An informed decision - considering a captive

Risk managers are responsible for managing every risk an organisation faces by ensuring those risks are identifi ed and controlled in line with the company’s strategic direction. Companies can choose to assume these risks directly or to pass them on to others by purchasing insurance in the traditional market. They may also choose to self-insure their risk in a formal manner by creating a captive insurance company.

The use of captives to insure the risks of parent groups has steadily grown in popularity and is a major component of many companies’ overall risk management programmes. Currently more than 60 percent of Fortune 500 companies utilise a captive structure. As a result, the captive industry has experienced solid, steady growth, most notably in the Cayman Islands.

• The number of captives domiciled in Cayman has exceeded 730;

• Total premiums registered exceeds $8.8 billion; and

• Total assets under management are in excess of $79 billion.

Key factors that come into play when forming a captive are a company’s size, risk appetite and risk exposure, all of which have an important role in determining whether a captive is the right choice for your company. Companies that choose to form a captive enjoy many benefi ts, the size and value of which vary depending upon the company’s needs and circumstances. Benefits of utilising a captive structure include:

• Ownership of the captive, allowing the parent to reap the benefi ts of favourable loss experiences;

• Tailoring of insurance coverage and underwriting standards to the specific circumstances of the insured, particularly for risks where coverage might otherwise be unavailable or expensive;

• The flexibility to transfer more risk when the markets are soft and to retain the risk as the markets harden;

• Assisting the parent with budgeting and planning cash flows;

• An exceptional degree of control in the determination of appropriate litigation and claims settlement strategies which refl ect the needs of the parent rather than only those of the indemnifying insurer; and

• The fact that having direct access to reinsurance markets may reduce the cost of layering risks. A captive insurance company escapes the high sales, marketing and administration costs usually associated with commercial insurance companies.

Unless you have internal expertise you will need to hire a qualified and experience third party fi rm to perform a feasibility study. The fi rm should have relevant insurance, audit, tax and captive experience along with the tools needed to properly analyse captive viability. Once the firm has been selected you will need to agree on the scope of the study—feasibility studies can vary from straightforward to highly complex, depending on the nature and needs of your business.

The key tasks in your feasibility study will include:

Review of current exposures, limits, losses, deductibles and premiums

As the risk manager you will want to analyse the current lines of coverage and expected losses and as a captive owner you need to understand the implications and risks of insuring your risk versus paying to take on third party risk outside your parent company. Often starting with a simple retention structure and increasing the coverage lines and complexity as the captive matures is a good method.

Obtaining an actuarial analysis

Many domiciles require the use of an actuarial analysis as part of the initial business plan. The report will outline the estimated losses, but will also provide guidance on premium levels. Some domiciles also require an annual report to ensure the premium written and reserves are still sufficient for the lines of coverage the captive is providing.

Review of options for the captive’s organisational structure

There are a variety of options for the ownership of the captive. Corporations will usually choose one of the following:

• Single parent captive—a captive owned by the insured;

• Segregated portfolio captive (also referred to a protected cell company)—this involves utilising another owner’s captive without sharing the liabilities with other members;

• Rent-a-captive—this involves the use of another owner’s captive, but it could also involve the renting of its capital and/or the sharing of risk; or

• Group captive—large group captives allow limited control of coverage and some potential for profit sharing.

Review of domiciles and captive managers

A key domicile choice for US companies is whether to remain onshore or go offshore. This decision will affect every area of the captive, from formation requirements, capital levels, taxes, ease of regulation, permitted lines of insurance and capitalisation requirements.

The leading domiciles historically have been Cayman, Vermont and Bermuda; new domiciles are being created every year and there are currently about 80 domiciles to choose from. While every domicile has unique pros and cons, the more established domiciles tend to provide more stability and experience in managing your captive.

The same applies to the selection of your captive manager. They range from small independent specialised firms to large worldwide organisations.

Review of costs, including the capital requirements

A variety of costs need to be considered when forming a captive. They include not only the premiums, but the cost of capital, federal excise taxes, audit, actuarial, captive manager, licensing and attorneys’ fees. The identification of all costs associated with the captive formation is vital to making an informed decision and avoiding surprise costs down the road.

"Creating the cash flow and income projections are vital to determining that the funding levels are sufficient under a variety of situations, as losses will vary from year to year."

Of all the initial and ongoing costs, probably the most important one to examine is the cost of capital. Most risk managers will want to compare the investment return on the capital to the internal rate of return criteria the company has for investments of this type. A company should also compare this to the cost to borrow the funds to capitalise the captive. Parents will also benefit from considering the lost opportunity cost should they opt not to establish a captive, such as potential tax inefficiencies.

Creation of projected financial statements

Creating the cash flow and income projections are vital to determining that the funding levels are sufficient under a variety of situations, as losses will vary from year to year. The projected financial statements should be reviewed carefully with accounting and tax departments as they are a key component to the captive feasibility study.

Tax analysis

The tax implications must be evaluated not only from the captive owner’s perspective, but from that of the insured. Insurance companies are subject to a different tax scheme from that of typical companies; in some instances this can be favourable, however in other instances it can be detrimental. Taxation is a complex topic and you should consult your tax adviser when analysing the tax implications of a captive.

For example, for US federal tax purposes, insurance companies can deduct reserves for unpaid losses; this is in contrast to other businesses that cannot deduct losses until they are paid. Contributions by US companies into deductible loss funds or the creation of loss reserves on the company’s books are not tax-deductible expenses. The expense can be recognised only when a claim is paid. A captive can allow the early recognition of these expenses, but to receive this beneficial deduction the captive must qualify as an insurance company as outlined under US regulations.

If the captive is located offshore you should carefully evaluate the benefit of making the Internal Revenue Code 953(d) election to allow it to be taxed as a US corporation. This election should simplify the taxation of the captive and its parent company, but it should be reviewed carefully because in some situations it can be detrimental.

Review of alternatives to captive programmes

A captive is just one tool that a risk manager can utilise to manage an organisation’s risks. You will need to compare the various captive solutions to your current programme, to a high deductible programme, to a guaranteed cost programme and to self-insuring the risks.

Identification of liquidation options

The exit strategy for a captive can be a very long and drawn-out process or a relatively straightforward process depending on whether you have potentially placed long or short-tailed coverages in your captive. With long-tailed liabilities it can take years for the captive to extinguish all liabilities to the satisfaction of the regulators. An exit strategy should always be considered along with the formation of the captive.

Each organisation will have a different point of view and risk appetite. By utilising a captive you can add value to the organisation and potentially turn a business risk into a profit centre. However, if not carefully analysed and considered, a captive can become an unnecessarily expensive exercise. By weighing risk, cost and business needs—especially if the latter are not currently being met in the commercial market—a business should be adequately equipped to approach a third party adviser to perform a captive feasibility study.

Melisa O’Brate is senior client services manager at Crusader International Management. She can be contacted at: melisa.obrate@crusader.com.ky