Captive best practice: an auditor's view

30-11-2012

Melanie Snyman, Ian Bridges, Damian Pentney

To derive maximum benefit from future audits, captives would do well to apply proactive best practice. Melanie Snyman, Ian Bridges and Damian Pentney of PwC outline exactly what captives should be paying attention to.

As an audit firm with a growing tax practice in the Cayman Islands, we audit and service a large number of captive insurance companies with a broad array of insurance programmes, investment strategies and risk management practices. Here we share an auditor’s view of a few of the best practices we have observed for successfully running and maximising the benefits of an offshore captive in the areas of investment management, claims management and reserve setting, tax and overall corporate governance.

Asset management

Most captives choose to delegate asset selection and management to a financial institution and, if so, the first step in investment management is selecting reputable and reliable service providers for custodian and investment advisory and management services. While some financial institutions fulfil dual roles of both custodian and investment adviser and manager, some captives choose to have a separate investment manager, while others seek more diversity by having several separate investment portfolios managed by different investment managers.

The role of the custodian, as well as being the interface with the investment manager and its respective financial stability, is vital to the physical control and accessibility of investment assets, so best practice would include performing, documenting and regularly revisiting due diligence procedures at both the investment manager and the custodian and evaluating their responsibilities under their service contracts.

A valuable tool for evaluating the quality of internal controls at the investment manager and custodian is the service organisation control report (known as an SSAE 16 or ISAE 3402 report). This includes the opinion of the service organisation’s auditors on relevant aspects of the organisation’s control environment. Consideration of a custodian’s Foreign Account Tax Compliance Act (FATCA) compliance status is also important to ensure the captive is not unnecessarily exposed to withholding tax when the withholding becomes required under the current proposed FATCA regulations.

The investment strategy adopted will be dependent on a number of factors including the nature of the captive’s insurance exposures and timing of cash flows, regulatory requirements, the amount of surplus expected to be retained in the captive, and the management’s risk tolerance. The use of a fronting carrier in the insurance structure can also influence the investment strategy where there are collateral requirements such as letters of credit or Section 114 Trusts, because the financial institution and/or beneficiary may place restrictions on the assets that qualify as collateral. A useful risk management tool is to capture these parameters in a set of comprehensive investment guidelines with sufficient detail to allow management to monitor and report on actual results against these benchmarks.

Where the captive insures working layers or other coverage resulting in a high volume of claim payments, laddering of fixed income investments to match future cash flow projections is an important control to manage cash liquidity while maximising asset returns. Risk managers play an important role in cash flow management by communicating projected settlement dates for significant claims in a timely manner.

It’s quite common for captives to have portfolios comprising a larger weighting of investment grade fixed income securities with a smaller weighting of equity securities, if any. Valuation and accounting for investment securities has received much public attention in recent years. This has led to complex and cumbersome accounting rules in some circumstances, particularly for certain fixed income securities, which can lead to a disproportionate amount of management time handling financial reporting on a comparatively small element of an investment portfolio. It is beneficial to give advance consideration to the accounting presentation desired for investments in the context of the intended investment portfolio. This is necessary to ensure the service providers can provide and track the information required to meet the financial reporting requirements, as there can often be a gap between the data an investment manager collates for performance reporting, and the data required for financial reporting.

In recent years there has been a trend towards the use of nonexchange traded mutual funds as a cost efficient method of holding a diverse investment portfolio. Even when dealing with the big fund managers, caution is needed to ensure the investment product is suitable, because investments in non-exchange traded funds can introduce some additional risks. Understanding the techniques the investment manager is permitted to use to achieve the investment objective is important, as funds often allow use of a broad range of instruments—including derivatives—which may not fit management’s risk tolerance. Some funds commission independent agency ratings that are publicly available and provide benchmarks for the risk profile of the fund’s objectives, performance and management to allow comparison of funds.

Good risk management practices would include documentation of the due diligence procedures performed to select the funds based on the captive’s risk/return objectives and the reputation of the fund’s main service providers. The fund administrator (who is often independent of the fund manager) has a key role in maintaining the fund’s financial records, performing financial checks and balances, calculating the net asset value (NAV) which can be evaluated in a structured manner if the fund administrator commissions an SSAE 16 or ISAE 3402 report. An understanding of the fund’s redemption frequency, redemption restrictions and any concentration risks for the captive’s proportionate holding is important for evaluating the investment for liquidity purposes. Consideration of the legal structure of the fund and its domicile is important as these can impact accounting treatment and can also have tax implications.

Claims management and reserve setting

Claims risk management is arguably the most important aspect of a captive programme and generally the driving motivation behind establishing a programme. The three most common strands to claims management are:

• Shareholders’ in-house risk management department;

• Third party claims administrator (TPA); and

• Fronting carrier/lead insurer.

"Charts of the components of each year's ultimate losses can be a great aid to visualising how ultimate claim costs are developing and identifying trends that may warrant further discussion."

Regardless of who is responsible for managing the captive’s claims, it is important that the programme encourages prompt and transparent reporting of incidents and that there are well-established controls surrounding logging of events, establishing case reserves for indemnity and loss adjustment expenses, payment of claims and reporting of the claims data to the insured, the captive insurance manager and the consulting actuary. Accurate and complete data are the cornerstone of reporting for so many aspects of captive management; best practices include regular evaluation of the loss runs (for both open claims and claims being settled) by risk management with the involvement of the finance team, internal legal counsel and— where appropriate—external legal counsel.

