A Guide to Captives

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FERMA member association Airmic is grateful to Chartis for producing this guide to captive insurance companies.

Airmic invited partners to select an area of expertise and produce an introductory to intermediate level guide for the benefit of Airmic members. The intention of this guide is to provide members with an overview of the topic and provide information on the practical considerations when managing this important insurance issue.

This guide has been written with a view to providing members with support when faced with such questions as...
- “What alternatives are available to buying cover in the commercial market?”
- “Can we save on premium spend and can we take more control of our risks?”
- “What do we need to do and what will it cost?”
If you already have a captive you may be asked to explain why and what it provides that the commercial market does not.

This is by no means a definitive guide; however we hope it will go some way to answer these questions and to help in your understanding of the world of captives and how they may work for your organisation.

This guide will take you through the life cycle of a captive from initial concept through to the benefit and uses and finally to exit strategies.

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A Guide to Captives

  1. 1. AG uid e to Cap tive s
  2. 2. EXECUTIVE SUMMARYAirmic is grateful to Chartis for producing this guide to captive insurancecompanies. Airmic invited partners to select an area of expertise and producean introductory to intermediate level guide for the benefit of Airmic members.The intention of this guide is to provide Airmic members with an overview ofthe topic and provide information on the practical considerations whenmanaging this important insurance issue.This guide has been written with a view to providing members of AIRMICwith support when faced with such questions as...“What alternatives are available to buying cover in the commercial market?”“Can we save on premium spend and can we take more control of our risks?”“What do we need to do and what will it cost?”If you already have a captive you may be asked to explain why and what itprovides that the commercial market does not.This is by no means a definitive guide; however we hope it will go some wayto answer these questions and to help in your understanding of the world ofcaptives and how they may work for your organisation.This guide will take you through the life cycle of a captive from initialconcept through to the benefit and uses and finally to exit strategies.The following topics will be covered:1. What is a captive? 10. What would it cost to set up2. Is it a legitimate insurance and manage? company? 11. Who would manage it?3. Why set up a captive? 12. How much would they charge?4. What types of companies 13. Where to set up your captive? consider captives? 14. Set up insurer or reinsurer?5. How do you know if it is right for 15. Typical examples of your organisation? captive structures6. What risks can it insure? 16. What exit strategies7. Advantages and disadvantages are available?8. Types of captive 17. Case studies9. When is a good time to set up a captive?2
  3. 3. 1WHAT IS A CAPTIVE?The name “Captive” was coined in the 1950’s Captives can operate as either insurance orwhen the concept was being brought into reinsurance companies and as such issue:practice for a mining company. A mine producing • insurance/reinsurance policesoutput which was being kept solely for thecorporations own use was referred to as a • bill and collect premium“captive” mine. When the mining company Generally they have no employees so all typicalincorporated its own insurance company, it was “insurance company” functions are outsourced toreferred to as “captive” insurance as it wrote third parties.insurance exclusively for the captive mines.Today, a “captive” insurance company iseffectively an “in house” insurance providerformed primarily to insure its owner and affiliatedcompanies and can be viewed as a form offormalised self-insurance. They can write somethird party business but this is dependant on thejurisdiction and its definition of a captive.2IS A CAPTIVE A LEGITIMATE INSURANCE COMPANY?Yes, a captive insurance company is a risk • There are over 5,000 captives worldwidemanagement and financing vehicle that offers an • Estimated annual premium flowing intoalternative to conventional insurance and also the captives is US$55bn-US$60bn per annumopportunity to combine with an existing riskfinancing (insurance) programme. Captives are • Captive (re)insurance companies have beenregulated entities within the domicile in which established in over 70 jurisdictions worldwidethey operate. Captive insurance has become an • Typically non ratedintegral part of the global insurance market; Switzerland 4% Malta 1% Sweden 6% Ireland 9% Isle of Man 16% Guernsey 41% Luxembourg 23% Active captives by European Domicile Source: Crain Communications Inc Sept 2010 A GUIDE TO CAPTIVES 3
