Do I need a captive feasibility study?

As captive insurance consultants, we commonly get questions such as “Do I need a captive feasibility study?” and “Why can’t you just form a captive for me?”. As with virtually all things captive, the answers depend on a number of factors.

What should be included in a formal feasibility study?

It might be helpful to review what a formal captive feasibility study should do for an insured:

The feasibility study will become the “backbone” of the captive licence application. It exists to fully inform the regulators of the intended captive utilisation. It also serves to educate the insured’s senior management as to why the captive should be formed.

That said, not every business needs a captive feasibility study. There are many kinds of captives, and some companies are simply too small or not sufficiently sophisticated about their risk-financing strategy.

This article is intended to clarify the difference between captive proposals and feasibility studies, and when a comprehensive study is warranted.

Size as a determinant

A single-parent (pure) captive will likely cost at least $100,000 annually to operate. Even cell captives will run $50,000 or more. Feasibility studies can cost from $20,000 to $100,000 or more, depending on the complexity of the risk.

So, we tend to use a rule of thumb: if the probable captive’s operational expenses would be more than 10 percent of the overall loss funding (ie, premium), directly retaining the risk on the company’s balance sheet or joining a group captive may be the most efficient captive strategy.

Case study #1

The insureds wanted, and thus thought they needed, a captive, and wanted it launched as soon as possible. During the initial discussions, there were multiple mentions of potential tax benefits.

Suspecting they were on the small side for a captive, a schedule of insurances, including lines of coverage, limits, premiums and deductibles/retentions, was reviewed. It was determined that the client spent a little over $1 million in annual premium, and the deductibles/retentions weren’t large enough to represent significant captive premiums.

The premiums were also spread across lines such as Errors and Omissions (E&O), Directors’ and Officers’ (D&O), Cyber and Crime—not coverages that easily fit in a group captive. Ultimately, the prospect was advised not to spend the money on a feasibility study.

Beware of ‘free’ feasibility studies

Some captive insurance proponents will provide a “free” feasibility study. However, they generally direct the insured to a canned solution that benefits the company offering the study. It won’t explore a wide range of utilisations, solve nuanced risk-financing challenges, compare domiciles, address the pros and cons of fronting companies, provide reinsurance options or even just compare the outcome to retaining the risk on the client’s balance sheet.

Case study #2

The insured was a small middle-market account that received a no-cost “feasibility study” to establish a cell captive for a number of risks that were unlikely to pose challenges in real life, including D&O difference-in-conditions (DIC), kidnap and ransom (K&R) and reputational risk.

The study was largely boilerplate and touted the benefits of the 831(b) tax election and the use of a risk pool to achieve risk distribution while implying there would be little to no sharing of losses with others.

It did not provide cover for the predictable losses the client regularly incurred (for which a captive might offer substantive benefits). Ultimately the client chose to engage in a formal feasibility study and launched a captive that exceeded the premium limitations of the 831(b) tax election.

Group captive proposals are not feasibility studies

Group captives can be an excellent solution for insureds paying between $250,000 and $1,250,000 in gross premiums for common coverages such as workers’ compensation (WC), general liability (GL) and auto liability. They can also be excellent solutions for leveraging reinsurance buying power on a joint basis. However, they are not always the best approach.

Case study #3

The insured was a light manufacturer that paid $750,000 annually in premiums, and thought that a group captive would be the best solution for its needs. It was not particularly concerned about tax deductibility due to historic net operating losses (NOLs) on its balance sheet. Its primary risks were product liability and WC, with limited auto exposure.

It received a group captive proposal which did not quantify the historic sharing of losses among the members. The captive also required collateral that would stack over a number of years. When large retention/deductible options were compared to the group captive, the client decided that large retentions/deductibles would be a more efficient manner of financing its risk, and did not join the group captive.

Creative thinking can be critical to feasibility studies

Insureds need to understand that a captive is a self-funding mechanism, and isn’t necessarily a panacea for policies that are too expensive or coverage that doesn’t provide the needed protection. Reinsurers will not foolishly replace commercial excess carriers. However, there are times when combining multiple lines of coverage or developing creative workarounds can result in solutions the commercial market is unwilling to provide.

Case study #4

In this case, the client was an insurance company that was faced with challenging renewals of its Cyber, E&O and D&O programmes. As the project evolved, there were other substantive amounts of retained risk in its WC and other lines. In addition, its reinsurers were increasing premiums and raising co-insurance participation requirements.

By reinsuring third party risk in the captive, the primary layers of the parental P&C risks could also be insured in the captive, thus generating tax deductions on its retained risks. Short and long-tailed lines could also be concurrently insured in the captive to smooth the cash flows of the required claim payments.

Ultimately, the recommended captive solved issues that involved coverage exclusions, the need to dovetail terms and conditions, improved control over the claims management, and the replacement of commercial reinsurance and excess coverage.

Industry-specific captive consulting may be required

Certain industries are highly regulated or have specific stakeholder interests that must be satisfied by their insurance programme. To some extent, “risk is risk”, meaning it can probably be financed in a captive somehow.

However, cross-disciplinary expertise that spans the industry subsector and captive nuances can help ensure the captive achieves its objectives in the most efficient manner possible, and in full compliance with relevant regulatory and contractual issues.

Case study #5

The prospect was a multistate physician practice with contracts that allowed for deductibles but not self-insured retentions due to the risk of insolvency of the insured. The medical professional liability carriers were looking for increased premiums and deductibles/retentions as well as significant collateral. In addition, state Patient Compensation Funds (PCFs) required authorised underlying coverage for enrollment.

The feasibility study needed to compare direct-issue options, fronting and RRG solutions, including the impacts of fronting fees, collateral, ratings and reinsurance. In this particular case, healthcare liability-specific captive expertise was required due to the regulatory, contractual and licensure ramifications.

Ultimately a RRG domiciled in the parent company’s state was recommended to achieve regulatory compliance and to reduce premium taxes.

Captive feasibility studies and revenue generation

The fees tied to most captive feasibility studies don’t include extensive profit margins. Rather, those studies are used to establish and support long-term brokerage, actuarial or captive management relationships.

If captive professionals sell their clients expensive, unnecessary studies or encourage them to form captives that don’t meaningfully fulfil long-term risk-financing objectives, they put key relationships at risk.

In conclusion

A comprehensive captive feasibility study would likely benefit organisations who have commercial insurance coverage that:

Bruce Whitmore is Director and Senior Consultant in the Global Captive and National Healthcare Practices at Willis Towers Watson. He can be contacted at:  bruce.whitmore@willistowerswatson.com