Insurance Renewal Got You Down? Maybe It s Time for a Captive Insurer?

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1 Insurance Renewal Got You Down? Maybe It s Time for a Captive Insurer? It s like a knee jerk reaction the insurance market changes direction and everyone s running for the alternative risk market at once. Being your own insurer may not be the panacea you envisioned. Like when your plumber tells you this will be his last house call, because starting next week he s going to be a full time day trader in 1999 he was a genius, in 2002 he s bankrupt! So before you trade in your conventional insurance program for an alternative approach, we suggest you take more than a moment to assess the landscape. One thing is for sure, no business alternative produces risk-free money. For the most part, forming a Captive Insurance Company is little more than an alternative to conventional risk-transfer mechanisms like insurance. Black s Law Dictionary (7 th Edition) defines Captive Insurance as: 1. Insurance that provides coverage for the group or business that established it. 2. Insurance that a subsidiary provides to its parent company, usually so that the parent company can deduct the premiums and set aside as loss reserves. In the following pages, we will provide general information regarding the formation, domicile, and management of a Captive program. It should be noted up front that two of the coverages likely to be considered for a Captive, Workers Compensation and Automobile Liability, are statutory requirements. Each State, with the exception of Texas (opt out), mandates the existence of Workers Compensation insurance or the licensure to self-insure. Likewise most states impose requirements for automobile liability coverage as well. FRONTING In order to satisfy these statutory requirements, evidence of coverage must be provided by an admitted insurance carrier. Since very few Captives will choose to become admitted in all the states in which their insured operates this process is long and expensive and would subject the Captive insurer to participation in pools, residual market sharing, insolvent insurer funds, etcetera the use of a Front will be required. A Fronting carrier is an admitted insurer who will, for a pre-determined price, issue a policy on its paper to cover a risk, sometimes only insuring a small percentage of the risk and reinsuring the majority (or all) of the risk back to the Captive. Although the concept of fronting is not new, for obvious reasons, relatively few admitted carriers are anxious to participate in such arrangements, which erode their surplus 1

2 (legally 100% of the risk is still theirs) for the relatively low revenues produced by fronting fees and excess premium (if any) for the retained portion of the exposures. Finally, because of the statutory nature of the Workers Compensation and Automobile Liability coverages and the need for the Front to file evidence of these coverages, the Front will be required to pay (and ultimately pass on to the insured ) the normal State Assessments, Residual Market Charges and Premium Tax. STRUCTURE While the ownership, risks insured and participation in a Captive vary considerably (e.g. Association Captive, Risk Retention Groups, Industrial Captive, Reinsurance Captives, etc.) we will limit our discussion herein to two specific types of Captive insurance arrangements: I. Pure Captive: This kind of Captive Insurance Company has one corporate owner insuring only the risks of the parent organization or its subsidiaries. See the diagram below, which shows the cash flows of a typical Captive Insurance Company. Parent Company Premiums Front Company (unrelated) Loss Fund Claimants Premiums Claim Fund Payments Unrelated Reinsurers Captive Insurer Premiums Reinsurers Retrocession (claims payments) Management Fee Captive Manager II. Rent-A-Captive: Under this arrangement, the insured buys into or leases the capital and infrastructure of an existing Captive insurer and the insured s 2

3 underwriting account is typically segregated (protected cell) from those of other insureds of this entity. Insured Premiums Front Company (unrelated) Premiums Loss Fund Claim Fund Payments Claimants Unrelated Reinsurers Purchase (rent) segregated cell within existing Captive benefits include shared expenses (not loss) and infrastructure. Multiowner Captive Management Fee Premiums Retrocession (claims payments) Captive Manager Reinsurers Within this context, we will provide an overview of: Brief History and Current State of the Captive Movement Factors Influencing Captive Formation General Considerations in Forming a Captive Domicile Captive Feasibility Studies The Implementation Process Advantages of a Captive Disadvantages of a Captive BRIEF HISTORY AND CURRENT STATE OF THE CAPTIVE MOVEMENT The Captive Insurance Company concept is not new. Tanker Insurance Company, Ltd., formed in August, 1920, by the Anglo-Persian Oil Company, the predecessor of today's British Petroleum, is one of the first examples of a Captive Insurance Company. Many of today s commercial insurers (Liberty Mutual, Allstate, FM Global) began as an effort on the part of individual corporations or groups to satisfy an insurance need to which the industry itself was not responding for one reason or another. 3

4 In the 30 years from 1960 through 1990, the number of Captives in operation grew from about 100 to nearly 3,000 with annual written premiums of approximately $10 Billion and combined assets of over $23 Billion. Currently, it is estimated that there are over 4,000 Captive Insurance Companies worldwide, writing more than $20 Billion in annual premium, with capital and surplus of more than $50 Billion. Some industry pundits believe that 50% of the commercial market will shift to non-traditional by FACTORS INFLUENCING CAPTIVE FORMATION While some experts contend that Captive development simply mirrors the overall competitive marketplace and that Captives are merely an attempt to improve upon the price and product of insurance for large organizations, most see the popularity of Captives as a response to a void unfilled by the traditional insurance markets. During the last 40 years, three critical factors have prompted insureds to seek alternatives to conventional risk transfer mechanisms: 1. Availability/Capacity Problems Even the casual observer can see the correlation between the surge in Captive formations and the tight or hard market cycles of the insurance and financial industry in general. Underwriters unwillingness to provide coverage for high risk exposures (e.g. Medical Malpractice, Mold, Terrorism, etc.) or limits of liability adequate to meet corporate needs has caused many insureds to adopt a do-it-yourself mentality. 2. Pricing Inequity and Volatility In an effort to recoup losses (either real or perceived), the traditional insurers who might be willing to provide coverage at all will increase rates virtually across the board during a tight cycle. This has gone from the business page to the front page during the last year. Many insureds whose exposures and/or experience do not appear to warrant such arbitrary price increases have sought relief outside the conventional marketplace. Likewise, insurance pricing and availability are notorious for their cycles. Costs of risk transfer can fluctuate significantly year-to-year, making the budget process challenging. Seeking relief from the capricious nature of the insurance system has probably been the most common reason cited for the establishment of Captives. 4

5 3. Lack of Flexibility Only in recent years perhaps to stem the flight of insureds has the industry begun to respond to the wishes not only of larger corporations, but of medium sized firms as well, by allowing higher retentions (with corresponding rating considerations) and unbundled (contracted-for claim and loss control services) programs. Historically, corporate insureds that were willing to assume high degrees of their own risk and/or sought more sophisticated loss control services and greater control over the claim process had no alternative but to self-insure. Insurers were unwilling to adequately recognize (rate-wise) the value of a substantial retention or allow administrative services to be managed by other than carrier-controlled providers. Other reasons may involve changes in the IRS s view of the deductibility of premiums paid by a Parent to a Captive Insurer. Previously, the IRS relied strictly on the economic family theory in guiding its position on the tax deductibility of such premiums, typically disallowing them based on the argument that no true transfer of risk had occurred. Now, given the right structure and arrangement of the Captive Insurer, the IRS is willing to consider these premiums tax deductible. GENERAL CONSIDERATIONS IN FORMING A CAPTIVE 1. Full Commitment to Loss Control Between 65% and 75% of the expenses incurred by the Captive should be losses. Without a total commitment on the part of management to control the source of this expense, claims or losses, the Captive endeavor will achieve less than satisfactory results, and may ultimately fail. 2. Minimum Size While there is no hard and fast rule relative to the size of one s premium (for risk transfer), a reasonable minimum Transfer Cost for the consideration of a single owner (Pure Captive) is about $3 Million. Rent-a-Captive arrangements can be successfully accomplished where lower premiums are involved, but generally $1 Million is the minimum for a Rent-a- Captive to make economic sense. 3. Organizational Risk Tolerance In any kind of program that contemplates a significant assumption of risk by the insurer, the organization must be prepared for substantial fluctuations in 5

6 expected and actual results. A single large loss or unexpected events resulting in an inordinate frequency or severity of losses will impact a given year s bottom line. This is true even in a Captive environment, especially at the outset of the program, until a loss cushion is developed. 4. Long Term Management Support Recognizing the relatively high initial costs (e.g. capitalization, start-up management and expenses) coupled with the above mentioned potential for early loss-induced disappointments, no less than a 5-year, and preferably a 10-year time horizon should be used in assessing the potential results of (and providing wholehearted management support for) a Captive Insurance Company. This time horizon is particularly important for a Pure Captive. Rent-A-Captive arrangements, where capitalization and start-up costs are considerably less, can withstand somewhat shorter periods of tolerance, although these, too, are as loss sensitive as single owner arrangements. 5. Strong Internal Management Regardless of the capabilities of the Captive manager or administrator, in either a Pure or Rent-A-Captive structure, the major decisions such as appropriate level of capitalization, retention levels, exposures to be included, etc. cannot be delegated to brokerage entities whose role is to place product. The insured must possess and maintain a high level of Risk Management awareness in order to direct those responsible for the day-to-day management of the Captive entity. 6. Domicile One of the key issues involved in considering the feasibility of forming a Captive, beyond what type(s) of risks to include, is where to locate this entity. A number of factors should be considered because of the variance of regulatory requirements and domicile-related factors among the geographies most commonly used. The following chart provides an estimate of the current number of Captives by jurisdiction. 6

7 MAJOR CAPTIVE DOMICILES Domicile /- Bermuda 1,136 1, % Cayman Islands % Vermont % Guernsey % British Virgin Islands % Luxembourg % Barbados % Dublin % Isle of Man % Turks & Caicos Islands % Hawaii % Singapore % Bahamas % Switzerland % Source: Business Insurance, 2/4/02 Some of the factors that affect the domicile selection process are: Capitalization Requirements: The initial amount of money required of a startup company. Surplus Requirements: The minimum written premium-to-surplus ratios allowed. This is especially important at the early stages of Captive formation when funds may be limited. Investment Restrictions: What types of investments are allowed (prohibited), including maximum percentages of investments in particular vehicles. 7

8 Reporting and Auditing Requirements: The types of and frequency with which reports must be filed with regulatory agencies. Loss Reserving Requirements: Some jurisdictions mandate minimum loss reserves to be posted. Some domestic (U.S.) domiciles, for example, may require Workers Compensation Captives to post initial loss reserves at no less than 65% of written premiums. Income and Local Tax: Taxes levied on premium, underwriting profit and investment income. These vary greatly and are a key factor in financial planning. Government Fees: Common to all offshore domiciles these fees (taxes) are levied on Captives operating within their jurisdiction. Formation Time: Will vary, but generally is less time-consuming in the older, more established domiciles, such as Bermuda, Cayman Islands and Vermont. However, up-and-coming domiciles are providing greater and greater navigation of the process. Underwriting Limitations: Certain jurisdictions require that rates and policy forms be submitted for approval and others may limit the types of coverage which may be written. Some prohibit the writing of unrelated business by the Captive. Acceptance: Both fronting companies and reinsurers may be selective as to domiciles. Generally the well established jurisdictions are preferred, and may also be important for making a credible argument to U.S. tax authorities regarding deductibility of premium paid. The following pages outline these and other particular items relative to Captive formation in those jurisdictions most commonly used as Captive domiciles. It should be noted that a number of Rent-A-Captive arrangements currently exist in many of these jurisdictions, and although many of the domicile considerations have already been addressed by the Rent-A-Captive manager, some of the above listed administrative expenses will affect the Captive Insurer s bottom line. Therefore to a certain degree, even in a Rent-A- Captive environment, selection of domicile is important. For example: Ireland currently enjoys beneficial tax positions with most of the EC nations. If one were seeking to direct Rent-A-Captive profits into one of those countries, Ireland may be the best choice even for a Rent-A-Captive arrangement. THE FEASIBILITY/IMPLEMENTATION PROCESS The decision to form a Captive must be preceded by a thorough examination of the advantages, disadvantages, savings and costs as they relate to the organization s risk 8

9 situation, risk tolerance and objectives. These kinds of examinations are generally termed Feasibility Studies. The objective of a feasibility study is to compare the costs and benefits of forming and operating a Captive with those of other financing alternatives available for financing a specific exposure, as well as to prepare basic materials that will be required in the application process. These studies are mainly performed by actuaries, Captive managers, consultants, or some combination thereof, working in concert. The selection of an organization or group to perform a feasibility study should parallel the selection process for accountants and attorneys. A careful examination of the experience with all types of risk financing, not just Captives of the individuals responsible for the work should be performed, as should reference checks. The time and cost involved in finalizing a feasibility report depends to a large extent on the size and complexity of the exposures being examined. It is interesting to note that much of the information required and its analysis is not unlike that regularly performed by ARI for our client-partners annual renewal process. The following is a thumbnail sketch of the data required for a Captive feasibility study: Detailed description of the organization s current insurance program including coverages, limits, retentions, insurers and effective dates. Copy of the most recent renewal support data including supplementary agreements. Description of the company s operations and products, including: an annual report, a statement of corporate long-range plans for expansion (especially into new products), locations and anticipated acquisitions or divestitures. Current financial information (e.g. balance sheet, income statement, 10K report, budget, etc ) A five to ten year loss history including detailed information on large ( large depends on the size of the company, but usually >$50,000) losses. Safety/Loss Control Program details for all operations. Prior, current and expected future exposure data for coverages to be included in the proposed Captive. Insured s projected income tax and interest rate assumptions (i.e. the investment rate versus its borrowing cost). Statutory requirements (capital to surplus requirements, liquidity ratios, etc.) in selected domicile, necessary to perform analysis of cash requirements for the Captive. Using this information the Feasibility Study then proceeds to identify and analyze the exposures, forecast losses, determine an optimal level of retention, identify and estimate the costs of alternative financing mechanisms and create functional models to select the best of these options. Ultimately, the cost of the best available, not necessarily the in force alternative, is compared against the estimated costs of a Captive program. 9

