During the past few months, I have been traveling and delivering Powered by SIGMA training to brokers and agents across the country. The training has been extremely well received and always generates some great follow up questions for me to address. One frequent topic concerns captives. Specifically, I am asked “what type of client might benefit from a captive?” Also, if a decision is made to establish a captive, “What is the process for setting up a captive?”
I also am asked about group captives, but I am going to leave that topic for another blog. Today, I want to address the more traditional captive option. Here, at SIGMA, we are fortunate to work with many captive managers both in the United States and in foreign domiciles. I wanted to interview one of these “experts” to fully address these two questions so I spoke with Jim Girardin, Managing Director at Amethyst Captive Insurance Solutions. The results of our conversation were very informative and resulted in us designing a couple of new documents (we call them “assets”) for the Powered by SIGMA portal.
Below is my conversation with Jim. This conversation started with a visit to their Vermont office and continued through email and phone discussions. I have edited it for purposes of tying all the information together. The “assets” will be posted to the portal in the weeks ahead as we finish them. Everyone who has registered SIGMA's blog (RiskManagementBlog.com) will be notified.
Question 1: What general guidelines could a broker use to identify who might benefit from a captive?
Most often, organizations have their own unique set of circumstances driving the decision about whether or not to form or consider forming a wholly-owned captive insurance company.
The “traditional” captive option is a wholly-owned insurance company licensed as part of a holding company structure insuring primarily the commercial risks of the parent company and affiliates. There are other non-group captive structures such as cell companies (sponsored, protected, series), special purpose (financial, variable interest entities, others) agency and producer-owned captives that also fit into the captive model.
Typically, a captive should improve the overall capital, financial or economic position of the broader sponsoring owner organization. In this regard, forming a captive is a capital decision and as such, the captive option should return a greater economic benefit when compared to viable competing alternatives. For example, one of the most common alternative scenarios is simply paying losses/claims from parent & affiliate cash flow and carrying retained reserves on the balance sheet(s).
Our firm, Amethyst, recommends clients perform a proper feasibility study that can bear out the economics; the financial impact; and the qualitative impact on the overall insurance & risk finance program. A summary of the pros and cons of a captive insurance structure is usually very helpful. A feasibility study need not be made overly complicated when the pro’s so outweigh the con’s a professional captive consultant can scratch out the big picture analysis on the back of the proverbial napkin.
Generally speaking, companies that form and own a captive over the long term report fairly common characteristics. Formation drivers can be summarized along a few basic lines or “typical” major themes. Bearing in mind at all times the decision to form a captive is a capital transaction with three important features.
- Formation and ownership of a pure captive, in most cases, involves issuing stock or a mutual ownership interest in exchange for assets and the establishment of all attendant corporate organizational features. Organizations can participate in cell or rent-a-captive structures to minimize captive ownership burden;
- The captive owner and affiliates will pre-fund some portion of projected net retained losses PLUS the operating costs of running the captive structure;
- The captive insurance company is a regulated entity and must adhere to certain statutory operating and reporting compliance requirements of the licensing domicile.
The licensing domicile regulator is not always the only master. Other regulating authorities may have an interest in how the captive is operating including tax departments, state departments of labor (for certain QSI workers compensation\captive structures), claims funds, rating agency(ies), public rate setting boards for utilities, and others depending on compulsory/statutorily mandated covers or participation in certain publicly funded or regulated programs at local, state or Federal level. Like HUD for homeowners warranty insurance or EPA to meet OPA financial responsibility for oil tankers, and so on.
Also, the captives Board of Directors and Officers will need to take measures to ensure the captive is operating within the parent compliance and quality framework. Our firm provides guidance and complete array of compliance and statutory services embedded in our daily captive insurance management procedures.
Question 2: Typically, what are the major drivers that push a firm towards a captive?
There are no hard and fast equations when a captive makes sense but there are some practical “rules of thumb” and certain operating conditions that may favor captive ownership.
Operating conditions that favor captive ownership include profitable operations, strong cash flow, good credit or favorable borrowing and cost of capital rates, familiarity and comfort with self-insurance, progressive firm culture committed to risk management including safety, loss prevention, loss mitigation, safeguards and quality practices embedded in business decision making processes.
Adherence to firm and industry quality assurance standards coupled with cutting edge technologies and on-going mandatory minimum continuing education programs. For example, these activities can be especially beneficial to law firms, accounting firms, architects, healthcare entities and other professional firms to help mitigate professional errors and omissions claims. These measures should help bring long-term stability to the retained loss layer(s) and the loss layer(s) insured in the market.
So, typically when a firm has grown to the point of i) possessing the financial wherewithal to take on larger layers and amounts of self-insured risk and ii) has committed firm resources to manage risk then typically the one last factor to push serious consideration of a captive is the condition of the traditional insurance market.
When traditional insurance markets fail to meet the needs of medium, large or group(s) of organizations the timing may be right for considering a captive. Failure by the traditional markets is usually characterized by inability to meet financial and coverage needs usually along the lines of price, services, terms, and capacity.
Question 3: At what size risk management budget, should a firm begin considering a captive?
Of course, like any captive decision, it depends. The nature of the risk, the projected loss outlook, financial strength, tax and ownership profile all factor into captive ownership planning. But, generally speaking, when a firm is spending at least $600k-$750k in premiums (lower if loss experience is very favorable) a long term self-retained loss strategy may start making sense using a captive structure.
At a very high level there are three basic captive risk assumption strategies i) a retained funded strategy or ii) partial retained and partial reinsured strategy or iii) a direct writing captive and fully reinsured strategy.
Increasing loss costs in the working or deductible layers
The primary driver of captive formations is a growing loss exposure base accompanied by actual claims and losses or expected increased claims in the working or deductible layers. Most captive owners are growing organizations with premiums in excess of $750k to $1m that are considering taking on larger self-insured loss layers. The average size captive writes approximately $3.5M annual premium, of course this statistic contains premiums from many of the largest organizations.
As insurance costs become more substantial on a line item basis, organizations start asking questions like:
- How can we hold costs flatter as our top line grows?
- What can we do better to minimize risk of loss and thereby improve our loss profile in the insurance marketplace?
- Is there a more efficient way to finance our claims / losses and achieve the same or improved insurance coverage outcome?
Drivers of Captive Formation
Increased or increasing retained casualty losses and loss expectancy costs especially for long-tailed classes of risk whose loss outcome can be influenced by risk management activities. Covers such as workers compensation and employers liability, general liability, professional liability (medical malpractice, legal, accountants, other E&O), products and completed operations, large deductibles of nearly any kind such as products liability for a pharmaceutical company, property coverage, extended warranty, customer risks, credit risk, marine cargo and transport, hull and aviation, compulsory and forced place insurance, statutory workers compensation for PEO’s, environmental and many others.
Question 4: Why do long-tailed classes of risk seem to work best for captives?
When evaluating the feasibility of a captive structure the longer the time lag between establishing initial loss reserves (IBNR and Case Reserves) and actual claim(s) payment the more opportunity there is to extract economic value from the transaction, especially if a firm can deduct loss reserves currently for both financial and tax purposes (albeit on a discounted basis). Furthermore, longer tailed risks can be influenced positively by risk management efforts providing an opportunity for a firm to return higher than average investment income thereby further lowering the overall long term cost of risk to the firm.
- Increased severity, loss exposure and loss expectancy costs especially for property, environmental, products, professional liability, workers compensation, terror (non-NBCR), and many others. It is common for captive structures to be formed to access the upper or catastrophic layers of coverage offered by reinsurers/panels of reinsurers and alternative risk capital markets.
