Things To Know about Captive Insurance Companies
November 2008
Those of us who toil in the alternative markets
sometimes lose perspective on reality. We assume that everyone we talk with
has a basic understanding of the various alternative risk financing techniques.
In some cases, this is true, but in the majority of cases, we're met with blank
stares.
by Donald
J. Riggin
Albert Risk
Management Consultants
You know what I mean. You're a proud member of the insurance industry; a
broker, an underwriter, etc., who perhaps would benefit from at least a rudimentary
understanding of how, for example, captives operate. But you've never really
devoted the time to research the subject because, truth be told, you haven't
had to do so.
So you're out at a local watering hole with friends from work and someone
says, "Hey, we just put ABC Company into its own single-parent captive!" Your
response? "That's nice." However, you're thinking, what if some of my clients
could benefit from a captive, and I've got no clue how to help them? Well, friends,
you've come to the right place.
This brief article will give you a "CliffsNotes"-style understanding of captives
and their uses. No, you will not become an instant expert on captives, but as
one of the senior underwriters at the Royal Globe Insurance Company told our
class of underwriting trainees exactly 30 years ago this month, "In this business
we don't have to know everything there is to know; we only have to know
where to find the information."
What Is a Captive?
First, let's start at the very beginning. You might be asking yourself, "How
can a company insure itself?" Good question. You've been trained to understand
insurance as a contract that transfers risk to another entity—an insurance company.
Well, the definition of insurance has not been rendered moot; for captives to
be considered real insurers, there must be some degree of risk transfer. Captives
that do not satisfy the risk transfer tests are nevertheless captives, but not
for tax and accounting purposes. More on this later.
Most captives cover casualty lines such as workers compensation and general
liability, and are fully or partially funded to cover "expected losses" for
each line of coverage. An actuary determines expected losses based on a company's
historical loss amounts and payout characteristics. Captives usually only cover
losses within a specific deductible or retention amount; $250,000 per occurrence
is a typical captive limit. This means that the actuary's expected losses only
include losses falling at $250,000 and under.
For example, let's assume that your company's historical general liability
losses are, as we say, all over the board. You've got many small losses, of
course, but you also have several large losses exceeding $250,000. Your actuary
will only use the losses falling under $250,000 to calculate expected losses,
assuming that all future losses over $250,000 will be transferred into the commercial
insurance markets.
The strict definition of a captive is an insurance vehicle that is owned
by its policyholder(s). Many of the world's captives do not satisfy the IRS
definitions but remain captives because of the role they fulfill for their parent
companies.
Captives must be formed in a special U.S. state or foreign country, known
as a captive domicile, that has special enabling legislation. Bermuda is the
most well-known offshore domicile, and the largest, and Vermont is the preeminent
onshore domicile. As of this writing, 28 U.S. states have captive enabling legislation.
Captives and Taxes
You, however, are mainly interested in captives that take the place of commercial
insurance. In doing so, premiums paid to the captive must be deductible from
your (or your client's) U.S. federal income taxes—just like the premiums paid
to any insurance company. So how does a captive achieve premium deductibility
for its parent company(s)? Two IRS tests—risk shifting and risk distribution—provide
the answer.
A series of IRS revenue rulings beginning in the late 1990s replaced what
we used to call the "mother of all captive-related revenue rulings," the venerable
Rev Rule 77–316. 77–316, the 316th revenue ruling of 1977, defined
the Internal Revenue Service (IRS) position on captive premium deductibility
for over 25 years. It's called the "economic family" doctrine, which said that
since a captive is just another subsidiary of its parent company, it falls within
the company's economic family. This means that premiums paid to such a captive
are tantamount to nothing more than a transfer of assets (so-called premiums)
from one part of the company to another, hence, no risk transfer, and certainly
no risk distribution (also known as risk sharing).
