With companies looking to retain more risk, David Hertzell looks at the case for captives

According to the statistics, the captive industry continued to expand throughout the recent soft market. Captives however, are traditionally the children of a hard market and, as expected, all captive domiciles are reporting a great deal of increased activity at present. Arguably, captive insurance is no longer really alternative but has become very much part of the mainstream risk transfer process.

However, a captive solution will not suit everybody. The starting point is to consider whether or not a captive makes financial or strategic sense. Do you have a big enough insurance requirement or premium spend to justify the cost in time and money of setting up and running your own dedicated insurance vehicle? The conventional wisdom is that you would need a premium spend of around £350,000 for a wholly owned captive and perhaps £150,000 for a protected cell.

If you have sufficient insurance business, investment in a feasibility study may be worthwhile. You will need to consider your risk profile and loss history. If you are going to set up your own dedicated insurance vehicle, you should have a better than market average loss experience, or, at the very least, a firm commitment to improve risk management. You must also consider your attitude to risk. If your organisation is risk averse, it may be preferable, despite cost, to transfer risk to independent third parties.

The nature of the risk to be underwritten is also important. Ideally the longer the tail of the risk the better, as the longer the gap between claim and payment, the greater the opportunity to provide for that loss and to invest against it. Professional indemnity and employer's liability risks for example, may be better than property and other short tail risks.

The parent company must have a reasonable degree of financial strength. A captive will need to be capitalised, and there is the risk that further capital may have to be injected if underwriting losses are greater than predicted. Finally, it is important to remember that a captive is a long term risk financing solution. It is likely to take between three and five years, depending upon the insurance market, before real benefits are seen, and it makes no sense to jump in and out of captive ownership. If you decide to go down the captive route, it would be prudent to appraise your risk management processes and integrate your captive with a new programme.

The UK is well served by nearby captive domiciles in Dublin, the Isle of Man, Guernsey and Gibraltar. All of these domiciles are acceptable to the international financial regulators and all of them have a good infrastructure of captive managers, lawyers and accountants, although it is fair to say that Gibraltar is still a fairly new domicile. For certain types of UK business, such as employer's liability and motor, you will need a fronting company if your captive is located in Guernsey or the Isle of Man. Dublin and Gibraltar can write such business direct within the EU. Guernsey and Gibraltar have protected cell legislation; Dublin and the Isle of Man do not. Inevitably, in the current hard market, fronting costs have risen sharply.

One of the prime reasons for captive ownership is to smooth volatility of insurance cost, which has been particularly relevant recently. However, you should bear in mind that the overall cost of insurance, when taking into account time and administration, might be higher in a future soft market than the cost of commercial insurance, as smoothing volatility is not just a one-way street.

Your captive may also be able to provide you with access to the reinsurance market. In an increasingly consolidated primary market, this will become a more important benefit. There is some evidence that reinsurance costs are more stable than insurance costs at present.

There are however some disadvantages to captive ownership. You will have to tie up resources in terms of personnel, time and money and, unless you are in the insurance business, you will have a subsidiary, probably managed offshore, undertaking a function with which you are not familiar. You need to be certain that those who are managing your captive are doing a competent job and that, for example, the insurance documentation along the chain from captive owner to reinsurer is consistent with regard to insurance terms, coverage, law and jurisdiction. It could be potentially catastrophic for the captive to find that it was liable to reimburse a fronting company but could not collect on its own reinsurance. It is also worth remembering that protected cell legislation is not generally recognised outside the relevant captive domiciles. The increase in insurances costs generally, while provoking an active interest in captive risk solutions, also makes such projects more expensive if the proposed captive is going to rely on fronting or reinsurance, particularly in its early years.

A captive insurance company can be a very effective solution to your insurance requirements. It is not however a universal panacea and it is not a short-term option. And, while it is quite easy to enter the insurance market, it is extremely difficult to get out.

David Hertzell is chairman of AIRMIC's special interest group on captives and an operations partner of law firm Davies Arnold Cooper, E-mail: dhertzell@dac.co.uk