10 Assuming that the Captive alternative produces the lowest estimated cost over the decision horizon, the final step in the feasibility study process is to prepare pro-forma income statements and balance sheets for the proposed Captive, both before and after tax, usually covering a five-year period. The Implementation Process Without going into particular detail (since in a Rent-A-Captive environment many of these functions are packaged), we list the steps required in the implementation of a Captive Insurance Company: Identify a fronting company (if required) Select a Captive manager whose specific services include: - Premium collection and billing - Policy & Certificate issuance - Insurance accounting - Providing local directors and officers as required by the domicile - Loss payments and/or fund transfers - Loss reports and claim data - Issuance of financial reports - Statutory filings which may be required - Federal Excise Tax preparation - Investment advisory services - Reinsurance placement Elect Directors and Officers of the Captive entity Determine domicile Select legal counsel Draft by-laws of the Captive Insurance Company Choose investment advisors, banks, actuary and accountants Assess SEC compliance and related registration issues Discuss relevant tax issues with appropriate counsel Manage the capitalization process 10

11 ADVANTAGES OF A CAPTIVE Beyond the cost advantages of establishing a Captive, which are demonstrated in the feasibility study discussed above, there are a number of other advantages that, more or less, influence the decision to pursue the Captive approach. 1. Reduced Operating Costs Conventional insurance pricing includes expenses such as underwriting overhead, loss control, claims management, commission, contingencies, profitsharing and insurer profit, many of which are not cost effective for a given insured. They include profit margin for other, perhaps non-essential, layers in the service chain. A Captive can eliminate or significantly reduce some of these expenses by unbundling services (i.e. purchasing only necessary services on an ad hoc basis) or performing some of these functions in-house. 2. Improved Cash Flow A major portion (65% - 75%) of a large organization s insurance cost is losses. Since casualty losses by their nature take time to mature and pay-out, collection of these loss dollars in advance (as part of premium) potentially provides the conventional insurance carrier with considerable float or use of money income. Since a Captive is essentially pre-paying these loss dollars to itself, the Captive insurer retains this use-of-loss-reserves benefit until claimants must be paid. Note: The Cash Flow, Self-Insured Retention and High Deductible Programs under which traditional loss sensitive casualty insurance coverages are currently written provide essentially the same pay-as-you-go loss structure as described above. However, a Captive, to which loss reserves will be paid in advance, can specifically identify and invest these unpaid losses separately from the general corporate funds. 3. Broader Coverage A Captive Insurer can, within reason, provide coverage for most fortuitous loss exposures to which the corporation may be subject. For example, a Captive may be used to fund the company s potential warranty losses for which conventional insurance may not be available or may be too expensive to purchase. 11

12 4. Equitable Rating The basic structure of conventional insurance rating has been to collect average premiums for comparable risks so that in theory at least the better-thanaverage insured can help pay for the losses of the worse-than-average risk. Likewise, the rate-making mechanics of conventional insurance are geared to recouping first dollar losses and do not adequately recognize the reduction in risk when the insured assumes high deductible or self-insured retentions. In a Captive environment, the insured will develop premiums (costs) of only its risks, with no recognition of a need to spread costs among other insureds; and, since excess coverage will generally be purchased from reinsurers, the Captive s insurance markets generally recognize the value of large retentions in their premium structure. 5. Coverage Availability/Stability The insurance marketplace is notorious for its cycles of coverage availability, capacity and pricing. Conventional insureds are constantly cautious that a soft market may harden and significantly disrupt even the most carefully produced insurance budget. Use of a Captive mitigates the extent to which these cycles impact an organization. The probability that coverage will remain available (and pricing more stabilized) is enhanced since these elements will track more closely with the specific risks of the organization rather than the general marketplace over which the insured has no control. 6. Direct Access To Reinsurers Reinsurers are carriers whose customers are other insurance companies. As a Captive Insurer, the organization can deal directly with the reinsurance marketplace. This relationship can reduce the cost of excess coverage by eliminating commissions paid to intermediaries. Also, the coverage and pricing obtained from reinsurance underwriters generally reflects the specific exposures of the organization rather than those of the general marketplace. 7. Improved Service Generally, the claim administration, loss control and management information services provided to conventionally insured organization are part of a package sold by the insurance carrier. The insured has no choice or management voice in the administration of these services. It is not uncommon for large corporations, 12

