14 August 2013Analysis

Middle market magic

Steve Kinion, the director of the captive programme for the state of Delaware, knows the definition of ‘middle market’ is hardly set in stone. He said, “If you asked 10 people what the term ‘middle market’ means, you’d get 10 different answers. I generally categorise it as employers that have annual revenues ranging from $50 million to $1 billion, but I don’t believe there is a clear definition.”

What is clear is that captives, once the refuge of multinationals and the Fortune 500 companies, are no longer the privilege of the powerful. As a variety of factors coalesce, smaller companies have found the risk management advantages of captive insurance increasing. Middle market captives, generally considered captives with $1 million or less in premium a year, are an integral part of the market.

Michael Douglas, director of business development for Aon’s captive and insurance management unit, told US Captive: “Access to the captive insurance concept has improved for the middle market due to what I call the enterprise risk management movement. Ten years ago the whole concept of enterprise risk management was largely unknown. Now, however, it’s an ingrained part of our conversation. We discuss it all the time and the concept has trickled down to our smaller clients. As a result, the middle market firms are now demanding that their brokers provide some kind of alternative risk transfer solution.

“Most of these middle market companies are saying to us, their brokers, that they see the storm clouds gathering. They want to be involved in captive risk transfer before the market hardens, rather than wait two years and start playing catch-up.”

Due to saturation in the larger captive space, domiciles and service providers must look to smaller companies to achieve real growth. Douglas said, “Going forward I see the middle market as being the growth part of the industry. The Boeings and Fords of this world— most of the major corporations—all have their captives in place. They won’t be doing much growth in the next five to 10 years.”

Jeremy Huish, director of business development at Artex Risk Solutions, added: “If the Fortune 500 companies already have captives you have to go smaller. That’s the only way to grow.”

Huish continued: “These are all captives no matter what size they are. The same issues and challenges that apply to big captives also apply to small captives. There are differences, but we have more in common than not.”

Utah, which passed captive legalisation in 2003, has a strong middle market presence and has encouraged smaller companies to form captives in the state. Brad Eichers, CEO of the Kornerstone Insurance Group, told US Captive, “Utah has a lot to offer mid-sized companies. They provide lower operating costs, and Utah regulators are easy to work with and friendly. Utah wants companies to do work here because it creates jobs and economic activity in the state. Utah is willing to work with new captives by providing more staffing and resources.”

Structural support

While the benefits middle market companies derive from the captive insurance concept are much the same as those of their larger counterparts, the structures best suited to their needs can differ.According to Douglas, “The premium dollars are usually too small for a middle market client for it to make sense to form a wholly-owned captive. Middle market companies have had more success joining together and forming group captives.”

Group captives are the primary choice for middle market companies because setting one up requires less initial investment, negates some difficult-to-navigate regulations and provides an easier entry into the captive insurance market. Douglas continued, “Certainly companies in the manufacturing industries are a perfect match for group captives. Frankly, they will be the first ones to see their premiums go up when the market hardens. Because of that, they are the organisations who can get best use out of a group captive, in anticipation of when prices go up in 18 months.”

In addition, joining a group captive allows companies to satisfy the regulatory burden efficiently. For example, certain lines in a single parent captive may be considered a prohibited transaction under the US Employee Retirement Income Security Act (ERISA)—health insurance and benefits included—but that same line of insurance would likely not be treated as a prohibited transaction if done through a group captive.

Huish said, “A group captive may allow you to write certain lines of risk that cannot be easily done in a single parent captive, such as risks covered by ERISA. The structure allows you to be in a captive and not be as worried about the compliance obligations you may face. We’ve seen it be successful with certain types of risk, such as medical stop loss, workers’ compensation and general liability.”

Group captives aren’t the only option. For middle market players writing less than $1.2 million premium volume, an 831(b) captive could be the perfect fit. All underwriting profits are federally taxfree under the 831(b) rules, making it an excellent way to plan for a rainy day. Douglas explained, “The 831(b) is a very useful tool for companies that have an exposure to something that is hopefully remote but still realistic. For example, a food manufacturer hopes that it won’t poison anyone, but it’s likely over a long period of time that an event will occur. They could use an 831(b) to pre-fund for a nasty loss situation in a more tax-advantageous manner. Big corporations could never take advantage of that.”

According to Kinion, the structure has been legal for more than 20 years but is only just starting to gain traction. He explained, “In some cases people are just catching on to the 831(b) structure. There are a number of reasons for that, being in some cases that they had no need or desire to know about it. What I’ve found in the past year is that with some commercial insurance premiums increasing, as well as taxes in the US increasing on some sectors, companies arenow looking at ways to insure their risks and do so in a very taxadvantageous way.”

