Captive Structures
April 2002
There are many different structures for a
captive insurance company. Michael Mead discusses the most common structures
and their potential uses.
by Michael
R. Mead
M.R. Mead &
Company, LLC
There are many different structures for a captive insurance company. This
article will discuss the most common structures and their potential uses. Some
of these are merely variations on a theme, and doubtless I will overlook some
as there are new structures being proposed every day. It is an exciting field.
The basic captive structures consist of:
- Single parent
- Group/association
- Rental captives
- Segregated protected cell
- Non-controlled foreign corporations
Common Characteristics
Regardless of the structure chosen, there are some basics common to all captive
structures. One of these is the participation of a risk sharing partner, or
traditional insurer. Risk sharing partners provide such necessary and desirable
services as certification of coverage and limits; reinsurance; loss control
and mitigation; claims reserving, adjustment, and oversight; risk management;
underwriting and regulatory response and assistance. This often-overlooked service
has become one of the most valuable services offered by insurers to captives
today. We will have more to say about this service on another day.
The insured that decides to establish a captive must carefully choose a risk
sharing partner as providing certificates to outside parties is often a material
service. The risk sharing partner must carry an A.M. Best's rating as required
by regulators and mortgage holders and lenders in order for the certificate
to be accepted. The risk sharing partner must be involved from the inception
of discussions and will have a say in the ultimate structure chosen. There is
little point in choosing a structure and then learning that no one will partner
with you.
Single Parent Captive
The single parent captive is still the most prevalent structure in use today.
This is an insurance company owned by one company, usually the insured. It's
usual purpose is to provide some risk transfer or financing for a corporation
on a specific line of coverage. It is not usually admitted to write insurance
in a domicile, other than it's own risks.
This form has been in use for over 50 years, and has stood the test of time
and challenge. It is an effective alternative to traditional insurance when
organizing the financial risks of a commercial business. This structure is welcomed
in all domiciles by all partners.
A single parent captive is most often used to provide coverage either directly,
where permitted, or as reinsurance of a traditional primary insurer. Frequently
this captive provides reinsurance on workers compensation programs. Increasingly
we see them used for property insurance, directors and officers liability, terrorism,
and toxic mold.
Recent developments have opened the door for writing certain employee benefits
programs in captives. The single parent structure would work well for this exposure,
and I expect to see a tremendous increase in this use for captives.
The single parent captive structure is a corporation, therefore some thought
must be given to who will serve as owners, directors, and officers. In most
captive domiciles the standard C type corporation is the form allowed. Few domiciles
allow limited liability forms, although some will allow a structure somewhat
akin to an S corporation. Often, the parent corporation is the owner of the
shares.
The single parent captive was often used for tax issues, but is now used
more for coverage or limits otherwise unavailable. It is sometimes seen as a
new profit center for the parent firm. All captives should be initiated with
a serious commitment of time and financing, and this form is often a new venture
within a larger firm in which the risk management department is planned to generate
profits and contribute to the parent companies' bottom line.
The offshore domiciles have been addressing criticisms of the Organization
for Economic Cooperation and Development and the Financial Action Task Force
in terms of knowing their customers. Many new procedures have been introduced
in the past few months that may surprise some who have knowledge of captives.
Most of the procedures are reasonable and not burdensome, but they should be
reviewed with care before the owners, directors, and officers are selected.
There may be issues to address that will slow down formation or even preclude
the participation of key organizers.
It may seem obvious that the insured corporation would be the owner, since
the form is a single parent captive, but in the case of a private or closely
held business, there may be multiple shareholders, and the captive will still
be referred to as a single parent. There may be a family trust as owner. The
essential element for being called a single parent is that it really insures
a single insured, does not entertain risks outside its business enterprise,
and the ownership is tightly related.
All regularly recognized domiciles and risk sharing partners welcome single
parent captives. The choice of partners is then determined by the other goals
of the owner, in terms of obtaining coverage not otherwise available, creating
a profit center, or smoothing out the future costs of risk finance. By increasing
and diminishing the amount of risk held by the captive, the parent company can
smooth its risk costs over time. This is viewed very favorably by many CFOs
and treasurers.
Seeking a tax advantage is a bit more challenging with single parent captives,
and the use and advice of qualified counsel is strongly recommended. Indeed,
there may be no tax advantage at all under this structure. While the current
operating philosophy of the Internal Revenue Service (IRS) is fairly accommodating
to captives, it is widely acknowledged that what the IRS giveth, the IRS taketh
away.
Group or Association Captive
The group or association captive is a structure in which multiple businesses
join together either through a formal association or an informal relationship
to use a captive to obtain coverage or limits otherwise unavailable. This form
has become a source of revenues and industry cohesion for many trade groups.
