Issues and Opportunities for Captive Insurance Companies: Part I

Overview of Captives

A captive insurance company is essentially a non-public insurance company that writes limited risks, generally those of its owner(s) and related parties. It is a flexible and customizable strategic complement to a company's use of third party insurance companies.

There are several types of "captives," including parent-owned, group, "cell" and rent-a-captives, and risk retention groups. Each insures risks only of a selected or restricted group of insureds. This limitation distinguishes captives from commercial insurers, which offer their insurance capacity to the public at large.

Why consider a captive? First, a captive allows management to adapt to changes in the commercial insurance market and to changes in the company's business, risk appetite, loss history, budgetary constraints, etc. A captive only insures the risks its owner(s) want it to take, and none others. Those decisions can be changed as the business environment changes.

Second, the pricing and availability of insurance in the commercial market go through notoriously erratic cycles, the so-called "hard" and "soft" markets. This "yin and yang" of insurance procurement creates havoc with budgeting, internal cost allocations and program predictability. A captive can minimize volatility and, properly structured, can do so in a cost- and tax-efficient manner.

Below, we review the business opportunities related to captives, as well as operational issues and new markets where organizations are beginning to take advantage of captives.

Understanding the Business Opportunities

A captive enables company management to constantly reassess its risk appetite, deciding the type and amount of risks to transfer to the commercial markets and those to retain within the corporate organization.

Captives provide additional business benefits, too. For example, a captive can directly access the reinsurance markets, with benefits that can include increased potential capacity, pricing, coverage benefits, and reduced exclusions. Access to reinsurers also permits the captive to manage its own risks and cap the internal economic exposure of the captive itself. A reinsurance carrier is not licensed to write direct (or "retail") insurance, but must only insure/reinsure risks originally written by another insurance company. Having direct access to this significant class of additional capacity and coverage can be quite beneficial.

A captive insurance company also enables businesses to centralize management of and accountability for their insurance program. In very decentralized corporate structures, there may not be full integration of purchasing or consistency in terms, conditions and definitions in various insurance policies. In these cases, a captive could ensure not only that the retained risks are centrally managed, but also that the policies themselves are not inconsistent or in conflict in terms of coverage, definitions, exclusions, etc., or otherwise leave unexpected "gaps" in coverage.

Captive insurance companies can also take advantage of their inherent flexibility to adapt to changes in circumstances or market conditions. Management may adjust use of the captive, depending on the pricing and availability of commercial insurance, or on whether the enterprise has had a significant adverse – or favorable – loss history from which it expects financial consequences in the commercial markets upon renewal.

Captives may also take on risk in the excess layers. Analysis of the exposures in such situations, and the likelihood of payment by the captive, must be undertaken on a case-by-case basis. If a significant excess layer risk is to be written and retained by the captive, the regulators will likely insist on reviewing, and possibly increasing, the capital of the captive in order to ensure it has adequate resources. The cost of this capital contribution must be carefully evaluated in light of the role and reasons for writing the excess layer(s). But, as with all other risks written by the captive, each year and policy stands on its own, so the company can change its use of the captive from risk to risk, and layer to layer, as required.

Location and Operations

Domicile (where the captive is incorporated and licensed) is a significant business issue. Captives may be domiciled in the United States or outside the United States. Relevant factors include, but are not limited to, cost issues, the types of risks to be written by the captive, licensing and disclosure information, annual reporting costs and complexity, and certain other specific constraints on domicile selection (such as employee benefits captives or U.S. terrorism captives). There are also significant U.S. tax implications to the decision.

Domicile regulators generally are focused on protecting the rights and expectations of the insureds, even if they are related to the captive. In this way, the regulators act in loco parentis. However, given past examples of abuses involving captives, regulators are also concerned with protecting the reputation of their domicile. There have been examples of captives that have been declared insolvent because of either mismanagement or inadequate capitalization, and it is likely that domicile regulators will be far more attentive to the financial condition, loss experience and investments of the captives than in the past.

