a significant line of coverage – for professional service firms this is usually professional liability. As captives mature and show value to their parent organization, additional lines of coverage can be added to the captive offering.
Captives can retain a variety of risks for a firm. A firm considering a captive must review their strategy and the external factors that influence their risks. By performing a detailed analysis in advance of forming a captive, a firm can decide whether a captive can help in achieving its long term objectives.
The Professional Services Practice at Aon values your feedback. If you have any comments or questions, please contact David L. Christensen, Connor Galvin or Henry Lim .
David L. Christensen
Vice President and Director
Senior Vice President and Executive Director