  4. 4. 3 WHY SET UP A CAPTIVE? Captives are set up for 4 main reasons: Cost gear premium levels to own Capacity hard and soft market cycles dictate group claims experience price and capacity Cover uninsurable or difficult to insure risks Control long term company strategy 4 WHAT COMPANIES CONSIDER CREATING A CAPTIVE TO MANAGE THEIR RISKS? Companies that in the main want to control their They have been commonly established by the own destiny with regard to their insurance Fortune 500 companies, large professional service programme and have a strong commitment to loss firms, and other large organisations. However, with control. They will also: the introduction of PCC’s and Rent-a-captives it is quite possible for small to medium sized 1. Be willing to invest time and money to create a enterprises to economically establish their own captive i.e. have the financial ability to pay captive programme. captive premium and provide initial capitalisation 2. Have premium large enough to justify the annual operating costs 3. Have a claims history that is better than other companies in their class of business or have improved risk management processes that are expected to improve its risk profile 5 HOW DO YOU KNOW IF A CAPTIVE IS RIGHT FOR YOUR ORGANISATION? If a company can answer “yes” to points 1 - 3 above • Source of business e.g. country, subsidiary or then the next step would be to have a feasibility third party study undertaken. The study is one of the more • The risk and circumstances of the client important steps in determining the value of a captive to its owners and provides a roadmap as • Identification of classes of business to to how a captive can be specifically used to meet be written the insurance needs of its owners and related • Details of existing reinsurance programme parties. The study will evaluate whether the captive is an optimal tool for business and will • Policy limits therefore likely include: • Advice on the most suitable structure for • Financial projections – estimated capital the captive required to meet legal and cost requirements • Where relevant actuarial reports – of the captive estimated loss experience • Premium volume that will make the captive • Underwriting guidelines financially viable, for example this should be in • Domicile review the region of £500,000 • Claims handling procedures4
  5. 5. 6WHAT RISKS CAN IT INSURE?In principal any risk can be covered through a • Operating risks, such as product recallcaptive structure. • Credit defaultPopular types of risk covered within a captive • Loss of key customers and suppliersstructure include professional indemnity andother commercial insurance – property, • Exclusions in disability insurance policies e.g.business interruption, employer’s liability pre-existing conditionsand environmental liability. • Types of insurance unavailable inInstead of looking at the usual business risks, commercial marketspotential captive owners could consider risks not • Natural disastercovered by their conventional insurance policies.This raises the question of why a business would • Construction defectswant to insure additional risks that it wouldn’t Generally the cost of self-insurance outside of aotherwise have to. Consider however, that those valid and qualifying captive structure is not tax-additional risks were always there; they were deductible. A properly formed and operatedsimply risks that were self-insured. In reality, most captive may, however, deduct insurance premiumsbusinesses knowingly or unknowingly self-insure a that are paid into a privately owned insurancelarge amount of risk, including the following: company. Also claims are paid with pre-tax funds.• Policy exclusions, such as mould and pollution If no claims are made, the captive retains the premiums for future business risks or distributes• High deductibles and self-insured retentions as profits. A GUIDE TO CAPTIVES 5