These groups can be artificial in the sense that an entrepreneur forms the
captive and offers coverage to otherwise unrelated insureds, and the insured
group can be either heterogeneous or homogeneous in nature.
This structure usually involves a corporate structure with more than one
class of share. These different share classes can enable the group to use a
dividend policy to reflect the actual claims profile of each separate member
of the group or association.
A group or association captive can be a management challenge as it can bring
risk related, non-group issues to the fore, such as appropriate loss control
and the ability of some members to promptly address security against future
claims. Playing well together is an important element.
Rental Captives
Rental captives gained popularity over 20 years ago as a reaction to the
costs of forming and operating a captive. The potential insured finds an existing
captive, often owned by a traditional insurer, which creates a separate set
of books within its own structure to reflect the singular risk of the potential
insured. Usually this method restricts the choices of risk sharing partners
and service providers.
The use of someone else's captive necessarily means that you will be paying
increased frictional costs. These may be offset by not having the costs of establishing
and operating your own facility. It is important to know these costs, compare
and contrast them, and consider the control and partner/provider issues before
making a decision on a rental captive.
In recent years, the IRS has had success in challenging the deductibility
of premiums paid to some rental facilities based on an apparent lack of real
risk transfer. Very careful consideration must be given to this aspect, and
the use of qualified tax counsel is again highly recommended.
Some rental facilities have also had difficulty with risk sharing partners
due to under-reserving for future losses. Before committing to a rental facility,
you should have a discussion with the primary risk sharing partner about their
reserving practices, and perhaps even consider an independent actuarial review
of the reserves.
Segregated Protected Cells
For the above reasons, plus IRS challenges and reserve inadequacies, several
domiciles introduced the Segregated Protected Cell structure. While very similar
in approach to a rental facility, there are marked differences that make this
structure a very popular choice today.
The segregated protected cell, or sponsored captive, which is not permitted
in all domiciles, has a structure in which an existing insurer or "captive,"
owned by an insurance company or service provider, assists in the creation of
cells within itself. These cells must follow similar procedures for establishing
a single parent captive, but stop short of ultimate regulatory approval as the
regulators look to the sponsor for compliance with their regulations.
All lines of coverage can be underwritten in a cell structure. This is of
course subject to the agreement of the sponsor and the risk sharing partners.
Indeed, a company could establish a captive and then segregate lines of risk,
subsidiaries, or businesses by creating cells within its own captive.
Legislation protects a cell and its owners from claims by creditors of other
cells within the sponsored company. To many people, this lack of a "firewall"
is a flaw in the typical rental structure. In the typical rental structure,
there is no absolute protection from each and every creditor, as at some level
the sponsored company has some joint liabilities. With the protected cell approach,
however, the firewall is sound and should provide considerable protection against
creditors of other cells.
The proposed owner of a cell will be asked to provide information and references
similar to what is asked of owners of single parent captives. Indeed, the ownership
of an individual cell can take the same variety of forms as a single parent
or group captive, or take no structure at all. It may be only a policy of insurance.
Since the cell is within an approved company, with its own already established
owners, officers and directors, risk partners, and service providers, it is
essentially an approved insurance company. The liabilities and responsibilities
fall to its owners in terms of ultimate success or failure. The regulators will
want to be knowledgeable of who and what is in each cell, but they will look
to the sponsor for assurances of legitimacy and competence.
Each cell will be required to post its own security against future claims
on its own risks. This makes it feasible to have more than one risk sharing
partner involved with the sponsor. The cell will have to provide an annual audit
and actuarial certification of reserve adequacy to the cell's owners, and thus
the regulators. The cell may have a different attachment point for reinsurance
than other cells within the holding structure. This feature makes the segregated
cell structure attractive to heterogeneous groups or groups with members of
very different premium sizes. This also greatly complicates the process and
adds to frictional costs.
Non-Controlled Foreign Corporations
Non-controlled foreign corporations are more of a tax approach than the other
structures. When forming an offshore captive, one of the early decisions is
to determine the tax status going forward. Thoughtful consultation with well-qualified
tax experts is highly recommended for the decision as to whether or not to take
the 953(d) election of the Internal Revenue Code, and be taxed as a U.S. entity,
or not. Fines and penalties for doing it the wrong way are formidable.
If the decision is made to not be taxed as a U.S. tax payer, then several
"gateways" must be traversed to assure compliance with all regulations. Again,
knowledgeable counsel is highly recommended. In general, the participation and
rights of U.S. taxpayers are limited, so this structure is most often used where
there are more than a dozen unrelated non-U.S. entities involved in ownership
of the captive. The tax advantages for the owners, if they establish the captive
properly and manage it prudently, can be considerable in some cases.
Conclusion
New captive structures are being created every day, and will be of great
benefit to the overall industry. Most will rely in some way on the above general
models.
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