Captive Insurance and the Perils of Parenthood

Originally published in September 2003

In law, a captive insurer is an insurance company like any other. A statement of the obvious, perhaps, but nonetheless a technicality that many in the industry have been known to lose sight of from time to time.

Typically, a captive insurer will enter into two contractual insurance relationships, that is to say the inwards insurance, either directly from the parent or from a fronting insurer, and its outwards reinsurance. Even those captives that have been adequately capitalised to bear a large proportion of their own risk will almost certainly need recourse to XL or stop loss reinsurance, in order to preserve the integrity of the security provided to the parent or the fronting insurer.

At the very least, therefore, there will be two links in the chain from the insured parent to the traditional reinsurer, as ultimate risk bearer, and three where a front is interposed. In practice, of course, a captive's reinsurance programme is frequently more complex than a single outward contract. It will often be structured in such a way that XL cover is superimposed on a proportional quota share treaty, and hence the handling of individual direct claims will impact on both proportional reinsurance and horizontal XL. On any view, there will be multiple parties involved in the structure, and the inevitable opportunity for disputes to arise.

Managers of group or association captives are accustomed to reviewing inward claims with a critical eye. They owe an obligation to the captive in its own right, and in turn to other parent policyholders, to ensure that only recoverable claims are agreed. As such, they can be expected to behave in much the same way as any traditional insurer, and this will often include the retention of outside advisers to assist with difficult coverage issues where necessary.

The same, however, is not always true in the case of single parent captives, where the process is often viewed as a simple risk transfer from the insured parent to the external reinsurer. Under the latter analysis, the intervening steps are little more than an accounting exercise, in which the captive is but a handy conduit through which the risk (or, at least, the excess risk) is channelled to the traditional insurance markets. The temptation to apply this holistic approach should be resisted, particularly when it comes to claims processing, not least because it overlooks the true legal relationships, and obligations, between the various parties.

In the event of a claim, both parent and captive must take steps consistent with an arm's length relationship, at least if they hope to effect a recovery under the captive's reinsurance. The paper trail may end up looking contrived at times, particularly where the directing minds of the parent and the captive are one and the same. In those cases, effective Chinese walls...