Effective risk analysis: offers protection for captives.

• Author: Kotch, Ken
• Position: Insurance

Creating a captive insurance company has become a popular alternative risk management strategy for middle-market businesses. But as captives become more commonplace, regulation and scrutiny is likely to increase and become more sophisticated.

[ILLUSTRATION OMITTED]

This summer, the world was introduced to the most powerful and destructive computer virus in history: the "Flame Virus." This pervasive data-snatching virus swept through the Middle East and many other countries, seemingly overnight. The long-term effects of such global mal-ware will not be realized for many years to come.

[ILLUSTRATION OMITTED]

The United Nations issued an urgent warning that the Flame Virus and copycat cyberweapons could be used to bring entire countries to a standstill. Imagine the effects on a company's bottom line.

The field of alternative risk management relating to cyberwarfare and other esoteric global exposures is evolving rapidly. Financial executives may be prepared with state-of-the-art antivirus technology, but are they prepared for the economic implications of the inevitable business disruption associated with cyberterrorism and other global risks?

Setting aside a "rainy day" fund for such an event sounds like a prudent idea. Setting aside this fund on a pre-tax basis is better still.

Creating the company's own bona fide insurance company, with congressionally mandated benefits, to indemnify the business for such a loss (and reward it for associated underwriting profit) would seem to be even more advantageous. This option is available to all U.S. companies under the general concept of captive insurance, as discussed below.

But a word to the wise: the benefits of a captive insurance company are only realized with the proper identification and underwriting of "insurance risk."

Creating a captive insurance company has become a popular way for middle-market business owners to participate in alternative risk management--a form of risk retention for risks not efficiently covered by commercial insurance. With more than 6,000 captives in operation worldwide, the basic tenets of captive administration are well established.

The rapid growth in captives within the middle market, however, has caused some state and federal watchdogs to scrutinize the legitimacy of the insurance transaction. Of particular interest in recent years among regulators, as well as the Internal Revenue Service, has been whether captives are assuming and distributing true insurance risk.

...