22 August 2019

Captive loan-backs: the pitbulls of finance

Loan-backs—a loan made from a captive insurer back to its parent corporation—are one of those areas of finance that insurers prefer not to discuss in polite society. The reason for the caution is that, if transacted indiscriminately, loan-backs can be in violation of tax law and breach the entire spirit of a true independent and bona fide insurer. Avoiding troubles requires careful planning and unfaltering record-keeping.

“If arm’s-length is maintained, loan-backs result in the captive getting an excellent investment and the parent getting access to liquidity.”

To understand the potential conflict, we must first recognise the types of captives and their purposes. The primary purpose of any captive is, of course, to self-insure a company’s risk. Conflicts arise depending on whether a captive is seeking to take advantage of the valuable benefits associated with a tax compliant insurer.

For captives not seeking those tax benefits, a loan-back is quite benign. If such a captive abides by state regulations regarding concentration and risk, loan-backs are simply another asset in the captive’s portfolio.

However, US-based captives that use insurance accounting and purport to be bona fide insurers per the Internal Revenue Service’s (IRS) guidelines, must be wary when using loan-backs to transfer cash back to the parent company.

To get the tax advantages associated with being an insurer the captive must be truly independent. That is Tax Planning 101. An independent captive must maintain an arm’s-length relationship with its parent company. In addition, like any independent insurance company, a captive must maintain adequate capital and avoid concentration risk with any single asset representing too large a share of their portfolio.

This is where making loans from the reserves of a captive back to a parent can begin, like a pitbull at a child’s birthday party, to cause concern—whether justified or not.

Benefit of loan-backs
If loan-backs raise concerns, why not avoid them altogether? The answer is simple. A captive is always looking for the best use of its funds and lending funds at a reasonable rate of interest to a risk that may be well understood is often an excellent use of those funds.

While there may be myriad investment options available, loan-backs—because they are dealing with a related entity—often provide greater flexibility and a simple outlet for placing excess liquidity. The captive and the parent both benefit from the other being stronger. If arm’s-length is maintained, loan-backs result in the captive getting an excellent investment and the parent getting access to liquidity. Shareholders, regulators and counterparties should all recognise that truth—if the captive abides by a few simple rules.

The rules of loan-backs
There are four basic rules to avoiding the pitfalls associated with loan-backs.

1. Market rate of interest: the most critical test of whether a transaction is objectively reasonable is whether the rate of interest charged is truly a market rate of interest. Demonstrating market reasonability is best done by documenting other available rates from larger independent third party sources.
The rates should be for similar risks, of similar tenors, and the source should be documented clearly and beyond question—in a manner that is easily discoverable.

2. Callable: the captive must be able to call the loan at any time, for any reason. There can be no covenants or other restrictions limiting the captive’s ability to call the loan. This may limit the uses for the proceeds of the loan-back, so that should be considered when evaluating the transaction.

3. Short term: loan-backs should generally not exceed three years in tenor.

4. Scale and concentration: no single loan or group of loans to a single counterparty, including the captive’s parent, should create unreasonable concentration risk. As with any portfolio, maturities should be staggered to minimise reinvestment risk.

How to manage the risks
Demonstrating that a captive has assiduously abided by these four rules is the key to managing a successful captive loan-back programme.

Validating market rates retroactively can mean an extensive amount of work. A better option is collecting data, showing the source of information, and ensuring that the data is appropriately time-stamped. Multiple sources would tend to strengthen this support.

Done manually, this would be a burdensome task. Fortunately, technology can make this type of record-keeping relatively easy. Blockchain technology can ensure that the data is tamperproof.

While verifying market rates is a straightforward mechanical exercise, maintaining permanent copies of the underlying loan-back agreements means storing and maintaining a large amount of authenticated documentation. Again, a tamper-proof database is required; cloud storage and database capabilities have made this a much simpler proposition.

Don’t let fear win
The benefits of self-funding through call-backs are substantial. Loans to a parent company, receivables factoring or other forms of internal finance are not prohibited in any way. The requirement is that a captive be independent.

Good planning, good record-keeping and good technology all make the path to a successful loan-back programme accessible. The process, much like that scary pitbull, must be tamed and well looked after.

Richard Magrann-Wells is head of North America at Adjoint. He can be contacted at: