Traditionally, captives are casualty risk financing vehicles. The reason for this is straightforward — casualty lines such as workers compensation, general liability, professional liability and employee benefits have long claims “tails,” (the portion of the unpaid loss that extends over a period of years after the loss occurs). The longer the captive can keep the funds, the better its investment income and surplus position.
Property losses, on the other hand, have short tails; they usually pay out in the policy year in which they occur, leaving little chance for the accumulation of investment income. Another drawback of property captives for U.S. companies is that IRS rules prohibit the establishment of “incurred but not reported” loss reserves for years in which no losses occur. This means that in loss-free years, the premium in a domestically domiciled captive (or in an offshore captive that has elected to be taxed by the IRS) falls immediately to earnings and is subject to income taxes, instead of being held in a loss reserve account that the captive deducts from its income taxes.
Despite these apparent downsides, however, property captives are becoming popular as companies seek new ways to use their existing captives or efficient methods of managing retained risk. Property-only captives are rare. They are owned primarily by nonprofit, non-taxpaying entities such as churches and universities. These captives pool a set amount of retained risk shared among a homogeneous group of property loss exposures. Actuaries determine the annual funding amounts, and a portion of what is not used to pay losses is usually returned as dividends. The captive also acts as a buying group for insurance or reinsurance, excess of the retentions. Large, geographically diverse groups are able to negotiate cheaper risk transfer premiums than individual members can.
A significant benefit of placing a moderate amount of property risk into a casualty/employee benefits captive is that it increases the captive’s portfolio diversity. Since property losses are not generally correlated with casualty or employee benefits losses, the captive benefits from the internal hedging. This does not mean that losses will be reduced; it means that the captive will be better prepared to manage the loss volatility associated with individual lines of insurance.
Furthermore, unlike casualty losses, once a property loss is paid, it is paid. There is little chance that the loss will re-emerge as they routinely do in the casualty and employee benefits lines.
Finally, captives are also considered bona fide insurers under the Terrorism Risk and Insurance Program Reauthorization Act of 2007, meaning that captives that write terrorism coverage are eligible for U.S. government funding of 85% of the loss subject to a maximum of $1 billion. In all, property captives are gaining momentum as more than just a financing vehicle.