3 March 2014Analysis

For your consideration

It was Henry Wadsworth Longfellow who said that it’s faster to do things right the first time than to explain why you did them wrong. It’s a useful maxim, in life and in captive insurance. For corporations looking to establish a captive insurance company—a long-term investment of a large amount of capital—it’s better to be thorough the first time around than to blunder into a briar patch (particularly one into which you’ve put large amounts of capital).

In the shuffle between captive domiciles, tax arrangements, protected cell legislation and looming regulatory pressure across Europe, first-time captive parents have their work cut out for them. But what gets lost along the way?

Kiran Soar, a partner at law firm Ince & Co, said, “Captives are different from normal insurance companies. Even though they write quite large insurance risks, reinsurers often see them as another arm of the assured. Captives can thus find themselves caught in disputes with reinsurers, as their insurance and reinsurance contracts may not cater for this unique relationship.”

While picking a domicile is an important and fraught decision—wrapped up in tax, regulation, governance, and even corporate culture—it isn’t the be-all-and-end-all of captive establishment. EMEA Captive asked all corners of the industry what else companies with an eye towards establishing a European captive need to keep in mind.

A question of capital

According to Clive James, group chief operating officer at Kane, a captive is a long-term risk management solution and needs to be treated as such right from the beginning.

He explained, “Especially in Europe, where the capital requirement is €2.5 million, a prospective parent company must feel that it has a significant amount of money on which it would like to see a return on investment over a fairly long period of time. Right from the off, you have to be thinking long term.”

“The current environment is certainly making European captives consider what assets they have and how those assets are invested, to make sure that they are maximising their returns.”

Simon Phillips, head of captive insurance at Barclays Wealth & Investment Management, stated that all of the stakeholders need to agree on an investment plan from the beginning. Establishing the framework for investments early on, taking goals and realistic expectations into consideration, makes day-to-day decision-making simpler. But, once the captive is established, investment guidelines shouldn’t be set in stone.

Phillips said, “We work with parent companies and captive boards to look at the current investment guidelines that may have been in place for a number of years. If they fundamentally don’t reflect the current objectives of the captive, or recognise some of the challenges and fundamental changes we’ve all been through since the financial crisis in 2008, we’ll work with them in a consultative capacity to develop more appropriate guidelines.

“Increasingly, captive stakeholders are welcoming that consultative approach. It’s fair to say that it is a challenging investment market, especially from an interest rate perspective.”

Other challenges

The financial crisis and credit crunch have increased the cost of certain trade instruments. Letters of credit (LoCs), a popular method of collateralising fronting obligations, are no exception. LoCs are still widely used, but parent companies should think carefully before they go for what seems like a default option.

Phillips explained, “If a parent has aggregate credit lines with its banker they need to consider how they use that if their captive needs to post collateral. If the captive puts in place a £20 or £30 million LoC this could reduce the parent’s ability to use its credit lines in its day-to-day business. This is where trust solutions may be an alternative to consider.”

Where strong investment incomes—even on the kind of conservative investments favoured by captives—were once enough to cover some operational costs, the financial crisis has changed all that.

“Unhurried thinking about your exit means that you have the resources to devote to the process, and a longer window in which to bring it about.”

“Cash rates are at historic lows. Pre the financial crisis a captive may have been getting a 4 or 5 percent return on its cash, which would fund a large proportion of the day-to-day operating expenses of the captive,” said Phillips. “It may also have covered a large amount of the LoC costs as well. The situation has fundamentally changed in the last four or five years: since interest rates have dropped significantly, costs from LoCs have increased as a result of the tighter credit market.”

He continued, “The current environment is certainly making European captives consider what assets they have and how those assets are invested, to make sure that they are maximising their returns within the parameters of any investment guidelines they’ve set down as a captive board.”

This presents new captive parents with something of a conundrum. While onshore jurisdictions in the EU allow captives within their boundaries to write directly into other member states—negating the need for an increasingly expensive fronting insurer—James pointed out that offshore domiciles such as Malta and the Isle of Man tend to require significantly less time and capital to set up a captive. “You can start from a lower basis,” he said. “The downside is that you can’t really write directly into Europe.”

Good governance

While adequate capital and intelligent investing are indispensable, they aren’t the only important elements. Good governance—including astute legal choices, careful selection of service providers and attention to regulations—is an equally important consideration.

