It is becoming increasingly common for an employer, or a group of employers, to insure or reinsure their employee benefits programmes through captives, says George O’Donnell.
In many countries, insurance is subject to local regulations that artificially increase the premiums and/or add ‘frictional’ costs to the insurance transaction, such as the required adoption of overly conservative technical bases in premium determination, mandatory use of brokers (sometimes with substantial commissions), etc. Captives can be used to reduce or eliminate these costs.
Furthermore, captives can eliminate the risk and profit charges imposed by commercial employee benefits insurers. The risks associated with employee benefits can diversify the captive’s risk portfolio, thereby significantly increasing the captive’s risk-bearing capacity. Finally, employee benefits can constitute unrelated third-party business for the captive, and thus allow accelerated tax deductions for loss reserves.
We believe that risk diversification for the captive, with the concomitant mitigation of overall claim volatility, is often a significant motivator for many employee benefits captive transactions. The overall result of including a large number of independent and relatively lowseverity employee benefits risks in the captive is to reduce the yearto- year volatility of the captive’s aggregate risk portfolio. (This result is based on the portfolio theory of variance reduction by combining uncorrelated risks.)
Diversifying a captive’s book of business allows the enterprise to consider adding other risks to the captive in order to redress the lack of risk-bearing capacity in the commercial markets or to avoid paying current market premium rates that are judged to be too high in light of the enterprise’s own risk profile.
Cost savings on benefits delivery
Under some circumstances, the reinsurance of employee benefits risks to the captive may reduce the employer’s costs on benefit delivery. There are three main conceptual components of potential cost savings:
• Premiums based on experience: Cost savings can be obtained by retaining benefits risks (through reinsurance to the captive) that are perceived less favourably in commercial insurance markets than may be warranted by the employer’s actual claim experience and exposure to catastrophic harm. However, we caution our clients that, while cost savings might be realised over a long period of time through a captive arrangement, there is no guarantee that savings will necessarily be achieved, particularly within a short time horizon.
• Risk charge reductions: These charges, which are in the nature of a ‘cushion’ for the commercial insurer, are inherent in commercial insurance and are applicable even if the underlying pure risk premium is assessed correctly. If the employer is willing to retain additional employee benefits risks via a captive reinsurance arrangement, these risk loadings might be eliminated.
• Investment returns on reserve: A third potential cost saving is the retention of insurance reserves by the captive rather than the commercial insurance carrier, whose interest rate assumptions on reserves are likely to be highly conservative (i.e. relatively low).
Structure of a typical employee benefits captive transaction
Based on publicly available information, as of April 2010, 21 corporations have obtained the approval of the US Department of Labor (DOL) to reinsure their US group benefits programmes (e.g. group term lifeinsurance and long-term disability) to captives. Transactions involving benefits programmes covering US employees are regulated by the DOL and, accordingly, must be structured in a specific manner that satisfies the DOL’s requirements.
"We believe that risk diversification for the captive, with the concomitant mitigation of the overall claim volatility, is often a significant motivator for many employee benefits captive transactions."
In these transactions, an employer sponsors employee benefits programmes, such as group life insurance and long-term disability coverage, for its US employees. In a typical transaction, the employer will request that its life insurance carrier (the ‘fronting’ carrier) reinsure the employer’s coverage with the captive. After completing the transaction, the employer pays premiums to the fronting carrier, which in turn pays reinsurance premiums to the captive. The reinsurance contract between the fronting insurer and the captive is an indemnity reinsurance arrangement, which means that the fronting insurer continues to be liable for any employee benefits claims incurred while the group employee benefits policy remains in force, regardless of whether the captive honours its reinsurance obligations.
The transaction is invisible to plan participants. The fronting carrier continues to provide all administrative service interactions with participants, such as claims adjudication. Participants have no direct contact with the captive, nor are benefit payments dependent on the captive’s financial solvency.
The result of the reinsurance transaction is to shift the employee benefits risks, as well as the premiums, from the fronting carrier to the captive. Of course, the fronting carrier does not perform its functions gratis, but instead charges various servicing fees and requires posting of collateral, or a letter of credit, to assure the captive meets its obligations under the reinsurance contract. Insuring medical stop-loss in a captive Employers that are sponsoring self-funded health benefit plans may choose to insure at least some portion of their health benefit risk through a stop-loss policy. Employers may choose to purchase stop-loss insurance from a captive insurance company owned by the employer, rather than from a commercial insurance carrier.
