Captive Strategies: Enhancing Value and Ensuring Compliance
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1 Captive Strategies: Enhancing Value and Ensuring Compliance
2 The Benefits of Diversification and the Need for Compliance Owners of captive insurance entities recognize the value that a captive can bring to their strategies to manage and finance risk. The growing maturity of captives and their utilization as a risk management infrastructure to support a Corporation s risk management philosophy presents new challenges and opportunities. Amid increasing regulatory and market developments, businesses have an opportunity to diversify the risks placed in their captives, which can offer significant advantages for the captive owners. But businesses today also face challenges in ensuring that their captive programs comply with burgeoning regulatory requirements. This white paper, from Zurich in North America, explores these challenges as well as the opportunities for businesses to enhance the value of their captive insurance company. Risk Diversification: An Important Strategy to Enhance Value Opportunities to include more risks in a captive are increasing. Opportunities to include more risks in a captive are increasing. A growing number of captive owners are considering adding employee benefit risks to their captives; others see ways to support various business relationships through captive-provided or enhanced coverage for suppliers, customers or contractual partners, while still others are looking at captives for emerging or difficult-to-insure risks. Using a captive entity to cover business partners, suppliers, franchisees and even customers can offer a range of advantages, including: Differentiation of the captive owner. Product enhancement. Strengthening of existing relationships. Provide assurances that proper coverages are in place. Acquisition of new partners and customers. Tax-efficient risk financing. Reduced volatility in the cost of risk transfer. TOTAL CAPTIVES WORLDWIDE 5,587 5,525 5,211 5,119 4,951 5,831 6,125 6,342 Similarly, using a captive to insure retentions or to fund emerging risks, such as cyber liability or supply chain risks, can be costeffective and advantageous to obtaining coverage or enhancing terms and conditions. Terrorism risks are another example where some businesses have used captives to provide coverage as some businesses struggle to obtain desired amounts of affordable capacity in the commercial insurance market. In those situations, using a captive to insure working-layer risks or to retain more risk can help, by raising the attachment point of available excess coverage and/or reducing the amount of coverage purchased in the open market Source: Business Insurance, March Used with permission 1 Captive Strategies: Enhancing Value and Ensuring Compliance
3 Gaining Momentum Property and casualty risks represent the majority of risks insured through captives in the United States. Insuring employee benefit risks for U.S. active and retired employees through captives is gaining momentum, however, in the wake of several developments¹ In March 2013, The Coca-Cola Co. obtained permission from the federal Department of Labor to reinsure life insurance and accidental death and dismemberment benefits through the company s South Carolina-domiciled captive, Red Re Inc. Early in 2014, Santa Clara, Calif.-based Intel Corp. won approval to fund life insurance and AD&D benefits using Intel s Hawaii-based captive, Technology Assurance Ltd. Also increasing the momentum for employers was the revival of the Department of Labor s fast-track approval program for applications to fund benefit risks through captives. The department had halted the expedited process, known as ExPro, in 2012 pending review of the criteria for approval. In 2014, the Labor Department announced it would resume ExPro. Interest in insuring benefit risks is increasing, with significant room to grow among existing captive owners. The Captive Insurance Companies Association s 14th Annual Captive Market Study in 2014 identified the top benefit risks insured through captives². Those benefit risks now being written by captive respondents to the study include: Medical stop-loss, cited by 12%. Disability Life, 5.3%. Life, 5.3%. Accident and health, 4.5%. Regardless of what kinds of risks reside in a captive, it is important for captive owners to understand their risk portfolio, to protect against adverse accumulations of risk in the captive and to set loss reserves accordingly. Source: Captive Insurance Companies Association 14th Annual Captive Market Study, March 2014 Used with permission Diversifying the sources of risk is not necessarily the same as managing risk correlation. For example, a captive owner that insures liability risks for its subsidiaries and offers liability coverage to key suppliers or distributors might face an unexpectedly large aggregation of liability exposure. True diversification of a captive s portfolio should seek to include different types of non-correlated risks, not just varying levels of anticipated losses. 2 Captive Strategies: Enhancing Value and Ensuring Compliance
4 Questions to ask about diversification To help captive owners decide whether risk diversification could make sense, owners should consider: What risks are currently covered by the captive program? What would a full-limit loss on any of those risks look like for the captive? What risks are self-funded outside the captive (e.g. on the corporate balance sheet)? What is the owner s tolerance for retaining risks where commercial coverage is available? A diverse risk portfolio holds several potential advantages for owners of captive insurance entities: Improved returns. Much like any investment, diversifying improves the chances of making higher returns over the long term. A broad underwriting mix offers captive owners the opportunity to offset losses. Avoidance of risk accumulations. Writing too much of the same kinds of risk in a captive can accumulate loss exposure. Even with actuarially determined premiums, an accumulation of similar risks could strain the capital base of the captive. A natural form of arbitrage. Captives that handle property/casualty and benefit risks also offer their owners greater flexibility in financing retentions, working-layer risks and deploying capital to support the owner s strategic objectives. Risk diversification through a captive offers a natural form of