- Traditional premium pricing volatility or increasing premium rates. Captive owners typically start self-insuring more risk because they believe their own loss experience is not being fairly factored into the traditional risk transfer charge for premiums.Most commonly, organizations that have committed to adhere to excellent process and procedure with an eye toward quality product, quality process, and quality safety practices will have a profile to support the notion of their own projected loss outcomes beating the market per se. Of course, a quality consulting actuary is an essential adviser in evaluating this piece of the risk finance puzzle.
- Lack of cover or unavailability of commercial coverage for certain classes of risk especially for certain casualty and liability lines. To the extent stressed classes can find coverage it will often be accompanied by predatory pricing by the few carrier(s) remaining in the market. Examples from recent market cycles include; long term care operators, contractors, physicians, hospital professional liability, attorneys, accountants and others.
Question 5: Typically, what benefits are reported by captive insurance company owners?
Stabilize pricing and reduce dependence on commercial insurance marketplace by taking on reasonably predictable loss layers (when viewed over the long term) of the insured’s own loss profile. In contrast to the traditional market carrier setting rates for the broader class of risk while not fully crediting the insured for their own positive (long-term) loss experience.
Reduce risk management costs and generate cash flow benefits– By retaining more risk, especially in the working/burning layers, and redirecting premiums into an owned captive the insured can potentially realize immediate savings by removing the traditional insurance carriers frictional costs of administration, marketing, sales commissions, and profits built into the premium rating (which is usually about 40%-45% of the premium charge). These savings are partially offset by the cost of administering the captive and exposure to more uncertainty with respect to retained claims and losses.
Also, a captive is in a better position to immediately reap the rewards of underwriting profit and investment income which is often highly correlated to risk management influence. Many medium to large sized organizations are already handling a large volume of self-insured losses using the balance sheet and current cash flow. A properly structured captive can potentially generate substantial positive cash flow benefits by redirecting self-insured funding through the captive structure.
Direct access to reinsurance/capital markets - While an insured can secure higher limits by purchasing direct excess coverage there are many reinsurance facilities/markets that deal only with licensed insurance companies, like a captive. These markets can expand otherwise unavailable insurance capacity to the insured firm. Reinsurance provides opportunities for broadened coverage; access to capital market products and represents another possible cost savings stream by eliminating the frictional costs of the insurance carrier (who buys higher limits from these same reinsurers).
There are barriers to entering the reinsurance markets in the form of minimum volumes of ceded reinsurance premium. Buying/accessing reinsurance is a question of feasibility for smaller/medium sized firms with premiums less than $1M or just getting started. There are very few reinsurance facilities that allow access without an intermediary, and typically minimum ceded reinsurance premium volume plus fees that exceed at least $200k annually, depending on many factors beyond the scope of this blog point.
Increased control over services and enhanced senior management awareness- Firms do not have to form a captive to unbundle risk management services but the captive does become a centralized entity platform to launch many of the firm's risk management programs and attendant services.
A captive is free to establish and handle its own claims processes, underwriting procedures and policy coverage and design thereby aligning the firm's broader culture into the captive's operations. Regular corporate governance and reporting procedures force the captive's Directors and Officers to stay involved and aware of the captive risk finance results and creates continuous planning opportunities for improvements on a regular and consistent basis.
Regulatory and tax advantages- Income tax and other tax savings may be achieved if the capital ownership and transaction flows are properly structured. If a firm can deduct current premiums paid to the captive while the captive currently deducts accumulated loss reserves (discounted) then an accelerated tax timing advantage will arise if the firm is not in a net operating loss position. The value of the current deduction depends on the line of business, the size of the loss reserve balance(s), projected premiums and loss volume and finally the actuarial determination of liability tail or payout duration.
There are potentially very favorable income tax advantages available to small insurance companies. This section of the Internal Revenue Code has been in existence for many years but there has been a rather large bump in the prevalence of usage of the small insurance company section 831(b) election over the last ten years. This very powerful tax advantaged structure requires the captive to “qualify” as an insurance company for tax purposes and write premiums at no more than $1.2M. There are pro’s and con’s to the election which should be reviewed thoroughly when planning to make the election.
