Captives: 101 and Beyond


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Introduction to Captive Insurance Companies.

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  • Closely held insurance companies typically set up to insure the specific needs or a company, association, or organization. Captives are owned and controlled by their insureds. Captive owners can have direct involvement in the captive’s operations. Most early captives were property captives. 1965 – Hurricane Betsy Insurance Cos. Began forcing major corporations to assume higher property deductibles. Mid-1970s Worst Underwriting Results in history = higher deductibles or unavailability Several major insurance companies began as captives – Allstate Ins Co. began as a captive subsidiary of Sears. Today, more than 4000 captives worldwide. Most large corporations have captives. Starbucks™ recently formed a captive, for instance.
  • There are numerous advantages to forming a captive insurance company. A partial list includes: the alternative to trading dollars with commercial insurers in the working layers of risk, coverage tailored to your specific needs, accumulation of investment income to help reduce net loss costs, improved cashflow control, incentive for loss control, greater control over claims, underwriting and retention funding flexibility, and reduced cost of operation.
  • Captive insurance organizations include insurance companies that are owned and controlled by their insureds. A captive insurance company is described as single parent captive if it is owned and controlled by one company and insures that company and/or its subsidiaries. A group captive is an insurance company owned and controlled by two or more non-affiliated organizations the captive insures. A group captive can be either homogeneous and insure similar types of businesses risks or non-homogeneous and insure risks of several types of organizations. In the U.S., group captives are licensed by a domiciliary state and use a fronting carrier, or they operate under the Federal Risk Retention Act. The companies may be either stock, reciprocal or mutual in organizational form. Hybrid – Diverse capital interests: Insured, Agent, TPA, Fronting/Reinsurer, Association Rent-a-Captive : an arrangement whereby an organization “rents” the capital from a rent-a-captive facility. Rent-a-Captives provide a means for an organization to quickly form a captive insurer without tying up capital.
  • Within the United States, an Insurer does not need to be licensed for many lines of property, marine, and liability coverage. Therefore a captive insurer can issue policies directly. However, the captive must comply with nonadmitted insurer regulations in each state and pay premium taxes. Fronting: In the U.S., states require an insurance company to be licensed to provide workers’ compensation and automobile liability insurance. The majority of captive insurance companies are not licensed and it would be time-consumeing and expensive for them to obtain licenses. Also, often outside parties require an acceptable rating from A.M. Best or Standard & Poor’s. Fronting fees range from 6-10% of Gross Written Premium volume. Risk-sharing opportunities -
  • A significant risk for a fronted company is the credit risk of the captive. Credit risk is generated from the captives inability to meet its financial obligations from the business and financial risk. They include adverse loss experience, catastrophic loss or inadequate spread of risk. The majority of captives are non-admitted insurance companies. In order to admit an unearned premium and loss reserve as an asset, the fronting company needs a letter of credit or securities held in trust to be held as collateral on behalf of the captive. Typically, fronting companies require guarantees for unearned premiums ceded to the captive, loss reserves for prior years and expected losses for the current and coming year. There are three types of guarantees which can be used as collateral: Letters of Credit are commonly used as the collateral vehicle. In short, the letter should be issued or confirmed by a bank which is a member of the Federal Reserve, it should be clear, and it should include a provision for automatic renewal. Trust Agreements are admitted assets placed in a trust account for the benefit of the fronted company. Funds Withheld is a method by which the reinsurance cession is delayed by the fronted company for up to a year or more. The balance sheet of the captive will show a reinsurance receivable as an asset.
  • More than half of the states have now passed captive insurance enabling statutes, and more than a half-dozen of those states now aggressively cater to the domestic captive market. Premiums paid to captives in 2006 in Vermont alone were estimated to exceed $11.55 billion.
  • Capitalization Requirements. Refers to the minimum initial amount of money required to commence operations. These requirements vary widely from jurisdiction to jurisdiction and in some (although not all) locales, part of the capitalization can be in the form of letters of credit. Surplus Requirements. Pertain to the minimum written premium-to-surplus ratios allowed by the domicile, which also vary significantly (e.g., from 1:1 to 10:1, depending on the location). This is especially important at the early stages of captive formation when funds may be limited. Investment Restrictions. Certain jurisdictions prohibit various types of investments, others mandate specific maximum percentages of funds that can be placed in a given investment vehicle, while others have more or less restrictive definitions of what constitutes "admitted assets." Reporting and Auditing Requirements. Stipulate the types and frequency with which reports must be filed with local regulatory authorities. Some domiciles require much more frequent and detailed reports than do others. Loss Reserving Requirements. A few domestic domiciles require captives to post loss reserves based on minimum loss ratios. For example, captives writing workers compensation insurance may be required to post initial loss reserves of no less than 65 percent of written premiums. Income and Local Taxes. Domiciles vary as respects the taxability of total written premium, underwriting income, and investment income. Some domiciles even offer certain tax credits. For example, Hawaii allows an income tax credit to captives for the amount paid in premium taxes on locally placed insurance. Also, the need to pay federal excise taxes, a key financial consideration, varies from jurisdiction to jurisdiction. Government Fees. Many domiciles levy an annual assessment on all captives operating within their jurisdictions. Overall Regulatory Climate. Varies widely from domicile to domicile. In the past, onshore domiciles generally were stricter than their offshore counterparts, but this is changing as major U.S. domiciles, such as Vermont, strive to offer flexible regulation and other states follow suit. Formation Time. Also affected by the local regulatory climate. Because of the competition between domiciles, the time required to gain regulatory approval is decreasing. Miscellaneous Underwriting Limitations. Certain jurisdictions require that rates and policy forms first be submitted for approval while others specify that only certain types of coverage may be written; still others prohibit the writing of "unrelated" business except through reinsurance pools. Acceptance by Fronting Companies and Reinsurers. Often influenced by where a captive is located. Naturally, reinsurers and fronting insurers prefer domiciles that offer the most growth potential for their operations, such as those with the most captive-friendly regulatory environment. Formation Costs. Include items such as a stamp tax (for offshore domiciles), registration fees, and incorporation expenses. In the aggregate, these amounts can vary considerably, which significantly affects the cost of forming a captive and making it operational. Management and Legal Fees. Entail the ongoing costs of administering the captive once it has been established. Again, local custom and practice will determine the magnitude of such fees. Availability of Banking, Accounting, and Other Services. Depends largely on the popularity (e.g., the number of captives that have been established) in a given domicile. Location-Specific Factors. Include subjective items such as political stability, ease of communications, accessibility, lifestyle, stability of currency, and absence of exchange controls. Accessibility is especially important in a group captive because if members must commute long distances for meetings, substantial additional time and cost must be factored into the feasibility analysis. Political stability is another key factor because several Caribbean nations have recently experienced internal unrest. Political overthrow of existing governments could imperil the security of any captive assets held within the domicile.
  • Captives: 101 and Beyond

    1. 1. Captives: 101 and Beyond Phillip J. Gajewski, CPCU, ARM AVP, Business Development Meadowbrook Insurance Group
    2. 2. What is a Captive? <ul><li>Captive insurance organizations are insurance companies that are owned and controlled by their insureds. </li></ul><ul><li>A captive insurance company can be defined as a special purpose insurer whose sources of business are (1) its shareholders and their affiliates which put their own capital at risk, or (2) other participants such as association or group members. </li></ul>
    3. 3. What are the Reasons for Forming a Captive? <ul><li>Stabilize insurance costs by getting off the pricing “roller coaster”. </li></ul><ul><li>Separate your own premium and loss experience from those of other groups or insureds. </li></ul><ul><li>Assure availability of tailored coverage. </li></ul><ul><li>If experience is good, insurance costs can be trimmed through premium reductions or dividends. </li></ul><ul><li>If loss experience is adverse, the situation should still be better because of realized investment income. </li></ul>
