Any hard market prompts the formation of captives, and the current insurance industry environment is no exception. In fact, according to A.M. Best, 2002 was a record year for the formation of new captives, with over 460 companies created for a total of more than 4,500 captives worldwide.
To feed the interest in these alternative means of risk financing, Risk Management Magazine has coordinated a compilation of stories and perspectives for the curious risk manager. In this feature, Paul Smith answers the eleven most frequently asked questions about captives.
Bill Coffin talks with two risk managers who are at various stages of creating and using their own captive companies. And Scott Barry outlines the new risks that captives are being used to finance.
Risk Manager’s Top Eleven Captive FAQs
1. What is a captive?
A captive is an insurance company that is formed by a corporation to insure the risk of the owner and/or closely related third parties. A pure captive or single-parent captive has only one parent company and insures the loss exposures of that parent. An association captive or group captive has two or more parents, which are typically members of an industry trade association. Rent-a-captives deliver similar benefits without capitalization requirements or hands-on involvement in overseeing the captive program.
2. Why is there renewed interest in captives right now?
Most corporations are retaining more risk than they were three years ago either voluntarily, as they seek to avoid more expensive premiums, or involuntarily, as the insurance market forces them.
3. What are the benefits of a captive?
The primary benefits are financial. A captive allows its owner to capture the underwriting profits of a program when losses are lower than anticipated. The captive also earns investment income on premium dollars from the time they are paid into the captive until they are paid out to claimants.
A captive typically serves as a formal funding mechanism for deductibles or self-insured retentions, as well as for risks that are otherwise uninsured or uninsurable. By housing such risks in a captive, a company can smooth the impact of those events by paying a fixed, predetermined premium to the captive, rather than paying for losses as they occur or settle. In doing so, a company can smooth both cash flow and earnings impacts.
Besides the financial advantages, a captive can provide broader insurance coverage. Coverages excluded by insurance companies (mold, terrorism, construction defect) can be written into the captive policies.
Finally, a captive will increase the profile of risk financing within the company. The formation of this separate insurance entity with its own board of directors—typically comprised of senior legal, operating and financial officers—often serves to focus management’s attention on risk, which in turn leads to greater efforts to identify risks and reduce the frequency of claims.
4. Are there any disadvantages to captive formation?
Captives often involve greater risk assumption and any unanticipated losses become the captive’s responsibility. In such situations, an additional cash infusion from the captive’s owner may be necessary for the captive to remain solvent.
In addition to the insurance expenses of the program, a captive also has set-up costs (up to $100,000) and annual operating costs (roughly another $100,000). Some captives also involve extensive tax planning fees.
5. What are the annual operating costs of a captive?
The chart below shows estimates of the costs of operating the captive, excluding insurance program costs: The additional costs might include fronting, reinsurance, premium taxes and federal excise tax, which vary greatly by program. A company’s actual expenses will depend on the number of lines written in the captive and the amount of service required.
6. How much capitalization is required to start a captive?
Regulators will examine several solvency ratios to determine capitalization requirements, but a shorthand estimate involves the premium written in the captive. Foreign domiciles generally allow a captive to write $5 of premium for every $1 of capitalization, while domestic domiciles require a 3-to-1 premium to surplus ratio. For example, if a captive writes $15 million in premium, a foreign captive would require only $3 million in capitalization while a domestic captive would require $5 million. Usually, a minimum amount has to be in cash (from $120,000 to $250,000), while the balance can be in the form of a letter of credit.
| SERVICES | ESTIMATED COSTS |
| Captive Management | $30,000 to $60,000 |
| Audit | $10,000 to $20,000 |
| Actuarial | $5,000 to $25,000 |
| Legal | $0 to $10,000 |
| Domicile Fees | $5,000 to $15,000 |
| Miscellaneous | $10,000 to $20,000 |
| TOTAL | $60,000 to $150,000 |
7. What are the tax benefits of a captive? Are there tax advantages to going offshore?
If a captive is considered an insurance company for federal tax purposes, it can deduct the present value of its unpaid loss reserve estimates of both reported and unreported claims, something that only insurance companies are allowed to do. Non-insurance companies must wait until claims are paid before the claims expense can be deducted. When you hear that premiums paid to a captive are tax deductible, that is the shorthand expression used to describe this process.