Net income is not taxed by any of the domestic states as well as many of the non-EU qualified offshore domiciles like Bermuda, Cayman, Barbados, USVI, Guernsey, IOM. In lieu of income tax the states collect premium taxes in many of the most popular domestic domiciles like Vermont, South Carolina, Hawaii for local risks, Delaware, Washington DC, Montana, Utah, Nevada and Kentucky. Foreign domiciled captives are subject to excise tax (1% or 4%) or income tax if the captive is a Controlled Foreign Company with a 953(d) election to be taxed as a US company. Absent this election the controlled foreign captive will be minimally subject to SubPart F indirect taxation provisions of the US Tax Code, as well as a panel of other possible taxation schemes not in the scope of this blog point. Amethyst is not a tax adviser and recommends all clients considering captive ownership consult with appropriate qualified tax counsel.
Question 6: What non-typical situations have you seen that have brought about the formation of a captive?
We have only discussed "general" rules of thumb but there are many examples of captive formations driven by sudden changes in firm operating environments, both internal and external factors.
History is riddled with captive formations in specialty classes of insurance and one-off type covers, a few recent examples include mortgage default risk (commonly known as "PMI") reinsurance when RESPA authorities determined mortgage originators and servicing agents can accept reinsurance premium in exchange for some portion of the risk. This allowed the loan originators to earn more than the 30% commission caps imposed in most states on the sale of PMI.
Also, direct writing captives formed or expanded in response to the Terror Risk Insurance Act in 2002, now extended and reauthorized through 2014. Firms with large concentrations of risk (property and life) in high risk targeted areas have found it strategically necessary to avail themselves of the coverage afforded by the TRIA Federal backstop.
Captives are being formed to reinsure so-called redundant NAIC statutory XXX and A-XXX loss reserves for traditional life insurance companies.
Captives are being more widely used to insure and reinsure (life, long term disability, health, deferred compensation, retiree medical being discussed) their owners/employers benefit plans. Employee benefits cost savings can be substantial compared to the typical property and casualty risks, but also carry a higher degree of diligence and oversight especially when the risks are qualified plans under the purview of the ERISA and the US Department of Labor.
In each of these non-typical examples of captive formation there was a particular market circumstance whereby the captive owner was able to strategically improve their sponsor-owners capital position.
Question 7: If a broker wants to dig deeper, but isn't yet ready to engage a captive manager, is there an assessment tool or process they can go through themselves?
Yes, the broker can do one of two things i) use Amethyst high level captive Q&A decision tool to see if a captive makes sense for your organization at a very high level or ii) call us at 802-735-1682 and one of our professional staff will walk through the client profile with the broker to determine the next recommended course of action.
Many times the best, first course of action should be one of the following:
- Hire your captive adviser
- Hire your actuary
- Consult with a qualified tax adviser
- Check with your broker to see if the traditional or alternative market can sharpen its pencil
These activities will most often occur simultaneously once we have gotten through Phase 1 basic question, “Does This Make Sense?” If the broker goes to our website at www.acisvt.com/, under the services tab there are various feasibility, checkup and new captive analysis downloadable tools available for use.
Question 8: When a broker engages Amethyst with their client, what is the process for completing the feasibility study and setting up the captive?
We approach the feasibility in a straight forward three phase manner. Amethyst's website, www.acisvt.com, contains guidance highlighting detailed feasibility steps, mature captive check-up, detailed management services and steps in formation of a captive.
If done properly the pre-feasibility stage is the best time to identify and highlight the potential strategic value of a captive structure. For midsize closely-held organizations, ownership and transaction planning can produce quite meaningful and significant financial advantages for its owners, whether closely-held or public companies.
