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Do Captives Earn Profits?

Donald Riggin | August 15, 2009

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The short answer to the question of whether captives earn a profit is "yes and no." It all depends on your point of view.

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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