Captive formation: the common traps

Brad Schock, Andrew Christie, and Mikhail Raybshteyn of EY identify some of the pitfalls that captive owners need to avoid when setting up a captive.

The decision to implement a captive is anything but straightforward due to the number of moving pieces, considerations and politics that may surround such a decision for an organisation, but actual implementation can present further significant traps and challenges. 

“What you may have expected to be a short application has turned into a 300+ page document with attachments.” Brad Schock

Premium, capital, taxes, domicile, time to implement, etc, may all have been perfectly laid out in a well-done feasibility study, but the implementation steps are often communicated in standardised form, without adjustment to a particular organisation and, as such, the complexity may become overwhelming.

Having the right advisors and knowing the right questions to ask prior to implementation will help a company avoid traps and time delays that can derail a successful implementation. 

Trap #1: Making assumptions

You have laid the groundwork through a captive feasibility study, but the decision to implement often hinges on a number of key post-implementation assumptions. This is the time to reaffirm those assumptions! Actuarial analysis has a shelf life, and if there is more than nine months between feasibility and application submission, this work may need to be redone.

Modelling assumptions, such as investment return, letter of credit and cost of capital rates, may change. A common tax pitfall for a newly formed captive is to analyse the tax impact of the captive entity on a standalone basis rather than analysing it as part of the consolidated group (if there is a consolidated group).

In year one, a captive will most likely face unfavourable book-to-tax adjustments for unearned premium reserve and loss reserve discounting, so it may appear as though additional tax is due. However, the tax impact must be determined as part of the consolidated (or at least affiliated) group, as the affiliated companies should generally receive a tax deduction for premiums paid to the captive.

Trap #2: Getting the board(s) on board

Forming a new captive entity is often subject to the approval of the parent’s board of directors. Not communicating with the board (or C-suite) early (and often) may slow down the implementation process at crucial dates or milestones. Additionally, captives are companies that require administration and corporate oversight, including the selection of a separate board and the filling of corporate positions.

Sometimes, approaching the chief financial officer for a director spot is met with: “What are you doing?” and “These guys want to see my personal financial holdings?”—questions that may be asked on a biographical affidavit during formation, thus bringing a quick end to the project. Socialising expectations early is the key to success.

“It may be necessary to establish a fronting carrier relationship.” Andrew Christie

Trap #3: Nightmare on Application Street

Completing a simple, on average, 28-page application, with the assistance of a local attorney and professional captive manager, should be a straightforward process, right? But beware: some applications require personal financial disclosure, police reports stating you have no criminal convictions and other items that many potential board members are reluctant to divulge (even if there is nothing to find there). 

Once these challenges are resolved, what you may have expected to be a short application has turned into a 300+ page document with attachments, including company background, actuarial work, feasibility studies and a copy of the 10-K. If your company requires a complete legal (internal and/or external) review of these lengthy documents, the process can require even more time and effort than initially anticipated.

Trap #4: Are additional approvals needed?

Depending on your industry, the selected domicile and coverages contemplated, you may need to obtain non-captive regulatory approvals. For example, utility companies may need to obtain regulatory approval for captive costs to be included in their recharge rates and billing. Financial institutions can require “know your customer” information and approvals from banking regulators that oversee them.

Loan covenants should also be considered, and advance approval by lenders may be required. Depending on local admitted rules in certain countries and the coverages being contemplated, it may be necessary to establish a fronting carrier relationship. While these approvals are not uncommon, it is essential to take steps early in the process to avoid unnecessary violations, scrutiny, delays and, of course, additional avoidable costs. 

“Considerations with respect to structure taxation should be taken into account early on.” Mikhail Raybshteyn

Trap #5: Ground control, we have a problem

All is well on the flight path to incorporation. The “perfect application” is submitted, including robust actuarial supporting work and solid pro forma financial statements, and a quick turnaround is expected. After six weeks of regulatory review, your captive manager receives a three-page list of questions and additional analysis required.

Questions often arise surrounding the premium and loss calculations for unique coverages, aggressive investment returns and other financial assumptions. While a short list of questions is common, the domicile chosen may be new and the licensing staff not seasoned in reviewing captive insurance applications or applications for risk coverage that is not general run-of-the-mill insurance. They may need more time and explanation of the details.

Under tight timelines, a pre-application meeting to explain the business plan often expedites the review process. Additionally, many domiciles have application deadlines, such as November 1 for a January inception date, which are rigidly adhered to.

