Group captives: the alternative for the middle market

Captive insurance companies have been used by insureds in a meaningful way since the 1970s. Initially they were the province of large companies which had the capital, the book of business and the sophistication to set up their own captives to manage their insurance risks and save money.

Over the past 40 years, group captives have become an increasingly popular way for smaller and medium-sized insureds to tap into the advantages of being in the captive insurance market. However, with that opportunity comes a number of issues to be considered before one joins a group captive.

How does a group captive get started?

Group captives need someone to organise them. Organisers might be local, state or national trade associations whose members have a certain commonality of insurance risks to be insured. Or the organisers are insurance agents who have groups of insureds whose risks would fi t together nicely in a group captive. Sometimes, because of insurance market defi ciencies in certain industries, the insureds themselves organise a group captive. Service providers such as accountants, lawyers and consultants may recommend a group captive to their clients. However it is organised, the key is that someone needs to initiate the effort, formulate projections, conduct a feasibility study andpresent the concept to the potential insureds. Indeed, sometimes the biggest hurdle is simply getting started.

What service providers are needed?

The group captive will need the services and expertise of a variety of professionals, including:
• Lawyer;
• Accountant;
• Insurance agent;
• Captive manager;
• Actuary;
• Fronting insurance company (maybe);
• Reinsurance facility (probably); and
• Claims management or loss control company (maybe).

It is important that the group captive retains service providers who are experienced in their various areas of expertise and have experience with group captives. It is also important that the service providers bring a certain objectivity to the group captive in that they are not motivated or compensated solely based on the size of the captive, without giving any attention to the quality of business. Ultimately the success of the captive is determined by the quality of the risks that are placed into that captive. Bigger is not always better.

Who should control the group captive?

The ideal situation is for the insureds in the group captive to have enough sophistication that they can appoint a group of directors and offi cers who will take responsibility for running the captive and overseeing its operation. In some cases a group captive might come to rely heavily on the expertise of certain service providers or sponsors and therefore not have an independent grasp of the captive’s business and ultimate goal, which is to return underwriting profi ts and investment income to its owners.

For example, the leadership of a group captive formed by a trade association must have the power to tell certain association members that they cannot be participants in the captive because they simply are not good risks. That may require an independent group running the captive apart from the leadership of the association.

Should I use a fronting company?

Captives by their very nature are not admitted carriers and therefore do not participate in state guaranty funds in the US. If you have a fronted insurance programme, the fronting carrier will be admitted and will participate in state guaranty funds. If the fronting carrier goes bankrupt, the state fund will take over the fronting carrier’s responsibilities. While a fronted programme may be a little more expensive, the comfort and stability that an admitted carrier—hopefully with a superior Best’s rating—adds to the programme will be well worth it.

What collateral will be required by the captive in addition to my premium payments?

Many group captives will require the insureds not only to pay premium into the captive but to post collateral, in the form of either letters of credit or cash. Collateral arises on two different levels. First, there is usually a gap between the amount of funds in the captive loss fund and the point at which aggregate reinsurance coverage attaches. That gap needs to be fully collateralised for the viability of the insurance programme.

In addition, the fronting insurance carrier, in order to take credit for the reinsurance provided by the captive (since the captive itself is not an admitted carrier), must have the full amount of its loss exposure net of reinsurance collateralised so it can obtain its Schedule F credit.

How do I get dividends back from the group captive?

Interest income and underwriting profi t that is left in the captive will be returned to the insureds. However, the real question for a group captive is what dividend formula will be used to return dividends to insureds? Many group captives take a rather varied approach to dividends and base dividends available to members on premium volume, loss ratiosand length of time in the captive programme. It will be up to the captive’s organisers to determine any dividend formulas and memorialise those formulas in the captive’s organisation documents.

How do I get out of the group captive?

Leaving a group captive may not be all that easy. Once a member of a group captive begins to put losses into the programme, the captive itself will set reserves and will want to keep up those reserves until claims run off. A member may feel that it is difficult to leave a group captive because much of its premium and future profits will be stuck in the programme. Again, it is up to the organisers of the captive to determine what monies will be available to members and how long they will have to wait for that money upon exiting the captive.

Should I participate in a protected cell or a standalone group captive?

Many captive domiciles have protected cell legislation. One of the advantages of participating in a protected cell programme is that the group captive does not have to organise the captive and capitalise it. On the other hand, to some degree, the cell owner is dependent upon the board of directors of the protected cell company itself with respect to the running of the captive and payment of dividends.

While a standalone group captive may provide more independence for the members and allow the members a wider range of control, the group captive must be capitalised which means meeting statutory minimum capital requirements of the domicile and any additional capital requirements regulators may impose on the captive.

What additional issues should I be concerned about?

Tax: Many captive owners, including group captive owners, make the assumption that if they form a captive offshore, any profits they accumulate in the captive will be accrued tax-free until repatriated. While that may have been true in certain cases prior to 1986, it is generally not true today. Group captive members may find themselves subject to tax on related person insurance income or may find themselves paying tax on subpart F income if the captive is a controlled foreign corporation.

Group captives that find themselves in protected cell companies should pay particular attention to the fact that the IRS now treats individual cells as standalone captives, so that all tax issues that apply to standalone group captives also apply to cell programmes.

"Group captives that find themselves in protected cell companies should pay particular attention to the fact that the IRS now treats individual cells as standalone captives."

Deductibility of premium: In order for premiums to be deductible, insurance must be present, which means there must be risk shifting and risk distribution within the group captive programme itself, whether it is a cell captive or a standalone group captive. That usually means having enough insureds in the group so that the law of large numbers can take effect. Insureds/owners also need to pay attention to IRS guidance on the number of insureds and size of risk assumed by each, as well as third-party risk to analyse this issue.

Onshore versus offshore

Many group captive owners ask themselves whether they should form their captive onshore or offshore, and there are today many options.Many of the offshore domiciles have a long history of being in the captive business and have developed solid regulatory schemes. In some limited circumstances, there is still some ability to defer taxes in an offshore captive.

Typically, capital costs are higher when going onshore, but the costs of running the captive and attending meetings onshore are lower because meetings can be held closer to home. One other thing to keep in mind is that if the captive is going to insure in certain benefit plans, coverage can be written only through an onshore captive.

Final considerations

Group captives are for insureds who want to be involved in controlling their losses, are willing to take responsibility for organising and running their own captive and have more predictable insurance risks that can be affected by attentive loss control. That is why workers’ compensation is probably one of the leading risks insureds place in such captives. Catastrophic kinds of coverages should not be placed in captives. Assumption of that risk should be left to the traditional marketplace.

Captives tend to become very popular in hard markets when pricing increases and coverages become more difficult to find. At that point, many owners are happy to find that they don’t have to deal with a cyclical, sometimes irrational, insurance marketplace. The test for captives is, when a soft market comes and prices drop, keeping those group members in the captive when they can go out and get attractive pricing in the traditional marketplace.

Group captives are not for everyone, but if the insurance programme is assembled with thought, the group captive engages experienced service providers and the captive is run in a risk-averse manner, they can provide a long-term insurance solution for many insureds.

Scott Penwell is a partner at Rhoads & Sinon. He can be contacted at: spenwell@rhoads-sinon.com