Captives: Here to Stay
Rosemary M. McAndrew
[Click on Endnotes to see Citations]
Captive insurers have become a well-established alternative to traditional commercial insurance, in hard and soft markets, and everything in between.
oday, many senior managers are aware of the benefits an organization can gain from the creation of a captive. Though this concept has existed for centuries, it has gained widespread acceptance only in the last two decades. As the commercial insurance marketplace continues to be diluted by alternative risk finance techniques such as captives, the agents, brokers, and insurers embracing these methods will be a vital part of the continuously evolving alternative market.
It is useful to begin this discussion by offering a working definition of a captive: A "captive" insurer is a limited purpose, wholly-owned insurance subsidiary of an organization not in the insurance business, which has as its primary function the insuring of some of the exposures and risks of its parent or its parent's affiliates.1
While this definition does not encompass some of the recent variations on the captive theme, such as association captives and rent- a-captives, the underlying concept remains the same. But before examining the current captive landscape, it is useful to put it in context by briefly looking at some history of insurance and of captives.
A Bit of History
In the early 1500s, ship owners met in the London coffeehouses where they selectively retained, shared, and transferred the cost of risks associated with their ships. In essence, these were often mutual or reciprocal arrangements, akin to today's captives.
During the 1800s, a group of New England textile manufacturers formed a group captive (a mutual) in response to the high fire insurance rates of the period. The company ultimately evolved into what is now known as the Factory Mutual System. Other notable captive insurers formed in the first half of the 20th century include the Church Insurance Company (formed by the Episcopal Church in 1929) and Mahoning Insurance Company, established by Youngstown Sheet & Tube Company in 1935.2
As early as the 1930s, the U.S. manufacturer of Lifesavers candy determined that a wholly owned offshore risk-funding company could provide significant benefits to its parent -- and it created that company in Bermuda. It was a generation later, with World War 11 over and an industrial boom taking place, that the concept of a wholly owned captive captured more interest. In the 1960s, Bermuda became an offshore financial center, and several more captives were formed there, taking advantage of the Exempted Undertaking Tax Protection Act of 1966. By 1978, Bermuda had formalized its captive licensing and oversight process in The Insurance Act.
In the late 1970s, Harvard University was interested in creating a medical malpractice captive in Bermuda for its Harvard-affiliated teaching hospitals and its affiliated doctors.3 The Bermuda insurance regulators were reluctant to authorize a captive to write both institutional and individual medical malpractice risks. The result was the emergence of Cayman as a captive domicile and Harvard's captive being licensed there under the Insurance Law of 1979. Today, Bermuda is a larger captive domicile than Cayman; however, Cayman's recent growth spurts make it a strong second-place contender.
A disturbing hardening of the insurance market in the United States in the 1980s resulted in the unavailability or unaffordability of certain lines of insurance for major corporations, large cities, and not-for-profit organizations. This market hardening created the captive movement as we know it today. Hundreds of captives were created in the late 1980s, and that trend continues in spite of a commercial market that has never been softer.
The Current Landscape
The number of captives in existence worldwide today is close to 5,000. Of this number, approximately 3,086 were domiciled in the western hemisphere (see Figure 1).4 A note of interest: In 1995, 44 percent, or 220, of the Fortune 500® companies had captives, with 55 having more than one; the 220 companies owned and operated a total of 310 captives.5 1998, 48 percent, or 240, of the Fortune 500® companies had captives, with 73 having more than one; the 240 companies owned and operated 349 in total.6
Types of Captives
Captives generally can be described as insurers formed by noninsurance entities or individuals in which they (the founders) are the primary beneficiaries. Most captives have a single parent; typically, this is the company that will benefit from placing its insurance in the captive. However, many captives have multiple owners. These are referred to as group or association captives.
Today, there are a few types of captives that are difficult to characterize as either single-owner or multi-owner: agency-owned captives, rent-a- captives, and protected-cell captives.
Agency-owned captives generally are formed by a group of insurance agents for the purpose of underwriting and profiting from controlled books of their clients' business. Some may argue that these are not really captives in their purest sense, but really agency-owned insurers or reinsurers. In this type of captive, the agents and promoters generally benefit financially. The clients may or may not profit from the success of the captive.7
Rent-a-captives are insurers or reinsurers organized by a sponsor (e.g., insurer, reinsurer, or broker) to insure or reinsure property-casualty risks of several insurance programs (typically those of the sponsor's clients) -- and to benefit the sponsor and the shareholder financially. The sponsor, not the shareholder, controls the rent-a-captive and generally designs a program with minimum commitment on the part of the client users. The sponsor issues the policies, collects the premiums, and invests the funds until losses are paid.8
Protected-cell captives are similar to rent-a-captives. These companies have core capital, but, unlike a traditional rent-a-captive, have segregated cells for each user. The assets and liabilities of each user are legally separated ("walls of brick") from those of the other users, pursuant to the protected-cell legislation of the governing domicile.9
Lower cost, more control, broader coverage, and better cash flow are the drivers of captive formation
Growth of the Captive Market
The last 20 years have seen a significant growth both in the number of captives formed and in the premium volume in captives (see Figure 2 and Figure 3). There are a number of reasons for this, including:
volatility of insurance pricing cycles in the mid to late 1980s;
desire of insureds to control their own destiny;
increased recognition of and desire to insure nontraditional exposures such as warranty, pollution, and product tampering; and
the perceived cost of state-by-state regulation.
