A risk manager’s guide to forming a captive

Read the article in the Cayman Financial Review Magazine 

Risk managers are responsible for managing every risk an organisation faces by ensuring the company’s risks are identified and controlled in line with the company’s strategic direction.

Companies can choose to assume these risks directly or to pass them off to others by purchasing insurance in the traditional market. They may also choose to self-insure their risk in a formal manner by creating a captive insurance company. 

The use of captives to insure the risks of parent groups has steadily grown in popularity and is a major component of their overall risk management program. Currently over 60 per cent of Fortune 500 companies utilise a captive structure. As a result of this the captive industry has experienced solid, steady growth most notably in the Cayman Islands.

As at December 2012: 

  • The total number of captives domiciled in Cayman is 737
  • Total premiums registered – US$11.8 billion
  • Total assets under management – of US$88.1 billion

There are many benefits enjoyed by companies who choose to form a captive. The size and values of those benefits vary depending upon the company’s needs and circumstances. Several key factors that come into play when forming a captive are a company’s size, risk appetite and risk exposure. These play an important role when determining whether a captive is the right choice for your company. Several of the benefits of utilising a captive structure are:

  • Ownership of the captive allows the parent to reap the benefits of favourable loss experiences.
  • Tailoring of insurance coverage and underwriting standards to the specific circumstances of the insured, particularly for risks where coverage might otherwise be unavailable or expensive.
  • The captive can also allow you the flexibility to transfer more risk when the markets are soft and to retain the risk as the markets harden.

In addition the captive can assist the parent in budgeting and planning cash flows.

Having ownership permits an exceptional degree of control in the determination of appropriate litigation and claims settlement strategies which reflect the needs of the parent rather than only those of the indemnifying insurer.

Having direct access to reinsurance markets may reduce the cost of layering risks. A captive insurance company escapes the high sales, marketing and administration costs usually associated with commercial insurance companies.

Unless you have internal expertise you will need to hire a qualified and experience third party firm to perform a feasibility study. The firm should have relevant insurance, audit, tax and captive experience along with the tools needed to properly analyse the captive viability. Once the firm has been selected you will need to agree on the scope of the study as feasibility studies can vary from the straightforward to highly complex depending on the nature and needs of your business.

The key items you analyse when you are looking to complete your risk analysis include:

Review the current exposures, limits, losses, deductibles and premiums

As the risk manager you will want to analyse the current lines of coverage and the expected losses and as a captive owner you need to understand the implication and risks of insuring your risk versus paying to take on third party risk outside your parent company. Often starting with a simple retention structure and increasing the coverage lines and complexity as the captive matures is a good method. 

Obtain an actuarial analysis

Many domiciles require the use of an actuarial analysis as part of the initial business plan. The report will outline the estimated losses, but will also provide guidance on the premium levels. Some domiciles also require an annual report to ensure the premium written and reserves are still sufficient for the lines of coverage the captive is providing.

Review options for the captive’s organisational structure

There are a variety of options for the ownership of the captive; primarily corporations will choose one of the following:

  • Single parent captive – a captive owned by the insured.
  • Segregated portfolio captive (also referred to a protected cell company) – this would involve utilising another owner’s captive without sharing the liabilities with other members.
  • Rent-a-captive – this would involve the use of another owner’s captive, however it could involve the “renting” of their capital and/or the sharing of risk.
  • Group captive – large group captives allow limited control of coverage and some potential for profit sharing.

Review domiciles and captive managers

A key domicile choice for US companies is the decision to remain onshore or go offshore. This decision that will affect every area of the captive from formation requirements, capital levels, taxes, ease of regulation, permitted lines of insurance to the capitalisation requirements.

The leading domiciles historically have been Cayman, Vermont and Bermuda, however new domiciles are being created every year and there are currently about 80 domiciles to choose from.

Whilst every domicile has unique pros and cons, the more established domiciles tend to provide more stability and experience in managing all aspects of your captive.

The same also applies to the selection of your captive manager. They range from small independent specialised firms to large worldwide organisations. 

Review the costs, including the capital requirements

There are a variety of costs that need to be considered when forming a captive. They include not only the premiums, but the cost of capital, federal excise taxes, audit, actuarial, captive manager, licensing and attorneys’ fees. The identification of all costs associated with the captive formation is critical to making an informed decision and avoiding surprise costs down the road.

Of all the initial and ongoing costs, probably the most important one to examine is the cost of capital. Most risk managers will want to compare the investment return on the capital to the internal rate of return criteria the company has for investments of this type. A company should also compare this to the cost to borrow the funds to capitalise the captive.

Create projected financial statements

Creating the cash flow and income projections are vital to determining that the funding levels are sufficient under a variety of situations as the losses will vary from year to year. The projected financial statements should be reviewed carefully with accounting and tax departments as they are a key component to the captive feasibility study.

Tax analysis

The tax implications must be evaluated from not only the captive owner’s perspective, but you must also analyses the tax implications from the insured perspective. Insurance companies are subject to a different tax scheme than typical companies; in some instances this can be favourable, however in other instances it can be detrimental. Taxation is a complex topic and you should consult your tax advisor when analysing the tax implications of a captive.

For example, for US federal tax purposes, insurance companies can deduct reserves for unpaid losses; this is in contrast with other businesses that cannot deduct losses until it is paid.

Contributions by US companies into deductible loss funds or the creation of loss reserves on the company’s books are not tax deductible expenses. The expense can only be recognised when a claim is paid.

A captive can allow the early recognition of these expenses, however to receive this beneficial deduction the captive must qualify as an insurance company as outlined in the regulations.

If the captive is located offshore you should carefully evaluate the benefit of making the IRC 953(d) election to allow it to be taxed as a US corporation. This election should simplify the taxation of the captive and its parent company, however it should be reviewed carefully because in some situations if can be detrimental.

Review alternatives to captive programmes

A captive is simply one tool that a risk manager can utilise to manage an organisation’s risks. You will need to compare the various captive solutions to not only your current programme but also to a high deductible programme and guaranteed cost programme to simply self-insuring the risks.

Identify liquidation options

The exit strategy for a captive can be a very long and drawn out process or a relatively straightforward process depending on whether you have potentially placed long or short-tailed coverage in your captive. With long tailed liabilities it can take years for the captive to extinguish all liabilities to the satisfaction of the regulators. An exit strategy should always be considered along with the formation of the captive.

Summary

Each organisation will have a different point of view and risk appetite. By utilising a captive you can add value to the organisation and possible turn a business risk into a profit centre. However if not carefully analysed and considered, a captive can become an unnecessarily expensive exercise.

By weighing risk, cost and business needs especially if business needs are not currently being met in the commercial market a business should be adequately equipped to approach a third party advisor to perform a captive feasibility study.

 

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