Captives, which could be viewed as insurance companies established by non-insurers, such as companies and trade associations, have been developed to finance a number of employee benefits.

Recently, interest has become more widespread among companies heavily affected by the financial crisis as they look to cut costs and improve the governance of benefits. This has fuelled some companies to look at other benefit risks, such as post-retirement benefits - retiree medical and retirement plans.

The most immediate financial gain is a reduction of the frictional costs that traditional insurers incur. A commercial insurance company adds a number of extra charges to the benefits bill, including underwriting profits, risk charges and margins, far-sighted costs, acquisition costs, and solvency charges, which have to be paid on top of overall administrative costs. While a captive doesn't normally target a profit, it is designed to match claims for the parent company, excluding the administration fee, and, therefore is free of extra charges.

Another benefit is control over the cash flow, premiums and assets. An insurer will traditionally invest a company's premiums in its general portfolio reserve, which will normally be fairly conservative and not be matched to the customer's individual liabilities. By investing the assets, a captive can achieve better returns, putting any residual profits, normally absorbed by a private insurer, towards reducing premiums.

There are also some non-financial reasons behind employing a captive, which allows an organisation to tailor the design of the benefits to achieve customised offerings. The risk profile of the captive improves the company's risk management function overall because it benefits from the diversification created by adding new employee benefits risks.

Employers would be advised to conduct a feasibility study to assess the economic value of a captive. Reward professionals also need to consult all departments involved, such as HR and finance. A clear business case needs to be drawn up, ideally outlining the captive's worth over 10 years.

In the current economic climate, large UK companies can't afford to ignore the potential benefits of a captive.

  • Mark Cook, head of captive consulting for employee benefits at Towers Perrin