Not only are the risks to be priced and the captives generally managed on an arm's length basis, there are also annual reports to be filed with regulators in virtually all domiciles, including, usually, audited financial statements and an actuarial certification by an independent actuary. The latter is generally required to assure the regulators that the captive has adequate assets to meet the expected risks and losses that are projected based on the information available as of the date of the report.

In terms of formation and operation, captives require the support and understanding of both the insurance/risk management department and the tax department before they can attract attention of senior management, especially finance. Both departments need to understand how captives work, how they fit into the company's planning and economics, as well as the benefits and the issues to be resolved. These days, tax department needs to understand especially the tax risks of certain structures and captive arrangements in light of recent IRS (and even Congressional) activity. Ultimately, other corporate functions also become fully involved in captive projects and implementation, such as accounting, finance/treasury, operations, and – in the case of employee benefits captives – HR. Then there are the insurance brokers, outside audit firm and independent actuary, all of whom have significant roles to play.

In short, captives are run as a business, have their own rules of administration and reporting, and require an array of internal and external business resources to be successful.

Other Uses of Captives

In addition to the more conventional uses of captives, such as worker's compensation, auto liability and general liability policies, etc., captives have also been used recently in the warranty and employee benefits areas.

With respect to warranties, properly structured, a product or service warranty provided by the manufacturer to its customers can constitute third-party risk, such that amounts received by the captive under that type of warranty program may enable the taxpayer to qualify even its own parent's premium payments as deductible for federal income tax purposes. This can occur despite the fact that many states do not consider such manufacturer's warranties as "insurance" and do not regulate it as such.

Employee benefits captives are among the newer uses of captives and provide an intersection between the federal tax rules and ERISA. In general, the concern is that the use of "plan assets" that are then made available to or paid to an employer-owned or controlled entity (e.g., the captive) could constitute a "prohibited transaction" under ERISA, thereby subjecting the violators to various penalties. Exemption from this exposure is available from the Department of Labor, and implementing an employee benefits captive requires counsel with experience in DOL matters, tax and captive insurance structures and issues. The benefits, however, are not just using those employee risks to qualify a parent's insurance deduction paid into its captive. There are also significant cash flow benefits and additional value to the employer and the employees.

Tax Issues

Part II of this series will focus on the tax and economic issues relating to the establishment and operation of captives. However, suffice it to say for now that after 28 years of controversy and uncertainty about the tax treatment of captive insurance arrangements, certain basic principles have been established that allow taxpayers and their advisors to structure captives with some confidence as to their tax consequences.

Summary

Captives are bona fide insurance companies that are licensed and regulated in the domiciles where they are registered. They are a sophisticated, flexible structure used as an integral part of a company's overall risk management program. Their use must be carefully coordinated with the strategy and coverage levels (as well as definitions and exclusions) of the company's commercial insurance program.

Their flexibility enables owners of captives to adjust to changing market conditions, their own loss history, their changing business needs, and the ubiquitous budgetary considerations. However, as in all tax-connected structures, care must be taken in the documentation of arm's length operation, pricing, funds flow, and formalization of contracts with respect to the captives. There are also a variety of federal and state income tax benefits from a properly structured captive arrangement.

There are a number of exit strategies available should a company decide to wind down, terminate, or substantially restrict or reduce the scope or use of its captive in the future. Generally speaking, given the complexity and cost of licensing as well as the implementation of a captive, it is not recommended that a captive be used for a one-off transaction or on a short term basis, but rather be considered as an integrated part of the company's longer term strategic risk management program.

One thing that is certain: the insurance market cycle will change in the future. Having a captive available enables companies to take advantage of insurance consolidation benefits, to react proactively and flexibly to changes in the commercial markets and their own business needs, and to take advantage of tax benefits and cash flow enhancements in a properly structured captive arrangement.