But, Douglas warns, anyone opting for the 831(b) structure needs to be careful not exceed the $1.2 million limit. “If you have an advantage given to you by the IRS, don’t abuse it,” Douglas said. “The 831(b) advantage does tend to be oversold by—I’ll put it politely—overzealous consultants.”

While single parent captives tend to be better suited for large companies, middle market companies uncomfortable with other structures can—with a bit of work—form one. According to Douglas, complying with standards on risk distribution set by the IRS is the single greatest challenge middle market companies will face.

“Risk distribution is the single biggest issue. The IRS tests are fairly straightforward—it’s a bright line test. Rules dictate that if you have 12 subsidiaries or more, generally speaking, that should be enough. Most small companies in the middle market don’t have 12 subsidiaries. Frankly, that’s why most of the smaller companies look to group captives—because we’re in a group of like-minded companies, so you have a risk distribution almost baked in. The challenge of risk distribution has a natural fit with group captives.”

Barriers to entry

Even as the middle market becomes a major opportunity for growth, challenges remain—foremost among them, the cost.

"These are all captives no matter what size they are. The same issues and challenges that apply to big captives also apply to small captives. There are differences, but we have more in common than not."

Huish said, “Captives, even in the small space, are expensive.” If premiums are too small, fees can be a problem. While a captive with $1 billion in premium may be paying one-tenth of 1 percent in fees, percentages for a smaller captive could be anywhere from 6 to 20 percent. He concluded: “Middle market companies on the smaller side often cannot implement a captive insurance programme, despite the need for one, because the economies of scale work against them and the cost to run the captive may eat up many of the benefits.”

In addition, a small programme often has trouble attracting fronting companies and other service providers for certain lines of risk. Huish continued, “Fronting companies, for example, often prefer to work with programmes that are at least $3 to $5 million in size if writing certain risks, such as workers’ compensation, but may be willing to work with programmes in the $500,000 range and above for medical malpractice.

“That prohibits us from doing some of the same types of things that the bigger captives can do. If a fronting company could somehow create a model that works with middle market captives, it would open up the industry quite a bit.” Huish pointed out that for some lines of risk the fronting company hurdle is solved by using a group captive, with a sufficient amount of premium volume in aggregate, but that the group captive solution does not work for all lines of risk.

Keeping up with massive companies is an issue in terms of regulation, as well. Huish explained that, while according to ERISA rules it may be a prohibited transaction to write health insurance in a single parent captive, 28 of the largest captives in the country were able to lobby the Department of Labor successfully for exemptions.

“The problem is that only 28 captives of 6,000 globally adds up to less than one half of 1 percent of all captives, and it’s not growing despite the strong demand in the marketplace,” he said. “Midsizecaptives don’t have the political clout or deep financial pockets that a larger captive would have. A large number of companies should write these lines in their captives but can’t overcome the cost and political hurdles. I hope we can find a solution that satisfies the government’s needs to protect the employees and the financial strength of the general population health insurance pools, but yet allows employers the options to manage healthcare risk in a captive. We should have a better tool to solve this problem than we do now.”

That lack of political clout for the captive industry as a whole can be an issue in an ever-changing regulatory environment like that of the US. Huish said, “We know what the rules are today, but we can’t predict how the US government will regulate in the future.

“We look forward to more guidance from the regulators on captive issues. Part of the challenge and part of the fun of this industry is guessing where the government is going to be in the future.”

The escalator effect

As a growth sector in a saturated market, the rise of the middle market captive presents opportunities for service providers and captive owners alike. As Douglas said, “Why spend money twice? If you’re spending money on loss control and insurance premiums it becomes a double dip. It’s wiser to spend that premium money on a group captive, so that when the losses are reduced because of good loss control you get back those premium dollars in the form of a dividend. That to me is a good, prudent way of buying insurance.”

While group captives may be the major way to draw in the middle market, there’s no reason they have to stay there, according to Douglas. He said, “As companies move up the chain from small middle market to large middle market, they’ll recognise the advantage of captives. Even just a captive play is a risk management play. At Aon we see this as being an escalator. Companies will start off in a group captive and stay there for three to five years. Once they’re comfortable with the concept they’ll move out of the group and have their own single parent captive. I see that a natural play going forward.”

In the words of Kornerstone’s Eichers: “The future is bright.”