In the 1970s, the first U.S. special law to encourage captive formation was passed in Colorado, followed by Tennessee, then Vermont. In 1981, Congress passed the Product Liability Risk Retention Act, amended in 1986 to the Liability Risk Retention Act, which allows entities with similar interests to create a liability insurer in one state and be able to market insurance in all states, a luxury not available to group captives.10
Many individuals associated with the captive marketplace agree that lower cost, more control, broader coverage, and better cash flow are the drivers of captive formation. A more in-depth look at the reasons organizations are interested in creating captives or participating in captives include to:
create a market where no reasonable market exists (e.g., for pollution liability);
provide more stable coverage or pricing (e.g., for medical malpractice insurance);
lower the cost of insuring certain high- quality risks;
reduce expenses associated with transferring risk (i.e., to have better operating efficiencies than commercial insurers);
become more involved in cost containment; and
have direct access to reinsurance markets.
Pros and Cons of Captives
There are differences between single-parent and group captives that lead to specific advantages and disadvantages of the particular type of captive. With these in mind, a company considering forming or participating in a captive should conduct a feasibility study, discussed later in this article.
When an organization creates a single-parent captive, it typically benefits from:lower operating costs than a traditional insurer;
investment income and underwriting profit ac- crued to the organization;
direct access to the reinsurance market, which offers lower costs and less regulation; and
freedom to obtain services such as claims handling and loss control separately from coverage.
Potential disadvantages includean increased administrative burden for the organization;
money needed to capitalize that could be put to better use;
the chance that greater than expected losses could impact surplus; and
the probability that insurance purchased from the captive will likely not be a tax-deductible business expense.
A group captive generally enjoys all of the benefits that accrue to a single-parent captive. In addition, a group captive benefits from:spread of fixed cost among several entities;
risk sharing; resulting in less volatility; and
potential to book premium as a deductible business expense.
The disadvantages of a group Captive tend to be different from the disadvantages of a single-parent captive. One major disadvantage is that losses of some participants can cause increased premium to all participants and, in the event of higher than expected losses, can require surplus to he used to cover claims. Another disadvantage is a greater reliance on service providers to make the right management decisions for the owner-participants.
Insurance Coverages in Captives
Captive insurance coverages can vary as widely as -- or more widely than -- the traditional commercial insurance marketplace.
... Traditional Lines
Many, it not most, captives provide some form of liability insurance. Primary general liability, products liability, workers compensation, auto liability, directors and officers liability, professional liability(such as medical malpractice), and excess and umbrella liability represent large segments of the market. However, in addition to liability insurance, captives write other traditional lines of insurance such as property coverage.
... Nontraditional Lines
More than ever before, captives are writing nontraditional insurance coverages. These include:equipment maintenance warranty, providing contract maintenance and repair coverage (this would be appealing to such equipment-intensive organizations as hospitals, which typically have multiple maintenance contracts);
credit life and disability, offered by lenders to loan applicants, covering outstanding balances when credit has been extended (paid for by the loan applicant and passed through the lender's captive);
sexual misconduct, extending coverage to religious institutions, schools, and daycare centers;
credit risk, typically used in large organizations that extend large amounts of credit for their products to their customers;
post-retirement medical benefits, including health, life, and dental, provided to employees after retirement and funded in part by the employer;
private mortgage insurance, protecting the lender from defaults on loans;
auto dealer extended-service warranty, which allows for the annual warranty fee (e.g., $295 per year for three years, parts and labor) to be passed through the captive;
voluntary employee benefits such as supplemental life (because the captive can operate at a lower expense ratio, savings can be passed on to the employees in purchasing benefits);
pollution liability, not consistently available or affordable in the commercial insurance market;
animal feed contamination (this coverage is difficult to obtain, could result in product recall, and would most probably be excluded under the commercial general liability policy);
medical stop-loss coverage for health-care providers; and
employee benefit medical stop-loss coverage for self-insured employers.
