Do Captives Earn Profits?
August 2009
The short answer to the question of
whether captives earn a profit is "yes and no." It all depends on your point
of view.
by Donald
J. Riggin
Albert Risk
Management Consultants
The term "profit" is generally described as the making of money in a
business activity for the benefit of the shareholders. There are two kinds
of profit: accounting and economic. Accounting profit, in its most basic
form, is the difference between the costs of producing a product or service
and its price. Economic profit is the difference between a company's total
revenue and its opportunity costs. Another way to understand economic profit
is through an investment. If an investor earns money on a particular
investment, that profit also reflects the opportunity costs of not investing
in an alternate investment.
Captives that conform to the strict definition—the policyholder and the
shareholder are one in the same, and the captive is on-balance sheet (i.e.,
its financials are consolidated into its parent's financials)—do not earn
profits for their shareholders. They certainly can and do produce losses,
but aside from investment income, they do not earn profits in the
traditional sense. I know that this will come as a bit of a shock to some of
you, but alas, it is true. The best a single-parent captive can do is
save its parent company money, which, in
the vernacular of the captive's financial statements, looks just like
profits, or more accurately, earnings.
A typical, garden variety captive's earnings are really just the physical
manifestation of the parent's ability to prevent and manage losses, save
money as compared to insuring in the commercial markets (maybe), and for a
for-profit company, possibly take advantage of the accelerated tax deduction
benefits, assuming the captive's risks were previously self-insured, such as
within a self-insured retention or a deductible plan. From the captive's
perspective, its earnings are tantamount to profits (after taxes, etc.), but
only when viewed in isolation from the parent company, which makes little
sense. This brings us to a discussion of group captives.
Group Captives
Most group captives, assuming they satisfy the Internal Revenue Service
(IRS) insurance company tests, are separate and distinct insurance entities,
not owned in the majority by any one shareholder. Let's have a look at what
happens in a typical group captive. The following is a simple example. Ten
members of the Amalgamated Society of Producers of Carrots of America
(ASPCA) decided to form a group captive. Each carrot producer pays on
average $1 million in general and products liability losses annually within
their $500,000 per-claim self-insured retentions. To satisfy the domicile's
capitalization requirements, each shareholder contributed $200,000 in
capital and surplus to the captive.
Ten shareholders, each with expected losses (at the $500,000 retention)
of $1 million equals total first-year loss funding of $10 million. Some
expenses are also ceded into the captive, but we're going to ignore them for
this example. So far, so good. Now we're going to perform a little surgery
on the captive's premium funding. Our actuary has told us that the captive's
annual premium for losses limited to $350,000 (as opposed to the $500,000
limit) would be roughly $750,000 per shareholder, or $7.5 million for the
captive.
In fact, it turns out that the majority of the loss frequency is
contained under the $350,000 loss limit, and a small minority of claims
actually exceeds $350,000. After reviewing the actuary's report, the
captive's consultant introduces this concept: let each shareholder continue
to pay its own losses under $350,000, and all of the losses between $350,000
and $500,000 would be shared by all of the shareholders. This means that
we'll have two separate and distinct captive premiums—one for the primary
layer (under $350,000 per claim) and one for the excess layer (losses
between $350,000 and $500,000). For simplicity's sake, we're ignoring the
FAS 113 issues). Those premiums would be as follows.
| Primary Layer Premium: |
$ 7,500,000 |
| Excess Layer Premium: |
+ 2,500,000 |
| Total Captive Premium: |
$10,000,000 |
Remember that the primary layer premiums represent the aggregation of
individual shareholder accounts; each shareholder pays its own losses up to
$350,000 per claim. However, the excess layer is the shared layer—risk and
premiums are shared among the 10 shareholders. After 36 months, the actuary
recommends that the first year could be closed. She's determined that there
will be no additional incurred but not reported (IBNR) losses or case
reserve development for year one.
Further assume that the captive's excess
layer losses for year one equaled a total of $500,000. When the first year
is closed, the remaining excess layer premiums are moved into the capital
and surplus account. In so doing, the capital and surplus (i.e., equity)
increases from the original $2 million to $4 million. Each shareholder's
equity, therefore, increases from $200,000 to $400,000. (To keep it simple,
these figures are not discounted and include no investment income.)
So now
we circle back to the question of profit. Has this captive earned an
underwriting profit? Of course it has. The captive is an independent entity;
no single shareholder owns a controlling interest. More importantly, has
each shareholder earned a profit (albeit on paper) on its
$200,000 investment? On its face it appears to be so, but if we consider the
economic definition of profit as discussed in the first paragraph, we have
to consider the opportunity costs associated with the $250,000 excess layer
premium. We also have to consider the logic we applied to single-parent
captives—profit is merely the savings that results from superior loss
prevention, claims management, etc.
Opportunity Costs
Let's first
explore the opportunity cost issue. In the absence of the captive, each
shareholder would have two options: (1) purchase first-dollar insurance or
(2) self-insure losses up to $500,000 per occurrence. We assume that the
first option is a non-starter; first-dollar insurance would most likely be
very expensive, especially as compared to self-insurance. The question,
then, is this: is the self-insured, discounted, after-tax value of the
excess layer claims payments potentially less expensive than the after-tax
value of the captive premium or vice versa? Is this even a fair comparison
given the fact that under the self-insured scenario, aggregate losses could,
in fact, exceed the captive excess layer premium?
Obviously, the intangible value associated with a fixed premium versus
variable losses should be factored into the evaluation.
Second, let's
revisit the notion that a group captive's profits, from the shareholder's
perspective, are identical to that of a single-parent captive. After all,
while there are 10 unrelated shareholders, they're not selling anything to
one another; they're participating in the same investment and assuming the
same risks. So is any captive capable of producing profits (without
third-party business)? The answer seems to be in the eye of the beholder.
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