    4. 4. How a Captive Can Save Costs. <ul><li>Eliminates normal insurance company overhead. </li></ul><ul><li>Realize investment income on premium and capital. </li></ul><ul><li>Realize investment income on loss reserves. </li></ul><ul><li>Specialized claims handling and administration. </li></ul><ul><li>Specialized loss control activities. </li></ul><ul><li>Potential tax advantages? </li></ul>
    5. 5. Advantages <ul><li>Reduced operating costs </li></ul><ul><li>Investment income and underwriting profit </li></ul><ul><li>Broader coverage </li></ul><ul><li>Pricing and coverage stability </li></ul><ul><li>Direct reinsurer access </li></ul><ul><li>Improved service </li></ul><ul><li>Increased control </li></ul><ul><li>Immediate reward for reducing losses </li></ul><ul><li>Enhanced risk management status </li></ul><ul><li>Fewer regulatory restrictions </li></ul>
    6. 6. Types of Captives <ul><li>Single-Parent Captive (Pure) </li></ul><ul><li>Group (or Association) Captive </li></ul><ul><li>Agency Captive </li></ul><ul><li>Hybrid… </li></ul><ul><li>also, </li></ul><ul><li>Rent-a-Captives </li></ul>
    7. 7. Method of Writing Business <ul><li>Direct Write Captives </li></ul><ul><li>vs. </li></ul><ul><li>Use of / Need for Fronting Companies </li></ul><ul><li>Risk-Sharing Opportunities? </li></ul>
    8. 8. Risk Sharing Partnerships Excess Commercial Reinsurers Front Co. Quota Share Premium Quota Share Losses Underwriting Profit + Investment Income Agency Policyholder Captive Shareholders
    9. 9. Excess Commercial Reinsurers 100% $750,000 (Excess Layer) $250,000 (Working Layer) QUOTA-SHARE (Captive decides their share) Limitation of Risk $1 Million Exposure Front Co. 50% CAPTIVE 50%
    10. 10. Collateral Requirements for Fronting / Risk-Sharing <ul><li>Letter of Credit (LOC) </li></ul><ul><li>Trust Agreement </li></ul><ul><li>Funds Withheld </li></ul>
    11. 11. Domicile Selection <ul><li>On-Shore </li></ul><ul><ul><li>AL, AR, AZ, CO, DE, DC, GA, HA, IL, KY, ME, MO, MT, NV, NY, RI, SC, SD, UT, VT </li></ul></ul><ul><li>vs. </li></ul><ul><li>Off-Shore </li></ul><ul><ul><li>Bermuda, Barbados, British Virgin Islands, Caymans, Dublin, Guernsey </li></ul></ul>
    12. 12. Domicile Selection Factors <ul><li>Capitalization Requirements </li></ul><ul><li>Surplus Requirements </li></ul><ul><li>Investment Restrictions </li></ul><ul><li>Reporting and Auditing Requirements </li></ul><ul><li>Loss Reserving Requirements </li></ul><ul><li>Income and Local Taxes </li></ul><ul><li>Government Fees </li></ul><ul><li>Overall Regulatory Climate </li></ul><ul><li>Formation Time </li></ul><ul><li>Miscellaneous Underwriting Limitations </li></ul><ul><li>Acceptance by Fronting Companies and Reinsurers </li></ul><ul><li>Formation Costs </li></ul><ul><li>Management and Legal Fees </li></ul><ul><li>Availability of Banking, Accounting, & Other Services </li></ul><ul><li>Location-Specific Factors </li></ul>
    13. 13. Average Annual Operating Costs <ul><li>Management Fees: $35,000 - 250,000 </li></ul><ul><li>Legal Fees: $15,000 – 40,000 </li></ul><ul><li>Auditing, Actuarial: $15,000 – 45,000 </li></ul><ul><li>Government Fees: $3,000 – 10,000 </li></ul><ul><li>Meeting Expenses: $10,000 – 50,000 </li></ul>
    14. 14. III. CORPORATION DOCUMENTATION A. Charter B. Offering Memorandum C. Subscription Agreement D. Escrow Agreement E. By-Laws IV. MULTIPLE OWNERS RELATIONSHIPS A. Voting Rights B. Capital Contribution C. Standards for Participation In A Group Captive D. Profit Participation In A Group Captive E. Departing Shareholders/Insureds F. Settlement of Disputes I. INTRODUCTION A. Domiciles and Legal Structures B. Corporation Documentation C. Relationships Between Multiple Owners D. Insurance Regulation E. Securities Regulation F. Insurance Documentation G. Management Services H. Contracts II. DOMICILES AND STRUCTURE A. Company Domicile B. Corporate Form C. Capitalization D. Board of Directors E. Officers F. Committees G. Name of Captive Captive Formation Steps
    15. 15. V. INSURANCE REGULATION A. U.S. Insurance Regulation B. Captive Domicile Regulation VI. SECURITIES REGULATION A. U.S. Securities Regulation B. Captive Domicile Regulation VII. INSURANCE DOCUMENTATION A. Policy Forms B. Fronting Arrangements C. Underwriting Guidelines D. Rating of Policyholders E. Miscellaneous F. Reinsurance Placement VIII. MANAGEMENT SERVICES A. Designate Manager B. Designate Law Firm C. Designate Bank D. Designate Auditors E. Other Service Providers IX. CONTRACTS A. Management Agreement B. Reinsurance Agreement C. Trust Agreement Captive Formation Steps
    16. 16. Disadvantages / Potential Pitfalls <ul><li>Captive Costs </li></ul><ul><ul><li>Capitalization and commitment </li></ul></ul><ul><ul><li>Dependent upon service providers </li></ul></ul><ul><ul><li>Internal administrative costs </li></ul></ul><ul><li>Poor Underwriting Results </li></ul><ul><ul><li>Inadequate loss reserves and potential losses </li></ul></ul><ul><li>Competitive Insurance Environment </li></ul><ul><li>Failure to Employ Loss Control Techniques </li></ul><ul><li>Large, Single Insured/Stockholder </li></ul><ul><li>Possible taxation problems </li></ul><ul><li>Some insurer/broker resistance </li></ul><ul><ul><li>Increased cost of other insurance </li></ul></ul>
    17. 17. Captive Resources: <ul><li> </li></ul><ul><li>IRMI – International Risk Management Institute. </li></ul><ul><ul><li>Captive Insurance Company Reports </li></ul></ul><ul><ul><li>Captives & the Management of Risk </li></ul></ul><ul><ul><li>Captive Practices & Procedures </li></ul></ul>
    18. 18. Thank You! Questions?