Phase 1 of a captive feasibility is high level with the goal to determine if looking closer at a captive structure makes sense. We profile the opportunity by identifying the relevant risk and ownership structure of the organization. We will recommend, if asked, appropriate expert partners to work through the high level evaluation with the client. These partners may be actuarial, tax, brokerage, and client internal key finance, legal, and risk management resources. Usually Phase 1 can be completed with a few phone calls and review of high level data.
Phase 1 may result in a recommendation to perform a loss reserve and loss projection study by a consulting actuary, like SIGMA. Tax profile and insurance market options should be fairly well determined prior to Phase 2 which is the more detailed feasibility analysis. This eliminates unnecessary time wasting for all involved.
A firm in a rapidly changing internal or external operating condition (regulatory change, operational developments, M&A or spin-off plans) may need to make an assessment because the firm’s exposure to loss has changed or is planned to change and risk management is trying to determine the most efficient risk finance structure with or without a captive. Sometimes the decision to proceed is very obvious and we need only spend just enough time and review diligence to identify the cautionary formation decision matters.
Phase 2 and Phase 3 of the study are the detailed assessment stages. Stage 2 requires creating and executing a plan to coordinate activities of the resource team, gathering and disseminating key data, assembling and modeling relevant financial and insurance program data and providing an executive summary for presentation to the client/owner decision makers.
Captive Set-Up and Management
The Amethyst professional team has nearly 40 years of combined captive formation and management service experience. Each client is approached as a unique opportunity to create a team based value added service. We not only bring a highly technical and competent staff to the fore but have some unique differentiating characteristics including performance based management agreements, secure client log-in area for client access to key data, reports, planning tools and corporate compliance and governance status reports.
Detailed steps in formation and development of a new captive depend on the specific chosen domicile but we can drill down these steps into major common themes and timelines.
Once a client decides to form a captive it takes approximately 6 weeks (on average) for a motivated and organized owner to obtain the license and commence operations. Our professional staff has been involved in formations taking as little as 2 weeks but a scenario like this is highly unusual. Generally, completing the application procedures takes 2 weeks assuming the client hired qualified local legal counsel at the outset.
We then allow 4 weeks for the outside or internal domicile review. If timed properly the approval and sign-off can be returned in as little as one week especially in offshore domiciles like Cayman or Bermuda as submissions are reviewed through a regular meeting schedule of the local governing authority(ies).
Applications for licensure as a captive will require:
- Preliminary meeting with the domicile regulator and the captive/owner principals, the licensed captive manager, and the local legal counsel
- Reserving captive name with Secretary of State or similar domicile incorporating bodies
- Selection of Directors and Officers (subject to background checks and submission of biographical affidavits)
- Completion of an application and/or a business plan detailing all relevant capitalization, underwriting, five year pro-forma financials, reinsurance (assumed and ceded), collateral, investment plans and any other data deemed relevant to inform the regulator and aid in understanding the captive program
- Supporting actuarial loss study and loss projection data
- Drafted and sometimes finalized corporate governance and organization documents such as Articles & Bylaws, ownership and key authorization details, and all relevant unique transactions requiring Board approvals
- Certain domiciles need a draft of the policy form and risk management plans with the application
- Some captives have such unique operational goals that additional operating information should be submitted in the spirit of fostering open and honest dialogue with the regulators office
I appreciate the time Jim spent responding to our questions. I hope this “conversation” has been helpful to our blog readers.
Powered by SIGMA Assets resulting from this conversation are listed below and will be discussed in detail in future blogs.
- An assessment tool similar to our Powered By SIGMA Actuarial Assessment tool
- Outline for the formation of a captive
If you haven't already, please take a minute to register for our free resource portal at www.SIGMAactuary.com/education.
We welcome your feedback by posting a comment, or contact Tim at TLC@SIGMAactuary.com.
© 2012 SIGMA Actuarial Consulting Group, Inc.