A case for forming a captive insurer*

Long Haul Trucking currently has an annual self-insured retention of $500,000 per occurrence for both workers compensation and auto liability insurance. The combined premium for its excess workers compensation insurance, which pays losses without a per occurrence limit, and for excess auto liability coverage, with a $3 million per occurrence, is $2.15 million. Long-Haul is considering establishing a captive in Vermont to fund its retained losses. If it forms the captive, it will incur start-up costs in the amount of $140,000 for licensing the captive and one-time administrative costs.

If Long Haul forms the captive, it will be able to obtain comparable excess coverage in the reinsurance market for an annual premium of $2 million, for a savings of $150,000. Long Haul also plans to use a captive management firm to administer the captive on an on-going basis. The fees paid to this firm will increase its total administrative costs by $30,000 per year. If it establishes the captive, Long Haul also will use a fronting company arrangement with an insurance company to meet state requirements concerning the purchase of coverage from an admitted insurer. The fronting insurer then will reinsure the coverage with the captive, which in turn will purchase the excess reinsurance coverage. The fee for this fronting arrangement is $80,000 per year.

Long Haul plans to pay the same amount to the captive to fund its retained losses as it maintains under the current program, and it will not change the way in which funds are invested. In addition, it does not plan to write outside business in the captive or seek to have the transactions with the captive treated as insurance for federal income tax purposes. As a result, neither its investment income on assets dedicated to fund retained losses nor its income taxes will be affected by the establishment of the captive.

Assume that the captive agreement will be effective for four years as shown below. The cost of capital is 10%. What is the net present value and internal rate of return? Should the captive be formed? Support your answer.

Type of Cash flow	Beginning of First Year	End of Years 1, 2, 3, 4
Total after-tax cash flow