Today, there are two ways for a captive to achieve insurance company status
per the IRS:
(1) It must insure third-party business equal to 50 percent or more of the
captive's total business, or
(2) The corporate structure must resemble a holding company with an array
of subsidiaries or operating units that generate their own financial statements.
This is described in IRS Revenue Ruling 2002–90, and it's known as the "balance
sheet" theory because each subsidiary is independent of the others—the failure
of one does not affect the others.
There are a variety of other
requirements needed to satisfy the IRS insurance company tests, but these two
are the most important. If your captive manages to pass one of the two tests
noted above, satisfying the rest can be relatively easy, (but don't take my
word for it, look it up in IRMI's Risk Financing).
Types of Captives
Captives take various forms. They can be wholly owned by their parent companies
or they can rent space, called a cell, from a third-party-owned captive. Ah
ha, you say! If a company rents a cell from a third-party captive, doesn't that
constitute a real insurance contract based on the discussion above? Well, the
answer is yes and no.
It is generally accepted that use of a cell captive constitutes risk transfer,
but the question of risk sharing remains open. IRS Revenue Ruling 2008–08 sets
forth the conditions in which cell captives may be considered insurance for
tax purposes; they're basically considered to be self-contained single-parent
captives. Now, group captives, as opposed
to single-parent captives, generally tend to satisfy the risk shifting/distribution
tests by virtue of the fact that there are multiple independent policyholders/shareholders,
each owning a minority interest in the captive.
Minimum Premiums
Any owned captive—that is, any captive that is
not a cell rented from a third-party captive—must
begin life with at least, in my humble opinion, $3 million in premium. This
applies to both group and single-parent captives. Some people think that $5
million should be considered the minimum premium threshold, but I've seen (and
formed) captives with $3 million as the opening premium.
Startup Costs
Single-parent captives may be launched for roughly $250,000 in startup costs.
These costs include the consultant (or broker), the actuary, the attorneys,
and the captive manager. Group captives can cost far more than this if the group
decides to have a private placement memorandum (PPM) written by an attorney.
A PPM is tantamount to a securities offering document. Groups are not required
to have PPMs, but they provide a solid legal foundation for the captive in the
event one or more members initiates legal action against the captive for whatever
reason.
Capital and Surplus
Like any company, every captive must be capitalized. Bermuda, for example,
has specific capital and surplus minimums depending on the amount of written
premium. For premiums up to $6 million, a Bermuda captive must adhere to a 5:1
capital and surplus-to-premium ratio. For example, a captive that starts out
with $3 million in premium must have at least an additional $600,000 of capital
and surplus. For premiums in excess of $6 million, Bermuda requires a 10:1 ratio.
New captives, regardless of domicile, usually begin life with a solvency ratio
between 3:1 and 5:1.
Captive Benefits and Drawbacks
So, now that we've covered some of the structural issues, let's talk about
why you or your client might want to investigate a captive. Space prohibits
a thorough recitation of all of the various benefits and drawbacks, but if you're
really interested, have a look at IRMI's Risk
Financing or go to
Captive.com.
The major consideration, however, is only tangentially related to the often
incidental reasons (both for and against) for forming or joining a captive.
What is the major consideration? It is this: Is your company (or client's
company) amenable, economically and culturally, to creating an on-balance sheet
asset (the captive) designed to manage your risk capital? If not, you will continue
to transfer insurable risk into the commercial insurance markets, with or without
a significant amount of passive risk retention (unfunded deductibles, etc.).
If the idea of building an asset devoted to managing event risk is attractive,
then and only then should you investigate the benefits and drawbacks of captives.
The question is really one of capital management—keep a large portion of
your event risk on-balance sheet, allocating the necessary capital, or allocate
your risk capital through insurance premiums and retain whatever amount of passive
(unfunded) risk demanded by the insurance providers. Answer these questions,
and then proceed to the next logical step.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author’s employer or IRMI. This article does not purport
to provide legal, accounting, or other professional advice or opinion. If such advice
is needed, consult with your attorney, accountant, or other qualified adviser.