The Use Of Captive Insurance Companies In The Financial Services Industry

The Legal Definition of Insurance All insurance transactions must have five factors, starting with a definite risk. Sometimes called the triggering event, a specific incident must occur before the insured can file a claim. For example, fire and lightning trigger coverage under a property policy. Second, the risk must be fortuitous. If the insured is aware of an upcoming incident, he can make adequate preparations to minimize its negative impact, thereby eliminating the need for coverage. Third, the insured must have an insurable interest; he must show that he will be personally hurt when the definite risk occurs. Court’s developed this factor in the 19th century, when individuals purchased life insurance on the lives of famous people as a way to gamble on the date of their death. Courts concluded this practice led to economic waste and was therefore against public policy. Fourth, there must be risk shifting which is accomplished through the issuance of a valid insurance policy.

The policy “shifts” the risk of loss from the insured (who is no longer responsible for the cost from damages) to the insurer (who will “make the insured whole” with its indemnification payment). The final factor is risk distribution, which requires a more in-depth explanation, best accomplished through an example. Begin with the risk borne by a single homeowner who does not have property insurance.

It is highly unlikely he will have sufficient financial resources to replace his home in the event it is destroyed by a fortuitous event. But if that individual pools his risk with other similarly situated homeowners who live across a geographically diverse area, a key development occurs – the possibility that the insured’s funds will return to him as part of the indemnification payment decrease, since all of the insured parties are unlikely to suffer a simultaneous loss. At the same time, it becomes more likely that one insured’s funds (and any earnings thereon while held by the insurer) will ultimately support a payment to another insured who has indeed lost his home. It is this pooling of premiums in the insurance company, resulting in a distribution of the risk of loss (and potential for indemnification) across the entire pool of insured persons that creates insurance.

 How a Financial Services Company Should Utilize a Captive

To understand how to utilize a captive insurance company, it’s important to know a small amount of insurance coverage history. Beginning in the mid-1960s, the plaintiff’s bar brought four lines of high profile cases: product’s liability, medical malpractice, environmental claims and asbestos losses. Each line eventually ended with large multi-million dollar judgments that forced insurers out of these respective markets. Captives filled this coverage vacuum. To this day, it’s very common for all but the largest companies to implement an insurance “tapestry,” where they maintain their CGL and property policies while using a captive to underwrite “stochastic” (lower frequency, higher payout) risks that are excluded from their commercially available coverage. Financial institutions are no exception. For a relatively small sum, they can obtain generalized policies for generic business risk. But these policies contain large gaps in coverage for risks that could, should they occur, potentially place the company in financial jeopardy. Some of the more common policy gaps underwritten by financial captives follow.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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