Bermuda Insurance Market . In Chapter 4, the firm provided an overview of captive insurance, which is reprinted here with permission.

Reasons to Form a Captive The Captive Insurance Directory defines a captive as a closely-held insurance company whose insurance business is primarily supplied and controlled by its owners (in the sense of having direct involvement and influence over the company's major operations, including underwriting, claims management policy and investments), and in which the original insureds are the principal beneficiaries.

For the most part, these companies (often referred to as either pure or association captives) will be classified either as Class 1 or Class 2 insurers for the purposes of the new classification scheme brought about by the Insurance Amendment Act 1995.

Various reasons have been advanced for the establishment of captive insurance companies. As a general matter, many medium to large organisations or groups of organisations have found that the conventional insurance markets have failed to meet their financial needs, especially in terms of price, service, cover and capacity for certain types of risk.

In making the decision to form a captive, they have often been compelled by the same reasons that have fuelled the captive movement world-wide. These reasons include: 1. Reduction of the costs of risk management The price of insurance cover purchased in the conventional market typically reflects a significant mark-up to pay for the insurer's acquisition costs (including marketing costs and commissions paid to brokers), administration, overhead and other costs as well as a portion of the insurer's profit.

The fact premiums are paid to the insurer in advance also represents a lost opportunity on the part of the insured to earn investment income on such premiums, as well as any profits that may arise on the insurance transaction itself.

While the establishment of the captive insurance company cannot eliminate these costs, it certainly can reduce them. The extent of the reductions will depend on the captive's own loss experience and claims handling costs, as well as the degree to which the captive form of self-insurance serves to promote cost consciousness and efficiency within the insured organisation.

2. Stabilisation of pricing Where the insured enjoys a stable and reasonable loss experience from year to year, a captive affords the ability to price insurance cover accordingly.

By contrast, the conventional insurance market will often set prices in relation to broad industry classifications, and thereby fail to reflect key differences in loss experience among individual insureds.

The result is the incurrence of a financial penalty in the form of price volatility consequent upon general market conditions and the actions of other insureds over whom the organisation has no control. In addition to the stabilisation of pricing over time, there are also advantages to be realised in terms of the organisation's financial planning and control functions.

3. Provision of cover where otherwise unavailable From time to time, depending on market conditions, the conventional market is unwilling or unable to provide cover for certain risks, especially in respect of liability and casualty loss. The establishment of a captive (or group captive) to write such lines or to provide additional capacity will often hold the answer to structural market problems within the insurance industry.

Examples of cover which has at times been unavailable or difficult to obtain on satisfactory terms include product liability, oil pollution and hazardous waste insurance. Whenever insurance cover is either unavailable or overpriced, the feasibility of a captive is enhanced.

4. Access to reinsurance markets Because reinsurers generally only deal with insurance companies, a captive affords direct access to the international reinsurance markets.

In bypassing conventional insurers in this manner, the ultimate insured is spared the mark-up costs discussed above. The savings associated with eliminating the costs of the conventional insurer will generally outweigh the incorporation and other start-up costs of a captive.

It is also the case that a captive can earn ceding commissions from the reinsurer for introducing the reinsurer to the ultimate insured.

5. Improved cash flow benefits The ability of a captive to generate investment income from unearned premiums received is often a critical advantage of forming a captive.

This is especially so where the premiums are paid in advance and losses are paid out over a lengthy period of time (which in turn depends on the kinds of risks insured). To the extent that investment income can accumulate in a tax-free domicile like Bermuda, there will be additional funds available to pay losses and a corresponding reduction in the need for further funding of the captive by its parent (the ultimate insured).

6. Reduction of government regulations and interference By contrast to the rigorous insurance regulation in most industrialised countries, an offshore domicile can provide a relatively less onerous, yet responsible, regulatory framework. In Bermuda, this has been described by the Registrar as a system of shared regulation, whereby the regulated cooperate with a view to achieving the most appropriate level of policyholder protection while at the same time permitting the captive to grow and prosper.

While the form of such regulation is described in some detail elsewhere in The AS&K Guide , it should also be said that there are no relevant exchange control regulations. As a result, income arising from net underwriting results, together with enhanced investment performance, can be returned to the parent in the form of dividends or lower insurance premiums.

7. Ability to customise insurance programmes For all practical purposes, a captive has complete freedom to insure any risk it chooses and to customise the terms and conditions of its policies. Indeed, the opportunity to do so (for example, by either including or eliminating common policy exclusions like those for certain types of personal injury in a general liability policy) can often lead to improved loss control efficiency within the captive and promote greater awareness of the factors which commonly give rise to losses.

8. Opportunities for improved claims handling and control A captive is also free to establish its own claims handling policies and procedures. This has obvious advantages such as the reduction of the time taken to process and pay claims.

9. Creation of a profit centre To the extent that a captive might offer insurance cover to unrelated customers (sometimes in response to tax problems of the captive), it will have diversified into open market operations not unlike conventional insurers.

Although there are special risks and capital requirements associated with engaging in such business, in doing so it will have the potential to generate additional profits for its parent.

10. Tax advantages While specific tax advice should be sought before taking the decision to form a captive, there may be certain tax advantages associated with such a decision. These might include the tax-free accumulation of underwriting and investment income (which may depend on, among other factors, the residence or citizenship of the owners or the source of the income).

Another advantage may be the deductibility of premiums for tax purposes (as premium expense of the insured) and the avoidance of state premium taxes.

While tax advantages may be of significance in the decision to form a captive, the better view seems to be that they should not be considered as the prime motivating factor.

Conclusion The decision to form a captive will involve careful analysis of the factors and developments outlined above. This analysis should form part of an overall captive feasibility study, the main purpose of which is to make a strategic assessment of the parent company's current insurance program, including its risk exposures and record of losses.

Thereafter, a host of additional matters (principally of an organisational nature) will need to be addressed, including the selection of the most appropriate local captive insurance managers (assuming, as is likely, the captive will not be self-managed), attorneys, auditors, actuaries and other service providers.

Indeed, a visit to the chosen domicile will usually be advantageous, so that the full range of service providers can be interviewed and other helpful contacts made (including, if desired, the Registrar of Companies himself).