As well as focusing on the valuation of open cases, a strong claims environment include controls around deductibles, attachment points, claim and policy aggregate limits as well as consideration of excess coverage layers and reporting obligations to any external reinsurers. Additional coordination is needed when a TPA is involved, to ensure that information is communicated and captured in a timely manner and at financial reporting dates. Coordination with the consulting actuary is important to ensure data used in the actuary study have been extracted accurately.

Where a TPA is engaged to handle claims, or a front/leader insurer is responsible for this role, due diligence procedures are, again, key to selecting service providers who are reputable and reliable. Good practice is to consider whether these service providers commission service organisation control reports (an indicator of their commitment to internal control), as this will provide transparency on the effectiveness of the service provider’s control environment.

Case reserves should always represent management’s best estimate of what the ultimate costs will be of seeing the claim through to its close. At the start of the claim life cycle that estimate is, obviously, significantly more a matter of judgement and the estimate will change over time as more facts become known. It will often require input from parties such as legal counsel or claims specialists. Good practices that we’ve observed in this area include benchmarking and monitoring of claims statistics.

At each reporting period the claims data, including case reserves, premium and exposure data, are used by the consulting actuary to estimate reserves for claims incurred but not reported (IBNR) andreserves for adverse development. Again, selection of service provider is important, but ultimately management is responsible for concluding on its best estimate of reserves. Good practices that we’ve seen in evaluating actuarial results include consideration of past history of reserve adequacy along with obtaining an understanding of what has driven any reserve excess/deficiencies. Charts of the various components of each year’s ultimate losses can be a great aid to visualising how ultimate claim costs are developing over time and identifying any trends that may warrant further discussion. Where management consider discounting of reserves to be supportable, selection of a discount rate creates a further layer of judgement and potential for volatility, especially with fixed income securities yielding record lows.

Taxation

Tax topics could fill this entire article so we focus here on just one: the investment portfolio is quite often, and generally unnecessary, the source of significant tax-related issues, ranging from compliance to after-tax return on investments. Unfortunately, hasty investment decisions or decisions made by those unfamiliar with the unique tax complexities of offshore captives, are typical causes of tax risk exposure lurking within an unsuspecting investment portfolio.

When a captive opens investment accounts with the custodian/ withholding agent, the captive is usually required to complete a certificate of status, whether it is Form W-8BEN, Certificate of Foreign Status of Beneficial Owner, or Form W-9, Request for Taxpayer Identification Number and Certification. It is essential that the person responsible for completing the form for the captive is aware of the captive’s tax status for US income tax purposes. This status could vary from a disregarded entity, to a foreign corporation, or an entity treated as a US corporation for income tax purposes for those captives electing this treatment under Internal Revenue Code Section 953(d). Failure to complete the correct form or the form in the correct manner could subject the captive to withholding taxes. While there are mechanisms to claim a refund of withholding taxes there are costs associated with doing so.

A number of significant risks are also associated with the domicile of the captive’s investments. Asset managers could be surprised to find that returns on equity investments are lower than expected, with a 30 percent withholding tax on US source dividends paid to foreign captives. Offshore captives could increase their exposure to US taxation and compliance costs by investing in certain US investment funds if the investments have effectively connected income to a US trade or business. Conversely, 953(d)-elected captives, disregarded captives or parent/subsidiary captives could increase the captive’s and/or the parent’s exposure to US income tax under the punitive passive foreign investment company (PFIC) rules by investing in certain offshore funds.

Not only does PFIC reporting increase the overall tax compliance costs, but it could even accelerate or increase tax thereby once again reducing the after-tax costs of investments. For example, if a 953(d) captive invests in a PFIC it may be required to accelerate tax on unrealised gains if the PFIC has elected to be taxed under the mark-to-market regime, whereas the tax on these unrealised gains may be deferred until actual disposition if the investment was made in a US-based investment such as a portfolio of stocks or similar US-domiciled fund.

Clear and timely communication between the captive’s officers and directors, investment manager, captive manager and tax advisory is critical to fully understanding the potential tax exposures related to an offshore captive’s investment portfolio. Benjamin Franklin was probably not thinking about the tax exposure of offshore captives when he said, “an ounce of prevention is worth a pound of cure” but many captive programmes would benefit using this approach.

Corporate governance

It is common for captives to have an active board of directors. Good practices we have seen include:

• Establishing a charter for the board;

• Understanding the objectives and goals of the captive and establishing metrics to measure extent of achievement;

• Robustly reviewing the risk management framework of the captive;

• Engaging a member of the group’s finance team in board meetings;

• Asking rigorous questions of the auditors and holding an ‘executive session’ where management are not present; and

• Including a non-executive, independent board member with insurance experience.

Board meetings typically take place only a few times a year, so the board should engage in frank and meaningful enquiries of management and all significant service providers relevant to the decisions and resolutions that are tabled at each meeting.

Melanie Snyman is assurance director at PwC, Cayman. She can be contacted at: melanie.snyman@ky.pwc.com

Ian Bridges is tax director at PwC, Cayman. He can be contacted at: ian.l.bridges@ky.pwc.com

Damian Pentney is a partner at PwC, Cayman. He can be contacted at: damian.pentney@ky.pwc.com

Cayman, PwC, audit, captive, insurance

Captive International