Plan sponsors purchase stop-loss insurance to reduce the financial volatility that arises when the employer’s actual health claim experience deviates from expected experience. In general, there are two basic types of medical stop-loss insurance:
• Specific: This provides protection against large individual claims; for example, it limits the employer’s liability to the first $100,000 of claims paid on behalf of any one claimant during the plan year.
• Aggregate: This provides protection on the overall claims paid during the plan year; for example, by limiting the employer’s liability to 125 percent of projected total annual claims. Claims reimbursed under specific stop-loss coverage do not accumulate towards the aggregate stop-loss attachment point.
There may be several reasons for insuring stop-loss through a captive, but ensuring long-term cost savings is the most common. Typically, in the commercial marketplace, 20 to 40 percent of stop-loss premium is allocated to risk charges, sales and administration overhead, and the insurer’s profit.
Medical stop-loss is generally not regarded as an employee benefits programme under the Employee Retirement Income Security Act of 1974, inasmuch as a stop-loss policy indemnifies the employer from unexpected volatility in the claim costs associated with a self-funded health benefit plan. Therefore, unlike employee benefits programmes, stop-loss programmes may generally be insured through captives without the need for advance DOL approval.
Captives and global (non-US) employee benefits programmes
Many companies operating across different national borders use ‘multinational pooling’ to manage and contain their aggregate employee benefits costs. A multinational pool is a method of combining the claim experience of insured benefits plans in two or more countries. Contracts are signed with locally admitted carriers, premiums are paid by the local offices, and claims are paid by the local insurers. At the end of each year, the local insurers submit the plans’ financial results to the financial unit of the pooling network. If the plans’ experience is favourable, the multinational company receives a return of the premium paid minus expenses as a multinational dividend. A multinational pool can typically achieve a saving of 10 to 15 percent of premiums paid.
In addition, large multinational companies have been reinsuring their global benefits risk to their captives. Through a captive, a multinational company with the minimum premium requirements ($5 million) could reduce expenses by $650,000 to $1 million annually as well as benefit from adding third-party business to its existing captive. When a captive reinsures the risk, the cost saving is the difference between the insurer’s risk charge (risk cost and profit) and the captive’s risk.
Typically, a captive will insure:
• Group life
• Group disability
• Group accident, and
• Travel accident.
Due diligence for global captive benefits programmes
A key ingredient of success is a strong central management process in place across all business units to obtain optimal results from a global captive benefits programme.
Moreover, it is important to understand the regulatory and business requirements of each location.
The company should determine in advance how it will proceed with bringing the employee benefits programme into the captive.
Issues to consider before placing employee benefits risks in a captive
We do not believe that an enterprise should begin by asking: “Should we place employee benefits into our captive?” Rather, we believe the first questions should be: “Why is the captive valuable to us, and how can it become even more valuable?” Often, a rationale for placing benefits risks in a captive is diversification of the captive’s risk portfolio so that it may assume additional property and casualty risk. The viability of this rationale depends on the company’s current utilisation and objectives for the captive.
The tax ramifications of including employee benefits risks in the captive should be evaluated, particularly whether the employee benefits coverage would constitute unrelated business that would bolster the parent’s ability to deduct premiums paid to the captive. This issue is interrelated with the risk diversification of the captive. For example, the inclusion of employee benefits may have the simultaneous effects of: (1) diversifying the captive’s risks and (2) substantiating tax deductions for premiums paid to the captive.
Savings in benefit delivery costs should be examined. However, it is not advisable to reinsure benefits to the captive merely because the loss ratios for the past several years happen to be favourable. The credibility of the underlying claim data should be assessed, and the transaction costs of implementing the transaction (fronting fees, etc.) should be evaluated carefully.
Past experience often sheds no light on the possibility of catastrophic losses, which must be gauged by considering such issues as the geographic dispersal of the covered population.
Employers should avoid focusing on employee benefits in isolation, and instead focus on the bigger risk management picture and a longterm perspective.
Placement of employee benefits risk in a captive can reduce the volatility of the captive’s financial results, reduce the enterprise’s long-term employee benefits costs, increase the enterprise’s flexibility in determining how much risk to assume and how much to farm out to commercial markets, and establish the ‘separateness’ of the captive for tax purposes.
George F. O’Donnell is senior vice president of benefit funding strategies at Aon Consulting. He can be contacted at: email@example.com