The answer to this question is a robust "maybe." It all depends on your point of view (and the particulars of the captive, of course). 1
I have a client whose captive has returned about $3 million of its earnings to the parent over the course of 10 years. There is nothing special about this captive. It covers a single line of insurance and is domiciled onshore. The captive's US federal income tax rate is 35 percent. So the questions are: what does affect the captive's earnings, and why are the earnings considered to be earnings and not simply premium overpayments?
In the above example, total annual captive premiums equal about $4 million. Over 10 years, the captive has collected about $40 million. Its 10-year average loss ratio has been about 30 percent. The captive's retention is $250,000 per occurrence; all losses have been contained in the captive's retention. The claims payout period is 5 years, with the following percentages: 20, 30, 30, 10, 10. Given these facts, it would appear that the captive's earnings are, indeed, earnings, out of which the parent received $3 million over the 10-year period leaving actuarially determined loss reserves to cover claims. So far, so good.
Deductible Plans versus Captives
Now let's see how a large deductible plan would compare to this captive. We know that companies that qualify for captive ownership usually compare the captive to a large deductible. (In most cases, guaranteed cost and old-fashioned retrospective plans could never compete against a large deductible.)
It is here where cash flow becomes an important aspect of the comparison. In financial parlance, cash flow is either positive or negative. Positive cash flow ensues when incoming funds exceed outgoing funds, and negative cash flows are the opposite of this. In this example, we use the term "cash flow" in the insurance sense—the length of time we are able to hold cash before we have to pay a claim. The longer we are able to hold onto the cash, the greater the potential investment or business return.
The large deductible plan is very cost-efficient, meaning that there are few frictional costs required to launch and administer the program. This plan provides the maximum amount of cash flow available, as the company holds the funds until a loss must be paid. Moreover, based on the 5-year average claims payout period, positive cash flow is enhanced—most losses do not pay out to ultimate during the policy year, hence the 5-year payout period.
Shared Traits
Now let's identify the traits shared by the captive and the large deductible. For each program, an actuary determines and annually certifies the program's loss reserves. Regardless of the program, losses must be paid (i.e., one plan does not reduce the amount of paid claims over the other). Claims are claims, as we like to say. Remember the object of this exercise—to explore whether or not a captive is more or less expensive than a noncaptive alternative. To this end, have a look at the following chart.
| Captive | Large Deductible | |
|---|---|---|
| Claims | Paid from the captive | Paid from the parent |
| Parent Cash Flow | Reduced as premium is due on day one (premium includes loss funding) | Far better than the captive as losses are paid as they occur during a multiyear payout period |
| Excess Insurance Cost | Same | Same |
| Cost of Actuary | Same | Same |
| Tax Effect | Captive premium comprises expected losses for the year. Thus, the premium may be deductible. This is known as accelerating the tax deduction. | Tax deductions are taken on losses as they are paid over the multiyear claims payout period. |
| Annual Administrative Costs | Significant—manager, auditor, attorney, tax counsel, domicile regulator, etc. | De minimis |
| Startup Costs | Same vendors as above but less expensive | None |
| Claims Administration and Loss Control Costs | Same | Same |
| Miscellaneous Costs | Travel to domicile for annual meetings, etc. | Few if any |
Remember that claims are claims—their costs are constant regardless of the risk-financing program. The key difference is when those losses are paid. As for taxes, the value of accelerated tax deductions is expressed as positive cash flow. Regardless of the plan, identical taxes will be paid—it's just a question of when the tax deduction is available. The reason we say that the captive premium may be tax deductible is that for basic single-parent captives, the premiums are not deductible unless certain requirements are satisfied. (Alas, tax deductibility is way beyond the scope of this article.)
Conclusion
The key to determining whether or not the captive saves money is fairly simple: add up the frictional costs of the captive and large deductible, factor in any cash flow advantages/disadvantages, and compare the results.
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