According to Soar, the domicile a parent chooses for its captive is less important from a claims perspective than the law that governs their contracts. “Captives owners spend a lot of time and effort getting set up in the right jurisdiction, with the right governance, but often forget one of the most important parts: ensuring that their contract wordings maximise the prospects of their reinsurance responding to a major loss scenario.”

He explained, “It is unlikely that a parent would sue its own captive for insurance coverage, and so from that perspective, there is less need to focus upon the jurisdiction in which is resides (for example, what is the system of law, how sophisticated are the local courts, what remedies are available for enforcement, etc). The governing law of the contracts is, however, important—particularly for reinsurance purposes. Most captives will seek to recover the largest of their losses from reinsurers.”

This, according to Soar, is why choosing the correct law to govern your insurance and reinsurance contracts is so vital. His point was proved when pharmaceutical company Astra Zeneca’s captive found itself in a dispute with reinsurers XL and ACE over claims resulting from anti-psychotic drug Seroquel. The dispute came down to whether the pharmaceutical company had actual legal liability, or only arguable liability, to the numerous plaintiffs that were suing it in the US.

The fact that the contracts were governed by English law meant that the captive had to prove that Astra Zeneca was actually legally liable to indemnify the third party plaintiffs.

English law tends to be the standard governing law for contracts because of the expertise present in London—smaller jurisdictions simply are not equipped to handle large-scale commercial litigation, according to Soar. That being said, it does require strict proof of loss.

In New York a captive can claim against its reinsurance if it is arguably liable, but arbitration tends to be expensive and drawn out. The classic Bermuda Form utilises New York law with London arbitration. It can be the best of both worlds, according to Soar.

He said, “There seems to be a myth that just because you set up a captive in one domicile, you have to use the law of that domicile to govern the insurance and reinsurance contractual relationships. In many cases, a different governing law may actually suit the needs of both the captive and reinsurer better. It is thus possible to create a captive in a domicile that suits you for other reasons—regulatory issues, or tax—but to consider a different system of law to govern the insurance and reinsurance contracts.”

There are domicile-specific rules that warrant careful study, according to David Grantham, a senior associate at Ince & Co. He said, “You need to make sure that you understand the rules for running an insurance company there, and the extent to which you can safely hand over duties and responsibilities to third party managers. This will need to be assessed against your normal governance requirements.”

James sees a role for service providers in this arena, and recommends that parents select partners with strong ties to local regulators.

“One of the key aspects of service providers is their relationship with their local regulator,” he said, “whether that’s in Vermont, Guernsey or Malta. Part of their value proposition is their understanding of the regulatory requirements of their individual domiciles, so that when we’re conducting feasibility studies, for example, we have a good idea of what the requirements are going to be.”

He also encourages prospective companies to assess the advantages of working with an independent captive manager. As he explains, “Independence ensures that you are fully focused on meeting the needs of the client. It removes any potential conflict of interest in the services provided, and enables truly impartial advice and full transparency.”

Phillips advises parents to think long-term when selecting service providers. With incoming regulations and more domiciles opening for business every year, a long-term partner could be a valuable investment. “There are some very common challenges across all of the key captive locations, and they’re being approached in different ways, recognising different attitudes and approaches in those locations,” he said.

“You’re also seeing captives deciding whether to move to different jurisdictions. Coverage as a global team gives us, for example, the flexibility to work with clients in all of the key jurisdictions in which they choose to operate, now or in the future.”

Goodbye to all that

Like all good things, the life of a captive must at some point come to an end. While the specifics of shutting down a captive don’t require too much attention before it has even been established, it’s worth bearing an exit strategy in mind. In general, Grantham says, exit strategies should be looked at early, ideally before the need for exit has actually presented itself.

He explained, “When setting up a captive, many in the captive industry would say that you already need to be thinking about the exit strategy. This comes with having clear objectives from the start, so that the performance of the captive can be monitored against the strategy. Unhurried thinking about your exit means that you have the resources to devote to the process, and a longer window in which to bring it about if that is the decision you take.”

While captives may face difficulties, proper planning and execution will go a long way towards a smooth operation. According to Phillips, the strength of the captive concept continues to prove itself as owners and shareholders look at more ways they can use their captive.

“It’s challenging, but there are still good opportunities for captives, managers and parent organisations that are exercising a high level of corporate governance to make efficiencies, whether this is around cost control or maximising returns on the assets of the captive,” he said.