Forming a captive? Don’t get caught short

There are many benefits both quantitative and qualitative enjoyed by companies who choose to form a captive. Naturally, the size and value of those benefits vary depending upon a company’s individual needs and circumstances.

Many factors including a company’s size, risk appetite and risk exposures play a role in determining whether forming a captive is the right answer and while the final decision is ultimately subjective, a captive feasibility analysis should be conducted to help management reach the right decision and avoid costly mistakes.

Premises and key metrics

Before a company embarks on a captive feasibility study, certain premises must be met and key metrics considered. Each metric will carry a unique weight or relevance depending upon a company’s specific circumstances. Before you get started, you should:

1. Abandon any preconceived notion that a captive may or may not work for your company.

2. Obtain management’s unbiased support of the feasibility process.

3. Hire an independent third party to analyse whether a captive is suitable for your organisation unless you have internal expertise and knowledgeable individuals who are capable of crossing business unit boundaries. These resources should have the relevant insurance, captive, actuarial and tax experience, along with the captive modelling tools, necessary for proper analysis of the variables required to assess captive viability.

4. Agree on the scope of the project, whether or not you use an advisor. Captive feasibility assessments range from straightforward modelling exercises to complex assessments.

5. Clearly identify and document the key metrics to be used in the analysis, such as:

•   State, US federal, and international tax rates;

•   Valuation of capital (eg, internal rate of return; borrowing rate; does management value cash in the captive the same way it measures cash in the parent?);

•   Corporate risk tolerance (eg, what is the individual occurrence and annual aggregate tolerable exposure; will management take more risk in a captive than the current programme?);

•   Letter of credit rates;

•   Premium and loss growth rate expectations;

•   Short-term and long-term investment rate assumptions;

•   Claim payout patterns for the lines of business to be placed into the captive and others that might be considered; and

•   Loss projections for lines of business to be placed into the captive.

Captive feasibility analysis

Once the metrics have been identified, a core set of items will need to be evaluated.

1. Look closely at the company’s current insurance programme to see where a captive could reasonably participate in the assumption of risk.

The analysis should include the lines of coverage and the amount of expected loss to be insured. Property and casualty lines are the foundation for most captives because they account for the majority of insurance premium expenditure. The new captive owner should understand the implications and risks of insuring third party business or risk outside the parent group, since the captive may unknowingly take on risk that is unacceptable to the company as a whole.

Starting a captive with a simple retention structure and a strong capital base will assist in obtaining regulatory approval.

2. Identify the captive premium flow by line of business. The flow of premiums to the captive can drive taxes, fronting and regulatory fees, collateral and administration.

A potential owner should determine if premiums should be paid to the captive in the form of a deductible reimbursement contract, through a fronting company or directly from the insured subsidiaries.

The owner should also review whether the captive will be a net retainer of risk, a reinsurer of risk to third parties or a combination of the two.

3. Review ways to manage the capital needed for a captive. Capital is used to secure the risk written by the captive. Companies that seek to limit the amount of cash residing in a captive can be selective about insurance and premiums written, use qualified reinsurance or employ direct insurance instead of a fronted arrangement.

The captive insurance company may invest its premiums and capital by purchasing assets from within the organisation or entering into loan arrangements with affiliates. It is also possible to use letters of credit in lieu of cash to capitalise a large portion of the captive’s capital base. The cost of capital versus the cost of letters of credit should be compared.

4. Obtain an actuarial analysis. The premiums written and the losses incurred should be actuarially determined where possible. Many domiciles require an actuarial analysis as part of the incorporation packet.

5. Analyse the cost of capital from three perspectives: internal rate of return, borrowing rate and investment return equality. Determine which capital measure is most relevant to management for application to the feasibility study.

6. Perform a detailed tax analysis. The tax impact of a captive insurance arrangement must be evaluated, both from the perspective of the captive insurance company and the insured.

•   For US federal tax purposes, insurance companies, including captive insurance companies, are allowed an accelerated deduction for reserves for unpaid losses. To be eligible for this accounting method, the captive insurance company must meet the qualifications to be an insurance company as set out in case law and Internal Revenue Service rulings.

•   Many states do not tax the net income of insurance companies and in those states the net income of a captive insurance company may not be subject to state income taxation. A few states, however, may tax a captive insurance company’s net income through a unitary tax scheme.

