Insurance is based on the law of large numbers. Take the example of a standard six-sided die. We don’t expect that rolling the die six times will yield each outcome only once. However, if we roll the die six hundred times, we expect a nearly even distribution of 1/6th for each outcome.
The insurance industry provides stability to employers by pooling large amounts of diversified premiums. Insurance companies use historical information to determine the probability of an event. By pooling multiple employers together, insurance companies can assume a risk that is unpredictable for one employer but predictable for the group. Typically, if an exposure or premium base is large enough, almost any risk becomes predictable.
Each dollar of insurance premiums can be broken into two components: predictable and unpredictable. As the amount of premium increases, a larger portion of the premiums can be allocated for predictable losses. A captive is simply the “bucket” used to capture or retain the predictable premium and its corresponding profits.
A typical captive program involves a fronting or policy issuing carrier. This carrier issues a policy and collects a premium. The predictable portion of the premium is then transferred, or ceded, to the captive. As predictable losses are paid, the captive reimburses the carrier for the losses.
Once the policy has expired and losses have been closed, the captive returns unused funds to the owner of the captive. Conversely, if losses exceed the portion of the premium allocated to the captive, the owner of the captive is required to fund additional amounts. The total liability of the owner of the captive is normally limited, and is often secured with collateral.
The current insurance market is an ideal time to consider a captive insurance program.