  6. 6. 7 WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF OWNING A CAPTIVE? ADVANTAGES: DISADVANTAGES: • Cover for risks that are unavailable or expensive • Formation can be costly in the commercial market • Capitalisation is required creating an • Ability to set aside separate fund for risks in a opportunity cost for the business more tax efficient vehicle • Ongoing expenses incurred for operation of • Smooth insurance prices over time the captive i.e. governmental fees, legal fees, accounting fees (audits) etc. • Premium based on own experience • Increased management involvement required. • Incentive for loss control Captive is not for the short term, there will be • Increases senior management’s awareness of an ongoing time commitment from the cost of risk and control management of the owner • Can be a negotiation tool during renewal • Exposure to underwriting loss discussions with the commercial market • Insurance premium tax when insuring a • Direct access to the reinsurance market previously uninsured risk • Underwriting profits and investment income retained6
  7. 7. 8ARE THERE DIFFERENT TYPES OF CAPTIVE?Yes, captives can take the following forms: PURE CAPTIVE Is a wholly owned subsidiary of its parent company and insures primarily the risk of the (also known as parent and its affiliates. In some circumstances it can extend cover to non owned third single parent) parties. Least costly type of captive to operate, outside of a cell in a PCC and provides most flexibility in terms of programme design, operating structure and lines of cover. GROUP CAPTIVE Has many owners and insures the risks of these owners, and usually cannot extend to third parties. These enable similar or diverse businesses to band together to share the risk, cost and benefits of providing commercial insurance to their members. TRADITIONAL This is set up by a sponsoring organisation such as an insurance company or a RENT-A-CAPTIVE broker. This organisation provides the capital for the facility and then “rents” this capital to participants who seek to establish their captive programmes as individual “cells” within the Rent-a-captive facility. It has all the benefits of captive ownership without the initial capital contribution and therefore can be more suitable for the SMEs. Traditional Rent-a-captive operates on the same basis as a PCC (see below) but risks are segregated on a contractual as opposed to a statutory basis. PROTECTED CELL Similar to a Rent-a-captive but unlike a traditional Rent-a-captive it has COMPANY (PCC) segregated cells for each user. The assets and liabilities of each user are legally separated ("ring-fenced") from those of the other users. INCORPORATED CELL Similar to a PCC, however each cell is a legal entity in its own right. Unlike COMPANY (ICC) with a PCC cells can transact with each other. Allows greater flexibility in the way segregated accounts are operated.Captives can operate as insurers, providing insurance The drivers behind the decision whether to set updirectly to the captive parent or reinsurers providing an insurance captive or a reinsurance captive willreinsurance to a direct writing insurer which in turn be discussed later under “Examples of captiveprovides cover to the captive parent. structures”.9WHEN IS A GOOD TIME TO SETUP?Generally captives are set up in what is known as Usually market conditions will not be the onlya “hard” market i.e. when the premium rates are factor which would dictate the point at which aso high that they are unaffordable and do not company should/might consider setting up amake economic sense for the purchasing captive. The parent company would need to be ofcompany. Alternatively, cover may not be a sufficient size and at a point in its developmentavailable in the market for particular risks, this that makes sense to establish a captive.may be because of bad loss experience in the For example, as mentioned earlier its premiumpast or the risks to be covered are new or spend should be in the region of £500,000 to bespeciality risks. able to justify the additional operating costs and capitalisation of the captive. Most importantly it will need to be willing to assume risk. A GUIDE TO CAPTIVES 7
  8. 8. 10 WHAT WOULD IT COST TO SET UP AND MANAGE? These will vary from a standalone captive to a cell feasibility study, consulting fees, regulators and within a PCC or Rent-a-captive. These costs are legal fees, and on-going costs such as auditors split between initial start up costs such as; and directors fees and captive management fees. 11 12 WHO WOULD MANAGE IT? HOW MUCH WOULD THEY CHARGE? The parent company itself could take the decision Captive Managers normally charge their fees on to manage the captive if it has the time, resources a time and expense basis based on the number and expertise to do so. More usually a Captive of hours to be spent on managing the captive. Manager is employed. The company can benefit This will normally be estimated in advance and a from the managers knowledge and expertise and fixed annual fee proposed to the client. they will likely have an existing relationship with Fees will therefore vary based on the complexity the regulator, often crucial when setting up a of the captive and the requirements of the captive. In nearly all jurisdictions or domiciles the captive sponsor. local regulatory authorities require that captive insurance companies are managed by experienced and qualified insurance professionals.8
  9. 9. 13WHERE TO SET UP YOUR CAPTIVE?Captive insurance companies are typically formed When making this decision the factors to bein countries that have laws allowing for the considered are numerous, these include:establishment of a captive insurance company. • Whether the captive is to write direct orThese locations are known as domiciles. provide reinsuranceThe choice of domicile for the incorporation of • The regulatory environment including thethe captive insurance company will depend on sophistication and reputation of the regulatorsmany practical considerations affecting the for example – Solvency II, regulatorsbusiness concerned. response timeDomiciles in the EU such as Ireland, Luxembourg, • Costs of creating and running the captiveGibraltar, Sweden and Malta or in the US such asVermont, South Carolina and Hawaii can have • Minimum capitalisation requirements –very different benefits and drawbacks to “off- can vary widely from £100,000 to £3mshore” domiciles such as Guernsey, Isle of Man, • Taxes (local premium tax, federal excise tax,Switzerland, Bermuda, Cayman and Barbados. double tax treaties) • Investment restrictions on the captive’s surplus • Type of cover to be offered (whether a particular domicile offers unique advantages regarding a particular type of cover) • Convenience – ease of travel, time zone The ultimate decision should be based on the parent company’s overall risk management objectives and the direction it wishes the captive to take and also how comfortable a parent feels with respect to the overall regulatory approach of a particular domicile. A GUIDE TO CAPTIVES 9
  10. 10. 14 WHAT INFLUENCES WHETHER A CAPTIVE OPERATES AS AN INSURER OR A REINSURER? We spoke about captives operating as either This is where a “Fronting” insurer is needed. insurers or reinsurers earlier. What influences A fronting insurer is a licensed carrier that issues this decision? the policies that a captive cannot issue with the intent of passing all or most of the risk to the Generally, a company must be licensed to do captive by way of reinsurance. In that case the business in the jurisdiction in which a policy is captive will operate as a reinsurer. issued. A captive licensed as such will most likely therefore write insurance directly. In some cases however, captives lack the required licenses to do business and, therefore often must use a fronting arrangement in order to do business in a country in which its parents risks are located. A typical fronting arrangement Fronting Carrier Retains: CAPTIVE PARENT FRONTER Fronting Fee (Insured) (Insurer) Taxes XOL Cover Premium (optional) REINSURANCE Dividend payments CAPTIVE CAPTIVE MANAGER Captive retains: (Reinsurer) Underwriting Profit Inverstment Income RETROCESSION Premium XOL Cover Claims RETROCESSIONAIRE e.g. cat cover Collateral e.g. LOC, Trust The decision to operate as an insurer or reinsurer is not solely driven by licensing requirements but can be driven by other factors such as administration requirements, readiness of the parent company to be hands on and cost of fronting etc.10
  11. 11. 15WHAT ARE SOME TYPICAL EXAMPLESOF CAPTIVE STRUCTURES?The most typical and simplest example of a GROSS LINE PROGRAMMEcaptive structure is that of insuring with the We have discussed how a captive generallycaptive the deductible or self-insured retention would reinsure 100% of the risk of the fronting(SIR) of the parent company. The insured parent insurer. The captive may decide that it will retaincompany transfers the liabilities related to the only part of this risk and therefore it will cededeductible layer from itself to the captive insurer the “excess” to a reinsurer - this is known asup to the limits of the deductible or SIR. “Gross line”.This ensures that funds are built up evenly over The benefit of a Gross Line programme is thattime and are available to pay claims when needed. the captive has more flexibility in its insuranceAlso claims within the deductible may not be tax programme and it controls the primary rates anddeductible, from a parent company perspective, reinsurance rates it pays.until actually paid. However, the disadvantage is that it is more If the deductible claims are “transferred” to a labour intensive. Also the fronting fees andcaptive, the captive will be able to deduct both security requirements may increase as thethe paid claims and the accrued unpaid claims for Fronter has no control over the reinsurancetax purposes. bought by the captive and therefore may view this as an additional risk. This would be more suitable for a captive that has been running for many years and has built up the expertise to take more control over the captive programme. An example of a Gross Line programme CAPTIVE PARENT (Insured) Pays premium Issues policy for £50m in the aggregate FRONTER (Insurer) Premium less fronting fee (e.g. between 4% - 10% of Issues policy for £50m in the premium) and taxes aggregate and indemnifies for all loss payments and provides collateral (LOC, Trusts) Issues policy £30m xs £20m RETROCESSIONAIRE CAPTIVE Pays reinsurance (Reinsurer) premium A GUIDE TO CAPTIVES 11
  12. 12. NET LINE PROGRAMME An alternative to the Gross Line programme is a It has the benefit of being much less labour “Net Line” programme which is more suitable for intensive then the Gross line programme with a company in a start up situation. fewer security issues. However the captives control of the programme is reduced and the cost In this case the captive only insures that portion of reinsurance is often higher as the captive, in of the risk it wishes to keep net. The fronter will this scenario, does not have the option to determine with the captive the level of risk the approach the market itself. fronter itself will retain, if any, and what is to be reinsured in the commercial market. Cessions to the captive are net of all costs and expenses to the fronting company i.e. fronting fees, taxes, any other overrides and cost of cover above the captive layer. An example of a Net Line programme CAPTIVE PARENT (Insured) Pays premium Issues policy for £50m in the aggregate Issues policy excess of £800k up to £50m limit REINSURER FRONTER (Insurer) Pays reinsurance premium Issues policy for £800k in the aggregate and indemnifies for Pays premium less fronting fee, all loss payments and provides reinsurance costs and all collateral (LOC, Trusts) other costs CAPTIVE (Reinsurer)12
  13. 13. 16WHAT EXIT STRATEGIES ARE AVAILABLE?Captives are typically long term vehicles and The options available to owners seeking to exitmany are around for decades. However for a captives are:variety of reasons, including merger & acquisition • Commutation (with the fronting insurer)activity or changes in risk managementphilosophy, some owners may wish to close down • Portfolio transfer or novationor sell their captive vehicles. (with another insurer) • Restructuring of liabilities (through a PCC) • Selling the captive to a third party (as a going concern or as a run-off vehicle) All of the above options require consultation with and/or approval from claimants, regulators, auditors and actuaries in order to achieve a satisfactory exit solution. COMMUTATION On fronted policies, fronting insurers are often happy to commute captive reinsurance reserves for a reasonable margin that should compare favourably with the full costs of run-off to expiry of all liabilities where the captive is to close down completely. NOVATION This involves replacing the captive with another organisation as party to the insurance contracts. Typically this would be another insurance company. The main drawback to such arrangements is the need to obtain full agreement of any fronting insurers. However, where the fronting insurer is unwilling or unable to commute, this can be an effective solution. PORTFOLIO In cases where a fronting insurer is not amenable to a novation of the subject TRANSFER business to another insurer, the captive can reinsure its liabilities with an insurer through a portfolio transfer. The captive will retain credit risk against the insurer providing the portfolio transfer reinsurance, and collateral supporting the liabilities to the fronting insurer may not be released. However, this mechanism will largely achieve the objective of removing the insurance liabilities from a captive and will potentially enable a release of any excess capital. RESTRUCTURING Typically this involves the novation of liabilities into a PCC cell, financed through OF LIABILITIES a combination of reinsurance and non-cash capital. This has the advantage of segregating the captive liabilities in another vehicle and has reduced operational costs and management commitment. Again it will need the agreement of fronting insurers. SALE OF CAPTIVE An alternative to closing down a captive is to sell it to an insurer or a third party which can either continue to use the captive as an ongoing vehicle or can put it into run-off. A GUIDE TO CAPTIVES 13
  14. 14. CASE STUDIES Property Cover in an Irish Captive PROBLEM: Deductible too large for individual affiliates ABC Company, a large global manufacturing The captive was set up in Ireland based primarily company insured its property and business on its proximity to Europe and US, its ability to interruption risks in the commercial market. access the EU on a direct basis and the favourable However, the policy has a deductible feature for corporate tax rate of 12.5%. Minimum capital the first £500k for each claim. The affiliates were required under the EU Insurance Directive too small to absorb a single large claim so the is €2.3m. company established an insurance captive to indemnify and reimburse the affiliates for any losses within the deductible. Premium of £5m was paid based on actuarial analysis of the exposure; this cost was spread over approx. 40 affiliates according to turnover. Liability risks PROBLEM: Premium rate increase A large drinks company set up a reinsurance Following a bad loss year the fronting company captive in a soft market cycle to retain a portion sought a sizable increase in premium and higher of its own risk. A fronting company was used to attachment point for the excess layers. provide cover from ground up to £550m. The Quotations from alternative insurers also primary layer £800k per occurrence and £4m in indicated a general hardening of the market. the aggregate was ceded 100% to the captive. Due to the surplus built up in the captive it was in Layers in excess of the captive’s layer were a position to take on this greater risk by increasing retained net by the fronting company. the captives aggregate and per occurrence limits - The captive loss experience over a number of allowing the fronting company to attach higher in years was good with loss ratios in the low 40’s the programme with a resultant reduction in leading to profits which were retained within the premium for the excess layers. captive. As a result a large surplus above the required solvency margin was built up.14
  15. 15. Motor CollisionDamage Waiver (CDW)PROBLEM:Take over of another car hire company meant fee incomefrom CDW cover was substantially increased.Following the take over of another hire company By establishing the cell the company now has thethe owner of the company recognised that it was advantage of not paying VAT on the CDW feean appropriate point in time to formalise the fees income, fees are now converted to premium andreceived in relation to CDW using an insurance therefore tax deductible, any claims paid wouldstructure. In doing so the company would have therefore be funded from pre-taxed funds andvarious tax advantages and would be able to build there is no requirement to release the surplusup a fund to finance future losses. funds as profit each year.The structure utilised had to be as simple and lowcost as possible and be set up swiftly to meetother company commitments. The structurechosen was that of a cell in an existing PCC inGuernsey. This meant no capital had to bedeposited above that required to meet the cellsolvency requirement. Cost of running the cellis lower than a standalone captive and thetimeframe to set up the cell was a matterof weeks. A GUIDE TO CAPTIVES 15
  16. 16. ce.com u ran t isins har w.c wwROBERT M. GAGLIARDISenior Vice President & Worldwide DirectorTel: +001 802 419 1234robert.gagliardi@chartisinsurance.comIVY JERMYN-BUCKLEYInsurance/Underwriting Manager – EuropeTel: +353 1 802 8791ivy.jermyn-buckley@chartisinsurance.comChartis is a world leading property-casualty and general insurance organisation serving more than 70 million clientsaround the world. With one of the industry’s most extensive ranges of products and services, deep claims expertiseand excellent financial strength, Chartis enables its commercial and personal insurance clients alike to manage riskwith confidence.Chartis Europe Limited is authorised and regulated by the Financial Services Authority (FSA number 202628).This information can be checked by visiting the FSA website www.fsa.gov.uk/Pages/register. Registered in England:company number 1486260. Registered address: The Chartis Building, 58 Fenchurch Street, London, EC3M 4AB.Chartis Europe Limited (“Chartis”) disclaims all warranties, expressed or implied, relating to the informationprovided. Chartis does not warrant or make any representations regarding the information provided in terms ofits correctness, accuracy, usefulness, completeness, reliability, or otherwise. Neither Chartis nor any membercompanies of American International Group, Inc. accept any liability of any kind for any direct or indirectloss arising from the use of this information.This brochure is intended as general information only and is not intended to provide specific professional advice.It is strongly recommended that you seek your own professional advice from suitably qualified professional advisers.AI427653 12/11

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