In 1986, the Federal Risk Retention Act (FRRA) was created. This act allowed similar or related businesses or groups to form for the purpose of buying liability insurance. The Act was in response to a severe shortage of liability insurance for certain types of business. Businesses that wanted to continue to operate needed a strategy to protect against their vulnerability to accidental losses. Two strategies were found – captive insurers and risk retention groups (RRGs).
Captive insurance companies were first created in the 1950s. This method of handling losses lowered insurance costs for corporations and, originally, also allowed huge tax advantages that were subsequently outlawed. In spite of that, and because of the volatility of traditional commercial insurance companies in the United States, the number of captives continued to grow.
Many large corporations wanted the investment income generated from the premiums paid to their captive insurance companies. Additional income was also created by the loss reserves (sums set aside for handling anticipated, accidental losses) generated by those premiums. This provided even more motivation to form captive insurers. Sophisticated corporate risk managers realized they could benefit from any of a number of insurance premium-related investment income opportunities. This was seen as yet another advantage over purchasing commercial insurance coverage from an insurance company that controlled premiums, loss reserves and the interest income that those funds generated.
Initially, most offshore captives were “pure” captives. As time passed, many pure captives found even greater tax advantages if they insured other, unrelated organizations. Unfortunately, due to writing too much business and lacking expertise, many of these early captive insurers became insolvent.
The insurance market problems of the mid-1980s also spurred the creation of Risk Retention Groups (RRGs) and the concept (also known as group or association captives) became popular. RRGs are insurance companies established and capitalized (funded) by a group of businesses to underwrite and insure their own collective insurance risks. In addition, many trade associations formed and funded association captives to underwrite and insure risks of the members of a particular trade association.
The Federal Risk Retention Act encouraged formation of Risk Retention Groups (RRGs). These were formed under the federal law to write liability insurance for members of the group. Such groups were usually formed outside of the United States or “off-shore.” Foreign and “off-shore” captives had the advantage of not being subject to the premium taxation and insurance regulations of any U.S. state. Besides Bermuda, other favored locations for offshore captives included the Bahamas, Barbados and the Cayman Islands. These groups contributed to the viability of the alternative risk market because they represented a viable, non-traditional method for providing insurance. However, as captives proved to be viable methods of offering protection, and due to their popularity and profitability, a growing number of U.S. States also allow the formation of captive insurers.
Other Captive Concepts
Pure captive: refers to a captive that is owned by a single, parent company. This form was the initial technique for solving insurance cost and availability problems because of the failure of traditional insurance markets to respond to those needs. Shortly after they came into existence, retention groups developed. The concept continued to mature and spawned more variations. They included:
Rent-a-captives: These are captives formed by insurance agents or brokers. With this concept, interested businesses rent the operating shell of the captive insurer to handle the coverage needs of the business. It allows the business to solve coverage problems and avoid high start-up and operating costs. The disadvantage is that the rented captive controls premiums and investment income but it still fulfills the main purpose of resolving the issues of cost and availability.
Segregated Cell: This is a sophisticated modification of a rent-a-captive. There is a significant difference. In the rent-a-captive approach, all premiums of the participants contribute to the group as a whole and the poor results from one participant affect all the others. In a segregated cell captive, the premiums, losses, reserves and investment income of each participant is separated from those of every other participant.
These modifications and others contributed to the growth of the alternative market. It allowed businesses skilled in handling risk to take advantage of new strategies where insurance is a component of risk management, rather than being the entire strategy.