•   If the captive is to be located outside the US, the captive should evaluate whether it should make an election to be treated as a US corporation via the Internal Revenue Code section 953(d), which could simplify the federal taxation of the captive insurance company and minimise exposure to adverse federal tax consequences.

•   Under federal tax law, qualifying small insurance companies, including captive insurance companies, can elect to be taxed only on their net investment income via IRC section 831(b) election. While generally favourable, the election can have adverse consequences.

7. Determine the captive’s organisational structure. The primary choices for a large corporation are:

•   Wholly owned (also known as ‘single parent’)—an insurance company owned by one company, typically the insured.

•   Group or association—multiple businesses joined together through either a formal association or an informal relationship in which the risk is homogenous.

•   Rent-a-captive—the use of another owner’s captive, with potential sharing of liability.

•   Cell company—the use of another owner’s captive, without the potential for the sharing of liability with other members.

The captive’s organisational structure may have an impact on tax, management and other operational costs, capital requirements and management time.

8. Review the benefits of various domiciles. For US insureds, the key differentiator is the management perspective regarding onshore versus offshore. Domicile choice is a consideration that can also affect capital, types of insurance that can be written, premium taxes, federal excise taxes, regulatory ease and so forth.

There are over 100 captive domiciles around the world, the leading domiciles being Bermuda, Cayman and Vermont. The more mature domiciles have a thriving service provider community (captive managers, lawyers, actuaries, accountants and brokers) capable of managing all aspects of the captive.

9. Identify the costs. Among them are capital, reinsurance costs, federal excise tax, direct placement tax, captive management fees, attorneys’ fees, audit, actuarial and domicile fees and so forth.

Identifying all the costs and keeping them in mind when making a captive feasibility decision will reduce cost surprises.

10. Model the alternatives. Creating a financial model outlining the current programme, a guaranteed cost programme, a high deductible programme and several captive options is an effective way to compare alternative captive and non-captive structures.

The model should take into account all the relevant variables and produce a bottom-line net present value of each option.

11. Quantify the benefit of a captive’s direct access to reinsurance markets. There may be savings in using the captive as a vehicle to access the reinsurance market directly (often the same reinsurers that the primary insurance companies would use).

In essence, the company should compare the premium cost difference of using an insurance company versus going directly to the reinsurance markets.

12. Quantify management’s required time commitment. The time it will take the risk manager and those selected as captive board members to manage the entity is seldom reviewed. The more complex the captive, the more time-consuming it will be.

13. Compare captive managers. The selection of service providers for the captive will normally occur after the feasibility decision is made, but understanding the level of management that will be delivered by the captive will provide insight into internal resource requirements.

14. Create proforma financial statements. It is essential to see the cash flow and income statement projections to determine if funding levels are correct and to examine how a captive responds under several loss scenarios (favourable, unfavourable, expected).

The financial statements should be vetted and reviewed with accounting, finance, tax and strategic planning professionals as appropriate.

15. Identify and evaluate indirect benefits, including use as an organisational tool to concentrate insurance; to smooth budget in cases of severe uninsured losses; the flexibility to retain more risk in hard markets and transfer risks in soft markets; reduction of onerous state self-insurance regulations; and employee benefits (Employee Retirement Income Security Act [ERISA], and non-ERISA).

16. Consider shutdown and liquidation options. The long-term nature of a captive’s liabilities and financial capital commitments can be difficult to wind down if the structure entails the use of a front company or reinsurance or if the captive acts as a reinsurer of third party business.

Typically, all liabilities must be extinguished and the proof of a ‘clean captive’ demonstrated to regulators.

Conclusion

Clearly defining the format of the study and the key criteria as they pertain to the insured and ranking what is most important will provide an analysis from which management can understand captive benefits and constraints and can then be used as a basis for executive decision-making.

The views expressed in this article are those of the authors and do not necessarily reflect the views of Ernst & Young LLP or any other member of Ernst & Young Global Limited.

James Bulkowski is an executive in the insurance and actuarial advisory services practice of EY’s Financial Services Organization. He can be contacted at: jim.bulkowski@ey.com

Paul H. Phillips III is a partner in EY’s Financial Services Organization, focused on U.S. Federal income tax matters and oversees EY’s Captive Services team. He can be contacted at: paul.phillips@ey.com

Bill Bailey is a partner and tax leader for the Bahamas, Bermuda, British Virgin Islands and Cayman Islands offices of EY’s Financial Services Organization. He can be contacted at: bill.bailey@bm.ey.com