Placement StructuresAdvanced

Captive

The parent's own (re)insurer

An insurer or reinsurer a parent company owns and uses to formally fund and manage its own risk, rather than buying all its cover from the open market.

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Definition

A captive is a licensed insurance or reinsurance company wholly owned by the organisation whose risks it insures, set up to formally retain and finance risk that would otherwise be bought in the open market. Rather than paying a commercial insurer's full margin for predictable, budgetable risk, the parent funds its own captive with premium, which the captive can then choose to retain, or to reinsure onward into the traditional market for the volatility it does not want to keep. A captive lets a large organisation act as its own cedent for risk it understands better than any outside underwriter would.

A captive only makes economic sense for risk that is reasonably predictable and where the parent has better loss information than an outside insurer could obtain.
Captives frequently buy their own reinsurance — the captive becomes a cedent in exactly the same structural sense as any commercial insurer, just with one shareholder.
Because a captive is licensed and regulated like any other (re)insurer, it must still hold real capital and reserves against the risk it retains, not just an accounting entry.

Worked example

A hotel chain with consistent, well-understood slip-and-fall claims sets up a captive to insure that risk itself, funding it with the premium it would otherwise have paid a commercial insurer, and buys a modest excess-of-loss reinsurance layer above the captive's own retention for the rare severe claim.

Scenario · figures in USD

A captive retains the predictable layer and reinsures the tail

A manufacturing group forms a captive to insure its product-liability exposure, which produces frequent, modest claims and rare, severe ones.

Premium the group used to pay a commercial insurer	$4M/year
Premium now funding the captive instead	$4M/year
Captive's own retention per claim	$500,000
Captive's excess-of-loss reinsurance above that	$9.5M xs $500,000
A $6M product-liability claim: captive pays	$500,000
Same $6M claim: captive's reinsurer pays	$5.5M

So whatThe captive lets the group keep the predictable layer of risk in-house at cost, while still buying traditional reinsurance for the tail it cannot comfortably absorb itself.

Check your understanding

What kind of risk is a captive best suited to retain?

Reasonably predictable risk the parent understands better than an outside insurer would. Captives make the most economic sense for predictable, well-understood risk, where the parent's own claims data lets it price and retain the exposure more cheaply than buying full commercial cover.

When a captive buys its own reinsurance, what role does the captive play in that transaction?

It acts as the cedent, structurally no different from any other insurer buying reinsurance. A captive buying reinsurance is a cedent in exactly the same structural sense as a commercial insurer — it retains a layer and cedes the rest.

Word problem

A group's captive retains the first $500,000 of every product-liability claim and reinsures $4.5M excess of $500,000. A claim settles at $3.2M. How much does the captive pay net, and how much comes from its reinsurer?

Show a hint

Work out how much of the $3.2M falls inside the captive's retention, and how much falls inside the reinsurance layer above it.

Reveal the worked answer

Captive's retention absorbs the first $500,000 of the claim.
The reinsurance layer covers losses from $500,000 up to $500,000 + $4.5M = $5M.
The $3.2M claim falls entirely within that layer once the retention is subtracted: $3.2M − $500,000 = $2.7M.
Since $2.7M is comfortably inside the $4.5M limit, the reinsurer pays the full $2.7M.

The captive pays $500,000 (its retention) and its reinsurer pays $2.7M — the claim never comes close to exhausting the $4.5M excess layer, so the captive's net cost is capped at exactly its own retention.