At one time, companies were able to pay premiums into foreign captives and avoid paying taxes on the investment and underwriting profits until the money was repatriated to the United States. The IRS now taxes U.S. companies on foreign income so the tax advantage that led many companies offshore has been eliminated.
8. Is my company big enough to form a captive? If not, what are my options?
A captive must be large enough to generate savings that are greater than its annual operating costs. The rule of thumb is $1 million in annual retained losses as the minimum size for captive formation, although exceptions do exist.
Companies that fall below the $1 million threshold may want to investigate a group captive or rent-a-captive alternative. Either alternative will enable a company to have a premium based on its own loss experience and to keep the underwriting and investment income earned on the program. Deciding which to choose depends on the company’s attitude toward sharing risk with others, its desire to have an ownership share, its cash position and its ability to make a long-term commitment to a program.
9. What lines of coverage are best suited for a captive? What about property insurance?
Workers’ compensation, automobile liability and general liability are all good captive candidates. It is possible to develop a reasonably accurate loss forecast for these lines due to the volume of claims. Additionally, there is a time lag, or float, between the collection of premium and the payment of losses. The longer the float, the greater the amount of investment income a captive is able to earn.
Property has traditionally been a poor choice for a captive because the losses are difficult to predict, they tend to have large payouts and the loss amounts are paid out fairly quickly (the opposite of the best reasons for captive inclusion). Also, companies saw little reduction in premiums for increasing their deductibles.
In today’s market, however, if you want to reserve for the possibility of property claims within a deductible, you might as well cover the property deductible in the captive through a deductible buy-back policy. The same holds true for other catastrophe lines such as directors’ and officers’, errors and omissions, professional and fiduciary liabilities.
10. Why do I need a captive manager and what duties do the managers perform?
Although some captives are self-managed, a local captive manager is generally recommended and often required. Because captives are usually formed by companies whose core business is not insurance, the captive manager serves as the resource of insurance-specific operational, accounting, finance and regulatory knowledge. The manager will also maintain the financial and operational records of the company and coordinate with bankers, investment managers, claims managers, insurers and reinsurers to manage the day-to-day operations of the captive. Captive managers serve as the primary liaisons with domicile regulators, and ensure compliance.
11. How do I assess if a captive is feasible for my company?
If you are interested, you should perform a captive feasibility study. This will serve as the blueprint of the captive. The feasibility study will recommend a program design for the captive, provide an actuarial loss forecast, estimate all expenses and show a series of captive financial statements. Additionally, the study will cover operational issues, recommend a domicile and discuss the tax implications of the captive. The study should provide sufficient information for management of a company to decide whether or not a captive will benefit its risk management program.
Risk Manager Profile: Considering a Group Captive
Roobik Galoosian, vice president of corporate insurance for Pasadena, California-based IndyMac Bank is in the process of deciding whether his organization should join a group captive consisting of six other workers’ compensation exposures similar to IndyMac’s.
“We are a pretty large company in terms of asset size and a medium-sized company in terms of number of employees,” says Galoosian. “We have a very good workers’ compensation loss record, and as we got closer to our July renewal this year, we noticed that the premiums we are being asked to pay do not make any sense.”
IndyMac has been considering its alternative risk financing options since the beginning of 2003. “There has to be a better way of financing this exposure,” Galoosian says. “If I get only forty claims per year across the company, it makes no sense to pay six hundred thousand dollars to eight hundred thousand dollars in premium.”
IndyMac’s insurers are charging a minimum premium, regardless of the bank’s losses. So the bank is looking at self-insurance. One option it considered was self-insuring in California and buying traditional insurance in every other state it operates in. But there may not be enough employees in other states to justify it.
Forming its own captive was another option, but that would entail administrative costs, hiring third-party administrators to handle claims and other expenses, so IndyMac looked at a joint captive.
“Because it is not just us buying insurance through the captive, there is some volume savings,” Galoosian says.