arbitrage against differences in risk transfer pricing and capacity. Access to reinsurance. Captives also have the ability to seek external reinsurance, to support needs for either increased protection as necessary or to take advantage of insurance market cycles. Case study: Diversification A growing global manufacturer with ancillary chemical operations has a captive program that supports the company s risk management philosophy of risk retention and loss control. This company further benefits from a deliberate strategy of risk diversification to better position the captive for long-term growth and stability. The corporation assumes significant risk and exposure into its captive insurer with a global property program and global general and product liability. While the global property program provides a spread of risk around the world and offers a diverse portfolio against natural disasters, potential short-term losses can be unpredictable. Assuming global general and product liability risks provides the captive with a longerterm and more predictable risk profile and works well to supplement more volatile property coverages. The general and product liability of the global manufacturing operations create a long-term and very predictable risk and exposure profile. Inclusion of the chemical operations, while slightly more hazardous, provides increased premium funding to the captive and a longer-term exposure profile, offset by the manufacturing profile. The corporation has included global employee benefits (employee life and long-term disability) in the captive program, which is generally not correlated with the property and casualty exposure noted above and is long-term and very predictable. Additionally, the corporation is considering using its captive for risk retention in its political risk program. While political risk could be highly volatile, it is very low frequency and generally not correlated with other risks, allowing for potential increased funding to the captive. 3 Captive Strategies: Enhancing Value and Ensuring Compliance
5 Compliance: A Challenge and a Necessity Insurance companies face a multitude of regulatory jurisdictions, both inside and outside the United States. Businesses also are seeing increasing controls as regulatory authorities scrutinize captive arrangements. These controls affect operational issues ranging from captive structures to collateral to policy administration. Amid heightened regulatory oversight, compliance requirements can be complex for corporate captives, especially those writing risks in many different jurisdictions. Indeed, the Captive Insurance Companies Association s 14th Annual Captive Market Study³ found that the top five challenges of owning a captive are: Regulatory issues. Ongoing justification to management of the benefits of a captive. Collateral. Low interest rates. Tax. For all insurance companies, meeting regulatory capital and surplus requirements is a mission-critical activity. For all insurance companies, meeting regulatory capital and surplus requirements is a mission-critical activity. Failure to maintain an adequate capital base carries a range of consequences. One is that the owner s financial goals may be unmet and losses may not be fully funded. Unpaid losses, whether from a captive or a commercial insurance market partner, can severely constrain a business ability to operate, let alone achieve growth targets. Other serious consequences arising from the depletion of capital or impairment of surplus due to loss or inadequate reserves are rating downgrades of creditworthiness and financial strength. More severe consequences can include regulatory intervention and seizure of the insurance entity. Regulations typically require certain lines of business, such as workers compensation, to use a fronting arrangement if the risks are going to be placed in a captive program. In such an arrangement, a fronting carrier issues the paper on the coverage and serves as a guarantor of the risk. The fronting carrier is legally and financially responsible to pay the claims even if captive is unable to pay the claims. A captive using a fronting arrangement will assume some portion of the risk as a reinsurer; the risk ultimately passes through the fronting carrier to the captive. While there may be tax benefits and many compliance considerations for captives, the 2014 Captive Benchmarking Report by Marsh surveyed more than 1,100 captives and found that only one-third of owners treat U.S. captives as insurance companies for federal income tax purposes. 4 Marsh s findings suggest that the vast majority of corporations utilize captives to create operational and risk management value. 4 Captive Strategies: Enhancing Value and Ensuring Compliance
6 Tax Compliance Regardless of the reasons that a corporation may form a captive program, tax compliance can be particularly complex. Owners are strongly advised to seek the advice of qualified tax professionals on captive taxation issues. Compliance with premium taxes and other fees and assessments on locally issued policies is an area where a global insurance partner can help captive owners. In a fronting arrangement, the carrier assumes responsibility for ensuring compliance with local policy premium tax and insurance regulations. Insurance programs may also be be subject to selfprocurement taxes and/or non-admitted charges on policies issued to the captive owner. Consequences of noncompliance with premium tax requirements vary by regulatory jurisdiction but can include financial penalties and loss of operating authority. Captive owners should consult with their insurance partners to address compliance questions. Case study: Compliance For a growing global manufacturer with ancillary chemical operations, managing risks and exposures around the world is not a simple matter. Coordinating coverage in a complex environment takes the focus and dedication of a global team, with experience and coordinated efforts to ensure that desired coverages are complete. With the company growing organically outside the United States, in some emerging markets and still-developing countries it also is growing through small acquisitions. Many of the acquired entities previously had local insurance programs that were neither coordinated nor correlated. Even in large organizations, often some smaller international units oppose taking large retentions typically required by the corporation s financial and risk