Seeking captive value part one: the context

Captive insurance companies come in several different forms, largely distinguished by ownership and control (single versus multiple owners), modus operandi (direct versus reinsurance), or tax position of the parent (for-profit versus not-for-profit)—as outlined by Hugh Rosenbaum more than a decade ago at the World Captive Forum ( http://www.worldcaptiveforum.com/Captive_Differentiators.html).

In this series I will be looking at just one of these forms: single-parent captive insurance companies which are insurance subsidiaries of for-profit non-insurance parent companies. These articles are the result of a brainstorming session earlier this year with Rosenbaum and Malcolm Cutts-Watson, both internationally recognised experts on captive insurance company operations.

We looked at many of the arguments that have been raised to support captive insurance companies over the years. Some have been retained in this paper, which is drafted from the point of view of a corporate risk and insurance manager charged with the responsibility of implementing an effective and efficient global insurance procurement and management strategy.

Since these comments are penned to add support to the Federation of European Risk Management Associations in its base erosion and profit shifting (BEPS)-related discussions with the Organisation for Economic Co-operation and Development, the focus will be on European-domiciled parent companies that own one or more captive insurance company subsidiaries.

Operational context—complex and fluid

It may be helpful to take a hypothetical example: a multinational for-profit company (ABC Co), where the ultimate parent company is domiciled within the EU and its six business divisions operate in about 80 countries around the world, the majority of which are not within the European Economic Area.

Let us assume that the six business divisions are distinguished by the industry segments they sell products and services to. Further, within each business division there are business units—essentially geographically defined—that ensure proximity to their corporate and public service customers in the many countries around the world.

The management structure is necessarily built on a corporate legal structure of interrelated legal entities that have been created to permit licensed operations to take place in the 80-odd countries. Neither the management structure nor the supporting legal structure is static—they change as new business opportunities are pursued and won with new clients in new territories.

Let’s now add some real-world complexity.

Not all the legal entities may be 100 percent owned and/or controlled by ABC Co. In a number of countries there may be joint ventures where ABC Co owns, directly or indirectly, more or less than a 50.1 percent stake. There may be joint ventures where ABC Co owns less than 50.1 percent yet is required to take effective management control in a number of areas under a management service agreement. There may even be occasions where ABC Co’s clients—typically public service clients—fully outsource the operational responsibility and management of their assets under multi-year contracts.

With increasingly unpredictable business cycles, the six divisions may become seven or four; the business units configurations in the different regions may change; and the composition and operational briefs of the multicultural management teams will almost certainly be regularly refreshed.

It is important to remember that business activity in complex organisations is constantly evolving and, in ABC Co’s case, in more than 80 different theatres of operation—each with its own political, regulatory, fiscal, cultural and linguistic specificities. The static state is not a natural state—everything moves in a constant, and often unpredictable, state of flux.

Finally, and most important of all, are the people who work for ABC Co around the world—a rich, industrious, multicultural population in permanent fluidity, working together and sharing (to a greater or lesser degree) a corporate culture, an overarching business strategy and multiple and diverse team and personal business objectives.

Commercial insurance procurement—a matter of choice?

It is often claimed, not without reason, that commercial insurance has, over the last 250 years, oiled the wheels of commercial and industrial development by providing an element of de-risking to the entrepreneurial adventure. Many small and medium-sized companies have grown to depend on the commercial insurance market to relieve them of much non-core exposure. For such companies, the question is not whether to buy insurance, but how to buy the necessary insurance protections on a predictably affordable basis.

For large and financially strong companies, however, the types of protection and limits available in the commercial insurance markets may appear to be largely immaterial. Why would a company generating positive cash flows, with a healthy balance sheet unencumbered by loan (or other) covenants, seek to transfer insurable risk to insurance companies with smaller, less robust balance sheets—especially when the transfer promise is conditional?

The response to this question lies with both the complexity of the operational context and the fact that the choice of whether to purchase insurance is not always one that companies—small or large—are free to decide for themselves.

In many countries, insurance is a highly-regulated business segment. It is not uncommon for local insurance markets to include state-owned insurance companies and/or privately-held insurance companies where the equity may be held by politically well-connected investors. Powerful local interests are obviously motivated to see the local insurance market thrive and to encourage local expenditure. Thus, there are often local regulatory requirements to procure certain types of insurance and, even when not compulsory, non-admitted insurance procurement may be prohibited

Then there is the issue of tax. In many countries, insurance premiums attract tax—and for certain lines of insurance these premium taxes can be significant.

Governments around the world are hungry for tax revenues and commercial insurance provides a useful source. There is plenty of anecdotal evidence to suggest that subsidiaries of foreign companies are of particular interest to local tax authorities as a potential source of revenue enhancement. Moreover, the rapid evolution of information and communication technology over the last two decades has enabled more extensive and effective cooperation and information-sharing between national tax authorities than at any other time in history.

In part two we will look at centralised insurance procurement and strategy.