Since the captive is set up for workers’ compensation, IndyMac can skip the lengthy administrative process (often ninety days or more) that setting up a captive normally entails. “When designing our own captive, we would have to decide on the structure of the captive, where to domicile it, and involve a lot of legal review by attorneys,” says Galoosian. “Unless you have a good partner to advise you, you are navigating unknown waters. But with joining a captive that is already in place, we submit our application, give further information as requested, the captive looks at our actuarial data, and they give us a quote for joining.”
But there are pitfalls. IndyMac would share the same exposures with the other members of the group captive. “We are a bank, so our workers’ compensation risk entails a lot of clerical exposure,” Galoosian says. “We might not want to share workers’ compensation experience with trucking or manufacturing companies. That has to go into the decision-making process.”
Risk Manager Profile: Old and New Captives
Robert Sweezey is the risk manager for the Seventh-Day Adventist Church, at its global headquarters in Silver Spring, Maryland.
In Takoma Park, Maryland in 1935, the Seventh-Day Adventist Church wanted to form a captive. But those were unheard of, so it formed a mutual insurance company owned by one policyholder—itself.
Fifty years later, the International Insurance Company was replaced by the Gencon Insurance Company of Vermont, a true captive. The transferal process took two years, but now Gencon insures the church’s property and liability exposures worldwide.
“Although the mutual concept was novel in 1935, by the 1980s, our mutual was archaic and needed an update,” Sweezey says. “We chose Vermont as our domicile for tax and fee savings, and also because it is a very user-friendly domicile. I can walk into Montpelier and talk to the person with the authority to make decisions. If I can explain to them what I want and demonstrate it in prudent business terms, they will accommodate me.”
Then, last December, the church formed a new captive based in Gibraltar. “With the advent of the hard market, operating fronts is expensive and challenging. So we formed Gencon International as a direct writing captive, which gives us a European front for Gencon of Vermont,” Sweezey says. It issues policies that are largely reinsured by Gencon of Vermont.
Forming captives today is easier than in the past, according to Sweezey, despite increasing regulation. Organizations do not have to explain how captives work. There are support services for forming captives. And while there are not as many domiciles for niche captives as Sweezey would like, there are many more options.
Sweezey says the church is very satisfied with its captives. “They have stabilized our costs during the hard market swing. They have given us the ability to craft our own forms, which is important to us for issues such as sexual misconduct liability. It has given us the ability to manage our own claims and to balance claims issues with public relations issues.”
What Are Captives Insuring Today?
The current market is a result of a multitude of factors: a prolonged soft market, increasing underwriting losses, lower investment returns, a dismal equity market, poor results for reinsurers, claims from asbestos and other environmental exposures, the failure of high-profile insurers and industry consolidation. The catastrophic September 11, 2001 terrorism losses also accelerated the hardening of the market. As a result, the role of captives is expanding as owners take a broader view of their exposures and how a captive can address them.
One fundamental change is in employee benefits. Several large corporations have successfully petitioned the Department of Labor and received permission to place their employee benefits into a captive. While the approval process is arduous, efforts are underway to streamline it for others that follow suit.
Another change is in property liability. Today, since a captive provides insureds with a mechanism to directly access the reinsurance market (or use intermediaries to do so), they are cutting their own deals with reinsurers. Property captives are being used to fill out missing layers of protection. Due to higher deductibles and retentions, captives are also being used to prefund for future losses within a retention or deductible as well as to postfund for future payments from exposures that have arisen from prior activities.
Captives are also being used to insure the liability of third parties. For instance, a captive can offer coverage to subcontractors, while allowing a manufacturer to mitigate some of its risk by assuring that coverage is in place should a claim arise.
As owners seek out new uses for their captives, many are looking at directors’ and officers’ liability, product recall, political risk, occupational disease, long- and short-term disability and enterprise risk exposures.
Paul Smith is vice president of Gallagher Captive Services in Itasca, Illinois. Scott Barry is president of Liberty Mutual Captive services in Boston. Bill Coffin is RM’s managing editor.
