When to Consider Exiting a Captive Insurance Program

Investing in a captive insurance program can be a strategic decision for many businesses, offering benefits such as risk management and potential financial gains. However, there are situations when it becomes necessary to consider exiting a captive insurance program. Here we will explore some key factors that may indicate the need to exit and unwind a captive investment.

Before delving into the reasons for exiting, it is important to establish a clear purpose when entering any investment. This purpose should outline the triggers that determine the value of the investment and the conditions that would warrant an exit. Having a well-defined purpose ensures that the decision to exit is based on a strategic approach rather than reactive impulses.

One of the primary considerations when contemplating an exit from a captive insurance program is the impact on cash flow. Captive insurance requires a capitalization payment or collateral, which ties up cash that could otherwise be utilized for the growth and profitability of the business. This represents an opportunity cost in terms of the internal rate of return. By investing capital in the captive, the business foregoes other potential investments that could contribute to its overall profitability. Therefore, understanding the internal rate of return and evaluating whether the captive investment aligns with the business's financial goals is crucial.

Another factor to assess is the distribution or dividend returns from the captive program. Many employers enter into captives with the expectation of receiving a certain return on their premium investment. However, if the actual returns fall short of expectations and are consistently lackluster, it may undermine the motivation to continue with the captive investment. Evaluating the historical performance of the captive in terms of return of premium distributions is essential to determine if it is meeting the anticipated profitability levels.

Operational considerations also play a role in deciding to exit a captive insurance program. Sometimes, the administrative burden of managing a captive can become overwhelming for the HR department or CFO. As the complexities increase, key members of the executive team might start questioning the value the captive brings to the corporation. If influential stakeholders are no longer fully onboard, it becomes a strong indicator that exiting the captive program should be considered.

While the factors mentioned above provide a starting point for evaluating an exit, it is important to recognize that there could be additional reasons specific to each business. Deciding to unwind a captive investment requires thoughtful consideration and should not be based solely on immediate circumstances, such as dissatisfaction with a renewal.

Typically, the process of unwinding a captive takes around twelve months. This means that if a decision to exit is made in October 2023, it would likely involve renewing the program for the current year and then exploring alternative financing options for the following year. The extended timeline is partly due to tail risk, which refers to the ongoing risks associated with the captive that may persist beyond the policy duration.

Additionally, it is important to understand that exiting a captive program may result in forfeiting underwriting profits earned during the current year. This topic will be discussed in more detail in the next article. However, it is worth noting that in most cases, once the fronting carrier concludes the treaty year and resolves all policies and risks, the collateral paid to the carrier is returned to the business. It is essential to consider any solvency risks or concerns associated with the captive before assuming the return of collateral.

Exiting a captive insurance program is a decision that should be approached strategically and with careful consideration of the factors discussed. Evaluating the impact on cash flow, analyzing the distribution returns, and assessing the operational burden are all important aspects to consider. Unwinding a captive investment requires time, typically spanning one to two years, and should account for tail risk and the potential forfeiture of underwriting profits.

Later this week, we will delve into the concept of the "golden handcuffs" in captive insurance.