Expanding With Caution
Many captives start off as monoline insurers, and after a time, the captive owner or manager decides that adding an additional line of coverage may be appropriate. The owners of these captives should be aware of the potential correlations between the lines of business and their possible effects. There are many lines of business that can have interdependencies. One example is the liability, property, business interruption, and workers compensation claims that would follow an explosion at a production plant.
It is important for captive owners to understand that the risk of a year with greater than expected losses can be increased by adding coverage lines if they are positively correlated. (However, spreading the risk across several lines of coverage can also reduce volatility.) The increase in downside risk implies a need to analyze the appropriateness of the current reinsurance and existing capital and surplus.11
____________________ The "winners" associated with captives are numerous. ____________________
Beneficiaries of Captives
Who benefits when a captive is formed and utilized? The "winners" associated with captives are numerous: Traditional insurers have typically viewed themselves as the "losers" (of market share) when business that has been commercially insured moves into a captive. A number of commercial insurers have continued relationships by participating in the captive as reinsurers, as fronting insurers, or as sponsors of rent-a-captives.
Insureds are the beneficiaries of underwriting profit and investment income.
Reinsurers have new opportunities to partner with captives and expand the reinsurers' products or clients.
Service providers have also found new opportunities:
Attorneys: Specializing in the legal aspects captive formation and captive taxation has created new opportunities.
Captive managers: These organizations, located in the domicile where the captive is licensed, are responsible for regulatory compliance and keeping the captives' books. Typically, captive management firms are independently owned or are part of a larger organization such as a financial services company, insurer, or broker.
Auditors: Captives are required to have annual audited financial statements. The audit firms they use may be the "Big Five" or regional firms with captive experience.
Actuaries: Captives require annual actuarial loss evaluations. Many captives rely on opinions from well-known national and international firms; however, some use small independent firms.
Agents and brokers: Captives have served as a tool for agents and brokers to use in successfully developing niche markets. In addition, some national brokers and regional independent agencies have created captives in which they share ownership and profits with their client- insureds.
Other constituencies that benefit from the development of the captive sector include consultants that give advice on such ventures, third party administrators, and loss control providers that supply some of the unbundled services to captives.
The Feasibility Study
The process of conducting a feasibility study is meant to confirm the potential advantages and expose the potential disadvantages of creating a captive so that a rational decision can be made. There are several basic questions to be answered prior to launching into a full-scale feasibility study, starting with:
"What do you want the captive to accomplish?"
"Can the captive accomplish what you want it to?"
"Are there better alternatives to the captive?"
Can you afford it?"
The answers to these questions can help the potential owner decide whether to go forward with a formal feasibility study.The Formal Study
Determining the feasibility of forming a licensed captive insurer is the first step for an organization looking at alternatives to a commercially insured program. A group of organizations or an association interested in forming a captive would also typically begin with this step.
The objective of performing a feasibility study is to evaluate the benefits provided by a captive and to determine how the costs compare to the current method of funding (and, sometimes, to other proposed funding alternatives).
An organization's internal staff, its broker, a captive manager, or an independent consultant may perform feasibility studies. All bring their own areas of expertise to the table but lack in-depth knowledge in other areas. Thus, the ideal is a partnering relationship that brings together the knowledge and skills of the various parties.
The feasibility study will look at the current insurance coverages being considered for placement in the captive and their current cost. Additionally, loss history for that coverage will be analyzed. The study will typically consider:
expected losses;Plan Implementation
availability and affordability of reinsurance;
amount of capital and surplus required;
need for a fronting carrier;
costs of required services and regulatory fees; and
choice of domicile for license.
If the feasibility study suggests that a captive would be beneficial, the next step is implementation. Implementation involves the preparation of a formal business plan to be presented to the licensing authority in the domicile of choice. It also includes finalizing any reinsurance arrangements. The business plan typically includes:
actuarial projection of expected losses;
application for license;
articles of association (articles of incorporation);
financial pro-formas (three to five years);
information regarding major owners and service providers;
proposed reinsurance; and
description of underwriting, loss control, and claims-handling procedures.
A determination needs to be made as to whether the captive will be organized as a stock insurer -- which most are -- or as a mutual or reciprocal. Since mutual insurers have no stock, owners contribute surplus to be used as a cushion for higher than expected losses. Most mutual insurers are nonassessable. Reciprocals operate with individual accounts and are managed by an attorney-in-fact.
____________________ The captive domicile market is growing and competitive ____________________
The domicile selection process is an important part of the feasibility study. While the major issue is whether to locate onshore or offshore, the specific locations have individual differences that need to be considered. The captive domicile market is growing and competitive. Several new domiciles are endeavoring to emulate the advantages of some of the major domiciles. While the laws may be similar, the regulatory knowledge and experience -- and the infrastructure -- may be lacking when compared to domiciles with a lengthy operating history.
