CoffeeAndMilk /
30 July 2018Analysis

Sweetening the deal? A captive’s value in the context of M&A

Greed is good, according to Gordon Gekko. During the famous mergers and acquisitions (M&A) cycle of the 1980s, the iconic fictional corporate mogul shared his vision of capitalism in the movie Wall Street. The current stock market is healthy and business owners are exploring various exit strategies. M&A are among the most popular exit strategies used by shareholders. Captive insurance companies are an intrinsic part of the exit strategy calculus. The creation or management of a captive insurance company has an enormous effect on the value of the parent company.

When selling a company, the price of the corporation will usually trade at a multiple of its EBITDA, or some variation of it. EBITDA stands for earnings before interest, taxes, depreciation, and amortisation. It is used to assess a company’s ability to generate cash flow.

A useful metric

EBITDA was created in the 1980s allegedly as a means of assessing whether a corporation would be able to make debt payments pursuant to a leveraged buyout. The metric is useful as it is one of the standards of corporation value and provides a rough approximation as to what the market will pay for a corporate asset.

EBITDA is adjusted for numerous factors. Assets are added or subtracted based on their real world financial impact. For example, surplus notes are generally not included as assets when calculating an EBITDA, but they may not be accounted as a liability in a traditional balance sheet under GAAP.

Once the EBITDA is calculated, the price of a company is typically estimated as a multiple of the EBITDA. For example, a corporation in a particular field may traditionally trade at 7.0 times EBITDA. As such, any increase to EBITDA leads to a multiplying factor in the value of the corporation.

Captive insurance companies provide value to their affiliated group. Where an insured company owns its own captive, the captive’s unencumbered assets should be added to the overall value of the company. In other words, a portion of the captive’s assets should be included in the EBITDA calculation.

Large captives with healthy historical losses and favourable IBNRs are gold mines for companies interested in selling to third parties. The captive is a source of assets that not only reduce the overall insurance spend of the affiliated group but also create a source of additional liquidity for other projects.

M&A discount the sale price of assets for negative factors. For example, a company operating in a very risky industry trades at a discount to a company operating in a safe industry. Captive insurance companies minimise this discount as the captive provides transparency with regard to the true risk of the affiliated group.

Rather than rely on the loss runs provided by third party insurance carriers, the captive has access to the claims adjusters’ notes, defence attorneys, and incident data giving rise to claims. This provides potential investors with greater transparency to the target asset.

Added value

Consequently, captive insurance companies add value to the affiliated group. Whether through the increase to the corporation’s EBITDA or through the improved risk analysis, corporations operating with healthy captive insurance companies command a premium during a merger or acquisition.

Middle market companies operating with a captive insurance company enjoy more efficient insurance spend, lower overall claims, and an improved risk profile. In addition, the captive serves as an additional source of liquidity to the extent that unencumbered reserves are available to the affiliated group. As captive insurance becomes ubiquitous in the middle market, the use of these financial vehicles will become mandatory in order to keep pace with the competition.

Unfortunately, some captives cause heartburn for potential investors. Long tail liabilities, such as professional liability, take years to unwind. If the loss history of the captive has been unfavourable, then the captive may provide the investors with reason to discount the offer or to walk away from the deal.

While this is a concern, the reality is that bad companies are worth less than good companies. Companies operating with high frequency of claims in complex areas of litigation are not as valuable as companies operating with fewer claims.

That said, there are strategies to mitigate this discount. For example, the captive can execute a novation, or a portfolio transfer, with a third party agreeing to be responsible for the claims. This replaces the captive with another party as the responsible entity for liabilities arising pursuant to existing insurance policies.

Another exit strategy would be to purchase reinsurance of the existing captive to cap the existing liabilities.

The cycle

However, not all M&A occur at the parent level. The captive industry is navigating an M&A cycle, which means that captive managers need to understand how M&A between captives works. There are numerous reasons for a merger or acquisition. Sometimes the captive needs additional capital and a new group brings the cash. Sometimes the captive owners want to sell their company pursuant to an exit strategy.

Mergers are distinct from acquisitions. Mergers require the approval of the board of directors of each company involved in the transaction. Regulatory approval of a merger from the domicile is required in virtually every captive domicile. Regulators frequently allow the transaction to proceed pursuant to the parties’ intentions, but sometimes the regulators will impose certain conditions in the transaction.

For example, a domicile may require a control statement filing outlining the surviving captive and its future plans. For US captives, state laws generally the transaction to clear various legal hurdles, such as vesting requirements or assignment considerations.

US picture

In the US there are two main types of business reorganisations: 1) taxable acquisitions; and 2) tax-free reorganisations. Taxable acquisitions include transactions where an acquiring party purchases all or most of a corporation’s assets. The selling corporation recognises gain and its shareholders report the gain pursuant to US Internal Revenue Code (IRC) general liquidation principles.

Stock acquisitions, another form of taxable acquisition, are where a corporation purchases stock or shares of a captive. In a stock acquisition, the shareholders selling their stock report the gain or loss to the IRS, whereas the purchasing corporation takes a cost basis in the shares purchased.

In contrast to taxable acquisitions, the IRC provides an exclusive list of transactions which qualify as a tax-free reorganisation. In general, no gain or loss is recognised by shareholders who, pursuant to a plan of reorganisation, exchange stock or securities in a corporation for stock or securities in a corporation that is a party to a reorganisation.

The various types of tax-free reorganisations are outlined in the IRC. If the captive’s transaction does not mirror the proscribed transaction, then the transaction is a taxable event. This feature of the IRC opens up numerous tax planning strategies for captives considering a merger or acquisition.

In summary, healthy captives should add value to the affiliated group. Unhealthy captives may act as an anchor around the neck of the selling party. As always, good companies trade at a premium and bad companies trade at a discount. When going through a corporate reorganisation, the captive should be a key piece of the negotiation at every step of the transaction.

Matthew Queen is general counsel and chief compliance officer and general counsel at Venture Captive Management. He can be contacted at: