Captive formation in recent times continues to be flat to moderately up, reflective of a mature market. With plentiful capital in commercial insurance markets, continued innovation in capital market products and no sign of a hardening market, this trend is likely to continue for the foreseeable future.
Captive formation in recent times continues to be flat to moderately up, reflective of a mature market. With plentiful capital in commercial insurance markets, continued innovation in capital market products and no sign of a hardening market, this trend is likely to continue for the foreseeable future.
The captive management industry has responded well by developing and promoting alternative cost effective self-retained risk vehicles, such as: 831(b)s, risk retention groups and protected and incorporated cell companies. These structures grant access to middle and lower market organisations that seek to manage and participate in their own risk for economic benefit at a lower cost than maintaining a wholly owned captive. Growth in these alternative structures is offsetting the decline in wholly owned captives.
On paper, a captive insurance company often looks economically disadvantageous and is often referred to as “left pocket to right pocket” when viewed at the consolidated financial group level. In times gone by, the taxation planning benefits of transferring risk (and premium profit) from higher tax regimes to lower tax regimes improved the economic optics. However, tax rule tightening and global tax harmonisation (such as controlled foreign company (CFC) legislation), increased scrutiny of internal arrangements (transfer pricing challenges) and general good corporate reputation (less established offshore domiciles) has led to a captive’s core strategy being primarily to manage ever more complex global insurance programmes.
These factors all make for challenging business conditions for a captive management firm, and as with any economically viable business, revenue growth and cost control is important for success.
Large firms have responded to these challenges by becoming more connected with their broking networks to drive cross sales and develop and offer complimentary services, also seeking to drive down cost bases by investing in new technologies and client service standardisation.
Small firms, which pride themselves on broker independence and a bespoke approach to client service, often lack large budgets to invest in operational efficiencies and are more reliant on opportunistic appointments by captive owners that move their service provider (even more so in a maturing market versus new formations). Operational matters such as attracting future talent, key staff dependency and continuity and availability of expertise in responding to regulatory changes challenge smaller firms, often distracting them from their dedicated client-driven focus.
Big brand or boutique independence?
There is often no consistency in the selection of a captive manager by a captive owner. One would think that large blue chip organisations would limit both reputational and continuity risk by selecting a blue chip service provider (often at a premium cost). By and large this is true, however, there are large organisations that use smaller firms as they consider themselves sophisticated enough to manage their own insurance affairs with little reliance on a broker and therefore consider independence important.
Captive manager duties and competitive edge
In a tender situation, captive owners often disregard a firm’s value proposition with respect to providing financial and regulatory reporting in a timely and accurate manner, and think that all providers can and should fulfil basic management duties that broadly include:
Insurance programme administration: policy management/certificate issuance, claims administration and liaising with actuarial teams to establish insurance provisions;
Financial reporting: maintenance of accounting records and submissions to head office to consolidate captive results;
Treasury: administering captive assets and maintaining cash books;
Regulatory: engaging with regulators and compliance with regulatory filing requirements; and
Governance: company secretarial duties, such as, maintaining registers and filing statutory accounts and company changes. Holding board meetings (often providing a director) and organising board materials for clients.
It is the ‘added-value’, a firm’s approach to innovation and staff put forward in a tender response that very often differentiates service providers. Traditionally, a relationship between owner and manager is one that remains in-force for long periods of time, even if broking engagements change. In fact, it is common for captive owners (risk managers, financial officers, treasurers) to form strong relationships with the teams that are engaged in the day-to-day activities of their captive, where they are considered an extension of the owner’s team.
Captive management business model
A typical firm’s business model is relatively simple and predictable in broad terms, ie, annual management fee inwards and fixed costs, such as: office, computer equipment and staff salaries outwards. However, with an increasing numbers of new domiciles enacting captive legislation it raises new challenges for firms in justifying a business case to establish and staff operations locally, particularly where regulatory bodies require local representation.
To improve operating margins and focus on strategic client development, many larger firms have invested in standardised technology and in-sourced more routine operational tasks to lower cost domiciles. In principle, this is a sound business decision and one that notwithstanding cultural and integration troubles appears to be beneficial.
However, reporting captive performance quicker and cheaper is not overly important to captive owners. Rather, it’s the interpretation of the data and understanding the trends that is of strategic importance to aid captive owner’s negotiations with underwriters to lower premium or improve terms and/or take further decisions on risk retention.
You could think that the majority of firms focus too heavily on administering a client’s captive rather than deploying resource to drive additional revenues from using captive data to improve the financial position of their clients. There is a continual debate globally on consolidating data and its use, however, one would expect that many captive owners would permit the use of their data (save for commercially or personally sensitive) if it directly benefits their own positions. In that respect, for firms, having trained and experienced staff to analyse this data is key to operational success.
Captive management firms and risk management
Risk for firms is primarily mitigated through service level agreements (SLAs), which traditionally list services provided, including key performance indicators. Some regulatory authorities are prescriptive on the requirements of an SLA. There is often a conflict with negotiating limits of liability (which typically follow other professional services firms as a multiple of fee) where there is a wider group relationship, for example, with a broking firm—in this case one could argue it unreasonable to expect a captive manager (whose primary role is administration) with a relatively low level of capital available to assume broker placement liability limit levels when the management fee charged is disproportionate.
Regulatory non-compliance is a key area that represents a significant risk to firms. Many firms act as directors for a captive and manage the conflict between acting as a director of a captive and not being too involved in the actual business of the captive owner. However, no firm wishes to be linked to regulatory breaches and/or fines. In practice, this risk is typically managed via detailed board packs and robust minute taking, however, it is challenging to strike the right balance between risk mitigation for firms and not providing too much information, which can disengage clients. Firms would be best to focus on key decisions in board meetings and focus efforts on working with owners to identify growth opportunities by utilising the captive. For example, there is a growing trend to use a captive to provide customer-focused insurance linked to products purchased, generating external revenues and improving customer loyalty.
Insurance premium tax compliance of a captive is an area that represents a significant risk to a firm. Delays in tax payments and/or non-filing of returns can result in substantial penalties and fines. While premium tax settlements are the responsibility of the insured it is often a grey area between manager and owner as to where the fault often lies. By and large, a firm’s loss results in an error and omission claim or a direct economic loss to a firm’s profit and loss account. However, the relationship damage can often lead to a manager move, resulting in loss of recurring revenue. For smaller firms, absorbing a loss can have a significant impact on the firm’s financial wellbeing.
If managed well, insurance tax compliance is in itself not overly complex and is often the responsibility of less experienced staff, traditionally the organisational layer that experiences higher staff turnover. There is no consistency in the approach of firms to manage this risk; some outsource the risk entirely and some rely on internal controls to manage a multitude of tax firms across a number of jurisdictions.
In summary, firms may wish to consider the following as they seek to grow client revenues and reduce operating costs:
Leverage existing clients by analysing data providing insight to identify opportunities for captive use, giving owners improved data for decision making;
Deploy staff skill levels that are commensurate with the task freeing up more experienced staff to foster closer client engagement to grow revenues;
Determine tasks that are key to client service with more routine tasks consolidated via improved technological infrastructure or outsourced to lower cost locations; and
De-risk firm balance sheets by seeking to limit contractual liability and non-compliance matters via well drafted SLAs.