Key considerations for many potential captive owners are:
amount of capital and surplus required;
regulatory restrictions, such as the prohibition of third-party business; and
Capital and Surplus
Judging from the numbers, it would appear that the advantages to being licensed offshore are significant. It should be noted that over half of all captives have a U.S. parent. Rather than make an assumption that offshore is better, each entity must evaluate based on its own particular circumstances. With regard to capitalization, the largest onshore captive domicile, Vermont, requires a statutory minimum for a single-parent captive of $250,000. Other states' capital requirements range from a low of $100,000 to a high of $500,000. Bermuda and Cayman, the two largest offshore domiciles, both require a minimum of $120,000.12
Group or association captives and RRGs typically have a higher capital requirement in all domiciles. Vermont requires $500,000 minimum for an RRG and $750,000 for an association captive.13 Usually, offshore domiciles have a lower requirement. Investment Limitations.
Investment restrictions typically are not as stringent for single-parent captives. Many onshore domiciles require association captives and RRGs to comply with the investment restrictions placed on admitted insurers. Usually, offshore domiciles are less restrictive.
Often, regulators make decisions on a case-by-case basis regarding permitted lines of business. This is particularly true as new risk-transfer products are designed -- products that do not fit the definition of traditional property-casualty lines. Vermont, for example, describes its permitted business as: All property/casualty lines and excess workers compensation, some life and health lines. Personal lines not permitted on a direct basis.14
There are other, "softer" considerations that, while less important, should nonetheless be given some attention:
Infrastructure: When potential owners go to one of the largest domiciles, they find a number of experienced attorneys, auditors, and captive managers operating in that domicile; a captive choosing to be licensed in a newer, less used, or lesser known captive domicile (e.g., Maine) will find that infrastructure lacking. However, it should be noted that there can be compelling reasons to locate in a little-known domicile. American Feed Industry RRG, with a constituency primarily in America's heartland, chose to domicile in Iowa. Operating costs can be lower in newer domiciles.
Government fees and local taxes: Vermont, the largest onshore domicile, has an annual renewal fee of $300 plus a premium tax of less than half of 1 percent, varying by size and direct or reinsurer status. Bermuda has an annual $2,500 fee and no local tax. The annual license fee in Cayman is $5,487 with no local tax. When placing insurance in an offshore location, Federal Excise Tax is due: 1 percent for reinsurance; 4 percent for primary or direct insurance. (Some attorneys suggest it is unclear if a wholly owned captive is really an insurer.) Fees and taxes vary considerably from one domicile to another.15
Other domicile considerations include:
adequacy of telecommunications;
reasonableness (ease) of travel;
formation time frame;
political stability (non-U.S. locations); and
Fronting is an arrangement whereby an admitted insurer, in a particular state, agrees to issue policies as a "front" for the captive, to overcome problems with the captive's trying to conduct business in a state where it is not licensed. The "fronting" insurer then cedes all or a portion of the risk back to the captive.
A wholly owned captive would rarely need to have a "front," as it is insuring itself. However, in some situations, an organization has to provide proof of insurance to its customers (e.g., a large construction firm bidding on jobs) or to some regulatory body (e.g., health-care providers), so it needs to have "paper" of a licensed, A.M. Best or other-rated insurer.
By comparison, RRGs, authorized under federal law, can sell insurance in all states while licensed only in a domiciliary state (with informational filings only in other states in which they sell insurance). This has been a significant advantage that RRGs have over other group or association captives.
Many group or association captives are "fronted" so that the captive's insurance can be legally sold without violating state insurance regulations. Fronting costs typically include:
credit risk (because the fronting insurer is responsible to pay claims even if the captive fails);
use of capacity -- renting or using some of the insurer's surplus;
policy issuance fee;
state premium taxes and fees, and
agent or broker commission (optional).
The availability of fronting has decreased, and the costs have increased significantly since September 11, 2001.
Now, with the prospect of continuing hard insurance and reinsurance markets, the opportunities for captives, cultivated and weathered by the cyclical market pricing, are plentiful and awaiting all interested parties.
We have traveled some 500 years in the presence of alternative risk transfer and insurance funding mechanisms. The future role of captives will be represented by diversification and expansion.
This column is an update of an article published in The John Liner Review Vol. 14,No. 1, Spring 2000.
Rosemary M. McAndrew, CPCU, CIC, CRM, AAM, is principal of McAndrew Risk Management, Inc. in Boston, MA. See: Professional Profile of Rosemary M. McAndrew
Rosemary M. McAndrew, CPCU, CIC, CRM, AAM
McAndrew Risk Management, Inc.
139 Clement Avenue
Boston, Massachusetts 02132-2036
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Revised: December 19, 2003 TAF
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