management team. That situation is perfect for a captive program with a compliant policy issuance infrastructure. For example, the manufacturer s smaller international entities can take a lower deductible on locally compliant policies issued by Zurich as part of a coordinated multinational program. For the manufacturer, this approach encompasses approximately 25 countries, where separate policies may be issued for the chemical units with higher local deductibles, but still not as high as the corporation s desired retention. Above the local deductibles, the risk and premium are ceded to the captive, where the corporation takes a larger retention, bringing all those small deductibles up to a more sizable corporate retention. Variability of risk retentions by country and by operating entity are evened out in the captive. All local policies are issued by Zurich with locally compliant, admitted coverage in all countries. Premium collection is achieved locally with the necessary funding of the risk retention flowing through to the captive and included excess and aggregate protection premiums, which are then paid to Zurich as the insurance company providing such coverages. This is a good example of partnering with a knowledgeable, global insurance partner to solve complex international coverage challenges with utilization of a captive while fully 5 Captive Strategies: Enhancing Value and Ensuring Compliance
7 meeting the corporation s risk retention goals. Choosing a Partner: Look for Knowledge and Experience Corporations seeking an insurance partner for their captive arrangements have choices. Some criteria to consider when choosing a partner include: Expertise in captives. Many insurance companies may say they support alternative risk transfer arrangements, but not all have the same tenure in working with clients to build successful captive programs. Look for a partner that has a track record of experience working with different kinds of captives single-parent captives, group captives and other alternative structures. Experience in a multitude of regulatory jurisdictions. A partner s global reach can help to provide advice and service wherever needed, to support a captive owner s business objectives. Such a partner can help captive owners to face the challenge of regulatory compliance. A commitment to managing different kinds of risks. Seek an insurance company partner that constantly strives to better understand and assess risk. A strong underwriting and claims culture can provide strategic advantages to captive owners, who may have relatively little experience in selecting risks and managing claims. A partner whose own risk portfolio is diverse is better able to help captive owners realize the benefits of risk diversification. A focus on data and analytics. Maintenance, organization and sharing of data are important to understand the cost of risk, and providing analytics on risk data is critical to assuming risks intelligently. Partners that invest in analytics can help captive owners to understand their own data and make better-informed risk financing decisions. Financial strength. Not every business requires a fronting company partner for its captive operations, but financial strength is an important quality in any captive partner. A strong balance sheet is a good indicator of a partner s ability to handle risk and be there for the long term. 6 Captive Strategies: Enhancing Value and Ensuring Compliance
8 Zurich can help any kind of captive enhance value and ensure compliance. For over 20 years, Zurich in North America s Captive Services professionals have helped corporations enhance the risk management value of their captives with access to a vast portfolio of solutions and consultative services. Today, we provide tools to help organizations with even the most complex captive arrangements deal more effectively with a changing world, including leading-edge enterprise risk management (ERM) tools and global employee benefits. Our capabilities range from award-winning fronting services to helping customers use captives for the financing of global employee benefits programs. Zurich truly can help you unlock the risk management potential of your captive, whether it s a conventional single-parent entity or a more specialized group, agency or program captive. Zurich Captive Services Contacts Single-Parent Captives Agency, Association and Steve Bauman SPC Captives Senior Vice President Pam Bryan Head of Captive Services Vice President, Captives Zurich Global Corporate in Zurich Programs & Direct Markets North America pam.bryan@zurichna.com steve.bauman@zurichna.com Group Captives Corporate Life & Pensions Catherine Komaromy Wendy Liu, FSA Vice President, Captives Global Partnership Director Zurich Global Corporate in Corporate Life & Pensions North America Zurich Global Life catherine.komaromy@zurichna.com wendy.liu@zurichna.com For more information, visit: zurichna.com/captives References and footnotes 1 Business Insurance, April 9, 2014, 2 Captive Insurance Companies Association 2014 Captive Insurance Market Study, March Ibid 4 Marsh USA, April Captives-50-Years-Later.aspx About this report Captive Strategies: Enhancing Value and Ensuring Compliance was produced for Zurich by BI Custom Media Group, and written by Regis Coccia of Wordsmith Strategic Communications LLC. CUSTOM MEDIA GROUP 7 Captive Strategies: Enhancing Value and Ensuring Compliance
9 Zurich 1400 American Lane, Schaumburg, Illinois The information in this publication was compiled from sources believed to be reliable for informational purposes only. Zurich neither endorses nor rejects the recommendations of the discussion presented. All sample procedures herein should serve as a guideline, which you can use to create your own policies and procedures. We trust that you will customize these samples to reflect your own operations and believe that these samples may serve as a helpful platform for this endeavor. Any and all information contained herein is not intended to constitute legal advice and accordingly, you should consult with your own attorneys when developing programs and policies. We do not guarantee the accuracy of this information or any results and further assume no liability in connection with this publication and sample policies and procedures, including any information, methods or safety suggestions contained herein Zurich American Insurance Company
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