Seventy-five percent of the world’s Fortune 500 companies are parent owners of captive insurance companies. More than 5000 captives have been established worldwide, with a total of captive premium income exceeding $14 billion...
Seventy-five percent of the world’s Fortune 500 companies are parent owners of captive insurance companies. More than 5000 captives have been established worldwide, with a total of captive premium income exceeding $14 billion. There are different types of captives, such as single-parent captives, rent-a-captives, protected cell companies and special purpose vehicles.
How does a captive work?
A captive is essentially a wholly-owned insurance company, usually located in a jurisdiction where taxation, solvency and reporting requirements are relaxed. They are usually managed by specialist companies that act as accountants and administrators. However, much of the decision-making pertaining to the risks being retained by the subsidiary company or transferred to the conventional insurance market, are undertaken by the parent company (parent).
A captive must operate as a true insurance company. The need for annual actuarial reviews, yearly financial statement audits, continuing tax compliance oversight, claims management and other regulatory compliance needs puts the day-to-day management of a captive beyond the skills of most general business people. The use of an experienced and capable captive management company is an essential element in a captive’s operations.
The cost of ’self-insurance’ outside of a valid and qualifying captive structure is not tax-deductible. A properly formed and operated captive may, however, deduct insurance premiums that are paid into a privately-owned insurance company. Claims are paid with pre-tax dollars. If no claims are made, the captive retains the premiums for future business risks or distribution.
Formation of a captive
The formation of a captive involves the following processes: feasibility studies, financial projections, determination of domicile and lastly, preparation and submission of application for an insurance licence. The need for a qualified insurance manager on the planning team is therefore very important, particularly in the formative stages.
The requirement for adequate initial capitalisation of the captive is dependent in part on the level of risk projected to be assumed by the captive (risk appetite) and the domicile chosen.
Legislative and regulatory issues to be considered when establishing a captive include identifying a sensible legal framework, choosing the appropriate type of entity, and evaluating its track record and cost and taxation advantages.
The decision to form a captive should be predicated upon the incorporation of formal and robust risk management procedures and culture within an organisation. Increased awareness and implementation of risk management practices is perhaps the most important reason for forming a captive.
There are numerous advantages to forming a captive, with the main drivers being risk management and risk financing:
Lower insurance costs
In establishing a captive, the parent seeks to retain profits within the group rather than have it go to an external party. A captive may also help reduce insurance costs by charging a premium that more accurately reflects the parent’s loss of experience. Commercial market insurance premiums must adequately meet the cost of claims. However, in common with other commercial enterprises, insurers are in business to make money and will therefore include in the premium an element to provide for their acquisition costs, overheads and profit. This portion of the premium can represent as much as 35 or 40 percent of the whole transaction.
Cash flow benefits
By utilising a captive, premiums and investment income are retained within the group and, where the captive is domiciled offshore, that investment income may be untaxed.
Additionally, the captive may be able to present a more flexible premium payment plan, thereby offering a direct cash flow advantage to the parent.
Apart from pure underwriting profit, insurers rely heavily on investment income. Premiums are typically paid in advance while claims are paid out over a longer period. Until claims become payable, the premium is available for investment.
A company’s willingness to retain more of its own risks, particularly by increasing deductible levels, may be frustrated by the inadequate discount offered by insurers to take into account the increased deductible and by the fact that the company is unable to establish sufficient reserves to pay future claims. Establishing a captive can help address both of these problems.
Increased coverage
A captive may provide the coverage required where the commercial market is unable or unwilling to provide coverage for certain risks or where the price quoted is seen to be unreasonable.
Link to risk management
Risk management can be viewed by a captive owner not as a cost centre but as a potentially profitable part of the company’s activities. A captive acts as a focus for the risk management and risk financing activities of its parent organisation. An effective risk management programme will result in recognisable profits for the captive.
A captive can also be used by a multinational to set global deductible levels, enabling local managers to insure with the captive at a level more suitable to the size of their own business unit while the captive only buys reinsurance in excess of the level appropriate to the group as a whole.
Access to the reinsurance market
By using a captive to access the reinsurance market, buyers can more easily determine their own retention levels and structure their programmes with greater flexibility. Reinsurers are the international wholesalers of the insurance world. Operating at a lower cost structure than direct insurers enables them to provide coverage at advantageous rates.
Underwriting unrelated risks for profit
Apart from writing its parent’s risks, a captive may operate as a separate profit centre by underwriting the risks of third parties. In particular, an organisation may wish to sell insurance to existing customers of its core business. For example, a retailer may sell extended warranty coverage to customers with the risk being carried by the retailer’s captive. The claims pattern of this type of business is usually very predictable, with a large number of small exposures, and can provide the retailer with a valuable additional source of revenue.
Tax minimisation and deferral
The tax considerations in forming a captive will depend on the domicile of both the parent and the captive. Integration of a captive as part of an overall tax planning strategy is a complex subject and professional legal and tax advice is essential.
Insurance benefits
The establishment of a captive provides a greater degree of flexibility and control over the risk management function. Insurance programmes can be designed in response to specific coverage, premium and retention requirements, and offer individual operating units of a company the coverage and deductibles they require, with the programme’s overall control and design maintained at the corporate level.
Thus, captives can help centralise the financial and administrative operations of a corporate insurance programme. Captives can also be used as vehicles for funding risk exposures should a company decide to self-insure, or if commercial insurance coverage is unavailable or uneconomical.
Captive owners have found that owning a captive brings much more focus to the derivation and amount of losses being incurred. This leads to a greater emphasis on loss prevention programmes and the captive’s use in measuring the impact of such programmes.
The use of a captive should be considered for entities that meet the following criteria:
- Profitable business entities seeking substantial annual adjustable tax deductions;
- Businesses with multiple entities or those that can create multiple operating subsidiaries or affiliates;
- Businesses with $500,000 or more in sustainable operating profits;
- Businesses with requisite risk currently uninsured or underinsured;
- Business owners interested in personal wealth accumulation and/or family wealth transfer strategies;
- Business owners seeking asset protection.