13 especially where high retentions are involved, to find that lack of control over these services is both frustrating and impractical. Some primary carriers, under high retention situations, will allow unbundling of these administrative services where the insured is permitted to buy from third party providers only those services necessary to manage the program. In addition to eliminating unneeded service costs, many of these service arrangements can be more competitively priced when unbundled. The ability to unbundle also allows the insured to shop for services and providers who well meet the service and pricing aspirations of the Captive and its insureds. 8. Fewer Regulatory Restrictions This advantage is mitigated in the case of statutory coverage (Workers Compensation and Auto Liability) where an organization must show evidence of insurance or qualify as a self-insurer. The use of a front (as discussed above) allows a Captive to meet these statutory obligations. It is not uncommon, however, to use the Captive vehicle (once established) to fund for losses of other exposures where insurance might not be purchased at all (e.g. product warranties) or higher deductibles on typically-insured exposures. 9. Foreign Tax Credits and Transfer of Currency Some organizations that have foreign operations can take advantage of certain international tax arrangements not available to a U.S based taxpayer. Another strategic purpose of an offshore Captive is that it can be used as a conduit for multinational organizations to transfer funds in and out of foreign countries, which may have currency controls. DISADVANTAGES OF A CAPTIVE A brief overview of the potential issues of establishing a Captive follows. A number of the perceived disadvantages of using a Captive are eliminated in a Rent-A-Captive arrangement. 1. Internal Administrative Costs Participation in a Captive Insurance Company arrangement will require more time of the organization s administrative and risk management personnel. 2. Capitalization and Commitment Initial capital outlay for establishing a Captive could amount to one-third to onehalf of the insured s premium for the line of coverage insured in the Captive. The 13

14 organization should commit to these extraordinary expenses for a minimum of 5 years. Lack of such a long-term view most likely will doom the venture to failure. 3. A New Cadre of Managers A Captive owner will need to establish relationships with a Captive manager, oversee the hiring and operations of service providers such as tax attorneys, actuaries, accountants, consultants, and reinsurers, as well as be responsible for dealing with regulatory authorities. 4. Inadequate Loss Reserves and Potential Losses While reinsurance can be structured to lessen the impact of a shock loss, the organization must be prepared for the possibility of having to infuse additional capital into the Captive to support unexpected losses within the retained exposures. 5. Taxation Issues It is likely that the formation of a Captive will subject the organization s tax and accounting treatment of losses, premiums, loss reserves and investment income to increased IRS scrutiny. 6. Increased Cost/Reduced Availability of Other Insurance Some conventional insurance programs are underwritten on an account basis wherein the carrier gears its income and underwriting expense, not by line of coverage of policy, but on an overall basis. Likewise, loss ratios are judged on a multi-line basis, which has a leveling effect on the account s value to the insurer. By removing certain coverages from the account package for inclusion in a Captive, the relative cost of insuring the remainder may increase significantly. CONCLUSION Establishing a Captive Insurance Company, whether it be a Pure Captive or a Rent-A- Captive, provides no assurance that your cost of insurance will be lower over a given period of time. In reality, particularly in the early years of a Captive, a shock loss could cause the Captive approach to be very expensive relative to traditional insurance. If, however, you are confident that you will be able to control your losses or have related financial objectives, setting up a Captive may make a great deal of sense. Why not deal directly with the reinsurance markets? Whether you are compelled to pursue other options due to the lack of capacity or reasonable pricing in the traditional market, or you are just looking for alternatives to deal with the capriciousness of retail insurance 14

15 pricing, investigating the formation of a Captive Insurance Company is an option worth exploring. Whether it s a Traditional, Captive or other Alternative arrangement, the answer is always the same: informed buyers consistently pay lower prices. To take a closer look at the possibilities and optimize your position, contact us now. 15