Trap #6: All domiciles are not created equal

How much capital?! The regulators said you could not fund the capital of your captive with corporate goodwill. Unless domicile capital regulations are formulaic, actual capital requirements could be dramatically higher than estimated in a feasibility study. This is certainly the case in domiciles that have adopted Solvency II and impose those requirements on captives.

The traditional industry standard, or rule of thumb, provides a premium:capital ratio of 4:1; so for every $4 of premium written, $1 of capital is needed. Solvency II turns those ratios around, and a 1:2 premium:capital ratio may be closer to reality, potentially eroding financial benefits as much of the capital needs to be in liquid, short-term investments.

On the flipside, the Solvency II regime may be beneficial to some companies looking for balance sheet support and better global capital management. With the Organization for Economic Co-operation and Development’s (OECD) base erosion and profit shifting (BEPS) guidelines and Pillar Two being adopted in various jurisdictions, companies need to determine the jurisdictional interplay between captive domicile and the rest of the affiliated/consolidated group and the domicile impacts.

Trap #7: A taxing issue

Somewhere in the feasibility study appendix, unless the feasibility study was prepared by a qualified tax advisor, you may see: “We are not qualified tax advisors, and we recommend seeking appropriate tax advice.” Bar none, this is very sound advice. The US has strict guidelines, such as the third-party premium test, Internal Revenue Service (IRS) safe harbours, the Harper test, the Humana structure, or the four pillars of insurance company qualification, as well as other “safe harbours”.

Falling foul could draw unwanted IRS scrutiny or auditor questions. Additionally, excess capital and surplus (or retained earnings) to be distributed to the parent may face withholding tax or tax on income at the parent level. State and local income tax issues also tend to quickly creep up if not considered at the onset of the proposed structure. Local country non-admitted, direct placement or self-procurement taxes could erode premium—and on and on. 

Considerations with respect to structure taxation should be taken into account early on and reviewed from the point of view of the entire group, not just the standalone captive viewpoint.

Trap #8: Bogged down by the policy

Your feasibility study stated that you should create tailored insurance policies with your exact coverage needs in mind. This sounds great, until you actually have to produce a policy. Crafting insurance language is arguably one of the most difficult tasks in all of insurance. You can copy an off-the-shelf policy terms and conditions, but this is difficult if a new or emerging coverage is desired. While a benefit of a captive is that you can craft your own policies, such drafts must be reasonable to justify pricing and support transfer pricing requirements.

Coverage too broad may spark captive losses, having an effect on captive capital, and may reverse anticipated economic and tax efficiencies.

Trap #9: It takes longer than you think

You may hear that “two to three months is how long it will take to establish a captive”, and for the most part, if everything runs perfectly, it is a true statement. However, this is referring to the time it takes for a regulatory body to review and accept the application. How long it takes company management to work through the application is another matter.

Once you receive the certificate of incorporation, you must mobilise your internal functions to provide the capitalisation and generate premium. It typically can take up to six months or longer from the time the feasibility study is initiated until an initial premium payment is made. A realistic timeline should be contemplated if payment is due before fiscal year-end.

Trap #10: Local substance

EU captives under the OECD BEPS guidelines require substance or operations in a country to avoid the appearance of shell companies and tax avoidance schemes. No longer is a simple post office box or relying on the manager to provide a resident director sufficient. Care must be taken to demonstrate alignment with BEPS objectives for the country of domicile, such as avoiding “tax planning strategies that result in a disconnect between the geographic assignment of taxable profits and the location of the underlying real economic activities that generate these profits” (Action 11 §56) and “transfers of profits that are not in response to changes in the location of real economic factors, labour and capital” (Action 11 §68).

This list is not exhaustive, but care must be taken to avoid these potential traps surrounding the creation of a new insurance affiliate. Feasibility due diligence, skilled external resources, and internal support and focus can mitigate or eliminate most traps.

Brad Schock is a senior manager in the Americas Captive Insurance Services practice and a member of the EY Global Captive Network. He can be contacted at: brad.schock@ey.com

Andrew Christie is a senior manager in the Americas Captive Insurance Services practice and a member of the EY Global Captive Network. He can be contacted at: andrew.christie@ey.com

Mikhail Raybshteyn is a tax partner in Ernst & Young’s Financial Services Organization Insurance Sector and the Americas Captive Insurance Services Co-leader. He can be contacted at: mikhail.raybshteyn@ey.com

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