It’s a good practice every now and then to fine-tune complex structures. The US captive industry is no different. Only this time, the tool used is the strategic review, says Michael Serricchio.
Beginning with the credit crisis in 2008 and continuing into 2010, a growing number of captive owners have arranged for strategic reviews of their captives, including those that are currently operational and those that are dormant. Interest in the reviews has not been confined to owners of multiple captives; firms with as few as one captive have also conducted reviews.
Several factors are driving these decisions, including the economic environment, cost-cutting initiatives, cash management and the need for companies to access trapped cash, changing insurance market conditions and tax situations, and domicile changes. In fact, owners currently initiate about 75 percent of all strategic reviews, with the rest suggested by the captive manager.
In 2008 and 2009, captive owners expanded the use of their captives to save money, provide diversification, insulate themselves more effectively from potential insurance market cycles and, ultimately, strengthen corporate risk control—all with cost savings as a key goal.
In other cases, parent companies initiated strategic reviews several years after forming a captive, following either a change to their corporate objectives or as part of a process to identify opportunities for increased captive utilisation. In some of these instances, companies had not fully utilised their captives or had left them essentially dormant. In others, the captive was in ‘run-off’, processing and paying out claims, but not writing new policies. While these captives may have been on a trajectory to shut down, organisations with new management have used the strategic review process to identify new opportunities for using a dormant captive to help achieve the organisation’s risk management, financial or business objectives.
The goals of a strategic review
According to Business Insurance magazine’s annual captive survey (Business Insurance Survey: By the Numbers: Captive Managers, page 32), there are currently 5,390 captives worldwide, of which approximately 70 percent are single-parent captives. Many of these captive owners are enlisting consulting firms to help them take a fresh look at their captive’s operations, with the goals of freeing up cash and capital, reducing collateral costs, realigning their insuranceprogrammes and saving on premiums paid to commercial insurance companies. In the process, many owners are exploring new approaches for using their captives, as well as for benchmarking their captive use and structure against peers in the same industries or geographies.
A captive strategic review—essentially a ‘refeasibility’ analysis of an existing captive—can often help uncover ways for a parent firm or other subsidiaries to access some of a captive’s cash, find alternatives to collateral and letters of credit, uncover overlooked opportunities for the captive, and unveil possibilities for tapping the economic and risk management benefits available through the use of one or more captives.
Generally, a strategic review should be conducted two to five years after the inception of the captive; it often takes a captive that amount of time to develop credible loss experience, accumulate investment income and establish other performance measurements that can lead to more robust analysis and recommendations.
For this reason, mature captives generally can benefit from strategic reviews, especially in the current economic environment. For many owners, it makes sense to conduct strategic reviews of their captives every five years.
Nonetheless, changing circumstances might dictate earlier or more frequent strategic reviews. These include: (1) a change in domicile regulations; (2) new guidance from the Internal Revenue Service or the courts that could affect the captive’s operations; (3) the appointment of a new risk manager, or other management changes at the captive owner, and the need for a fresh look at a company’s insurance portfolio; (4) an acquisition or merger where a company inherits a captive or multiple captives; and (5) the establishment of new domiciles.
What does a strategic review entail?
Operationally, a strategic review involves analysing the lines of business in the captive to determine whether there is an opportunity to include additional lines of coverage within the captive’s risk portfolio. By reviewing a company’s retained losses, expected losses and various other data points, the consultant can prepare pro forma models of the captive under various financial scenarios.
For example, with a growing number of companies reinsuring employee benefits through their captives, many risk managers are working with their company’s human resources and employee benefits departments to analyse whether or not using their captive to reinsure employee benefits may be a viable option for their company. The US Department of Labor recently approved a proposal set forth by a large US company to reinsure post-retirement health benefits through its South Carolina captive; this is expected to lead to widened use of captives to reinsure employee benefits in the coming years.
In some instances, a strategic review can help identify ways to return cash from the captive back to the parent company through inter-company investments. The review typically includes an analysis of the captive’s current investment strategy, which tends to focus on inter-company investment opportunities rather than the captive’s investment portfolio. The analysis may identify an opportunity to increase returns and eliminate opportunity costs by expanding the captive’s investment policy to include such ‘arm’s length’ investments as accounts receivables factoring, unencumbered mortgages and real property. A review can help establish a dividend policy for the captive that might be based on favourable loss experience and loss prevention, among other factors.
"The review typically includes an analysis of the captive's current investment strategy, which tends to focus on inter-company investment opportunities rather than the captive's investment portfolio."
Captive owners should also consult with their tax advisors to discuss any relevant federal, state and international tax issues. Depending on the situation, a strategic review may yield a recommendation to evaluate whether the captive should add additional lines of business, such as related party or unrelated business (extended warranty, US employee benefits or global employee benefits, which may be accomplished through a pooling arrangement with a fronting carrier). Many captive management firms and consultants can help captive owners determine which of these approaches is most suited to a parent company’s overall risk management philosophy.
The analyses typically are conducted in conjunction with the parent company’s treasury group, which can provide necessary details regarding the parent company’s dividend policy, investment policy and investment rates of return.
Selecting a location for a captive involves an analysis of domiciles and a comparison of local insurance laws, regulatory flexibility, tax considerations, services, capitalisation and annual expenses. Consequently, a strategic review generally should include an analysis to determine whether the current captive is suitably domiciled. In addition, if appropriate, the review can include an examination of alternative domiciles. In the years following a captive’s inception, specific laws may have changed, along with the domicile’s regulatory landscape. And there may be new domiciles, direct writing domiciles, no premium tax domiciles, among other developments, each of which could make a captive’s structure less than optimal for its current domicile.
For example, relatively new domiciles include the Dubai International Financial Centre, which authorised its first captive licence in 2008, setting the tone for the future development of Dubai as a captive insurance hub in the Middle East. In the US, Michigan, Missouri, Louisiana and Connecticut introduced captive legislation during the past two years that is similar to existing Vermont statutes. These states plan to attract new captives and to encourage existing captives to redomicile.
Businesses can compare new domiciles for innovation and regulatory leadership, opportunities to expand coverage to new lines of business and the ability to consolidate various programmes in one captive located in a single domicile. In some instances, firms have changed domiciles as a result of the changing circumstances of specific insurance programmes. In some situations, it may be appropriate to consolidate multiple captives for annual costs savings, or to run off or liquidate a single captive.
Customisation: key to achieving results
Strategic review projects generally must be tailored to the needs of specific businesses. For example, one captive owner was only interested in adequate capitalisation; in that case, the strategic review focused on determining appropriate capitalisation levels relative to the captive’s business plan and risk profile.
Similarly, a strategic review might be conducted to address corporate governance and issues related to the Sarbanes-Oxley Act 2002 (SOX). For example, some firms have used the review process to establish a corporate governance manual of established procedures and controls for their captive. They have also helped to develop a captive committee structure for various disciplines to assist the parent company with its overall SOX procedures and controls.
The strategic review concept has become more timely for many captive owners, given the current economic environment, evolving commercial insurance market conditions, new Department of Labor rulings, federal and state tax developments, tighter operating budgets, the need for companies to access cash, new sponsor management, the establishment of new and emerging onshore and offshore domiciles, and other potential strategic opportunities. In this context, businesses have increasingly used the strategic review as a way to help improve the effectiveness of their captive arrangements and to make them more valuable to the parent corporation and its various operating units.
Michael Serricchio is the senior vice president at Marsh Captive Solutions Group, Marsh USA. He can be contacted at: michael. firstname.lastname@example.org