CAPTIVE INSURANCE COMPANIES
Todd Birlingmair
Chris Herring
February 28, 2006
Abstract
Rising commercial insurance costs and difficulty in obtaining certain types of insurance
coverage has resulted in businesses reviewing “alternative risk transfer” (ART) vehicles. One of
these alternatives is to form a captive whereby the insurance company is owned by the insured.
“In its 2003 study, The Picture of ART, Swiss Re estimated that the global market for alternative
carriers, consisting of self insurance, captives, risk retention groups and pools, accounted for
about $88 billion in premiums in 2001, and projected that the market will grow about 10 percent
per year through 2005.”1 Captives are gaining momentum in use by corporations and are
changing the landscape of the insurance industry. Our research paper will review why captives
are formed, benefits and costs of operating, types and uses of captives, and responsibilities and
regulation governing use. We will then look at how captives are impacting taxing authorities, if
they are an effective risk management tool, monitoring issues and who should regulate.
Introduction
Risk management is about protecting assets. The primary risk management tool
corporations have is insurance to transfer certain risks at a fixed cost.
Self insurance has
become a viable alternative to traditional insurance when obtaining coverage outweighs the
benefits of transferring the risk to a third party. A captive is a legitimate insurance arrangement
for tax purposes if separate legal entities are correctly setup by the parent, captive and insured to
appropriately transfer risk. The legal structure is important in order for the captive to be treated
as insurance so that the premiums may be deductible.
The ability for corporations to use the
captive to accept various layers of risk and manage their own claims has resulted in
implementation by several large companies. Many corporations inherently assume risk for
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different exposures but a captive essentially allows reserves to be setup in a tax advantaged
manner.
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Literature Review
Why are Captives Formed?
The following summarizes the primary benefits and economics reasons to form a captive:
1. Lower insurance costs - Corporations know their loss experience and risks better
than an insurer. However, insurers must charge a premium commensurate with other
commercial companies. Included in the premium charged are the administrative costs
of the insurer and a profit margin, which can represent almost 40% of the total.
Therefore, corporations may want to retain that profit by setting up their own captive
to underwrite their insurance. 3
2.
Cash flow and investment income– Corporations can improve their cash flow by
deciding when to pay the insurance premiums. The insurance premiums paid can be
invested in an offshore domicile and untaxed.
The investment income can be a
primary component of the savings due to the time difference of when the premiums
are paid versus the claim. This savings is then captured by the captive rather than the
insurance company. 3
3. Risk retention - Corporations that can retain more risk may not be offered a
deductible with an adequate premium to compensate them for the additional risk.
With a captive, reserves can be setup to manage this risk at a fair price.
4. Unavailability of coverage – Commercial insurance may be limited or unavailable
and therefore a captive may be the only choice for insurance.
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5. Risk management – Captives can force organizations to do a better job of managing
and financing risk. The different divisions within an organization can have more
flexibility in insuring for risks suitable for their individual business. The insurance
market changes from soft to hard for coverage and captives give a place for a
company to store risk. The ability to use reserve funds to manage different exposures
is advantageous. 3
6. Access to the re-insurance market – Forming a captive will allow corporations to
deal directly with re-insurers. This may result in customized insurance coverage, and
lower premiums due to the size of the re-insurance market. The re-insurance market
provides more flexibility in how corporations can develop their risk management
program. 3
7. Writing unrelated risks for profit – Captives allow corporations to underwrite risks
to third parties. For instance, retailers could provide warranties to customers since
they have insight into possible losses making this a profitable business. 3
8. Tax minimization – Professional tax planning is essential in developing a strategy to
allow premiums paid to the captive to be tax deductible. Issues such as domicile of
the parent and captive are important considerations in determining setup. 3
9. Facilitate Business Planning and Cost Allocation – Captives better allow diverse
companies to allocate costs of risk management to each division and shift risk as
necessary between companies.
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Types and Uses of Captives
Captives are used for a variety of reasons and therefore many different types have been
developed such as the following:
1. “Single-parent captives - underwrite only the risks of related group companies.”3
2. “Diversified captives - underwrite unrelated risks in addition to group business” 3
3. “Association captives - underwrite the risks of members of an industry or trade
association.” 3
4. “Agency captives - formed by insurance brokers or agents to allow them to
participate in high-quality risks, which they control.” 3
5. “Rent-a-captives - insurance companies that provide access to captive facilities
without the user needing to capitalize his own captive.” 3 In this type of captive, the
user pays a fee and will be required to provide some form of collateral so that the
rent-a-captive is not at risk from any underwriting losses suffered by the user.
6. “Special purpose vehicles (‘SPV’s) – “They are reinsurance companies that issue
reinsurance contracts to their parent and cede the risk to the capital markets by way of
a bond issue.” 3
Onshore versus Offshore Captive Domiciles
Captives were previously formed offshore in tax haven jurisdictions like Bermuda or the
Cayman Islands due to fewer regulations. Almost half of the U.S. states now have enacted
captive insurance regulations in hopes of capturing some of this business.2 The top domiciles of
captives as of 2004 are listed in the chart below:
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LEADING CAPTIVE DOMICILES
Rank
Location
2004
1
Bermuda (1)
1,150
2
Cayman Islands
694
3
Vermont
524
4
Guernsey
410
5
British Virgin Islands
350
6
Barbados
257
7
Luxembourg (1)
219
8
Dublin
214
9
Isle of Man
175
10
Turks & Caicos (2)
164
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Hawaii
147
12
South Carolina
114
13
Singapore
57
14
Switzerland
50
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District of Columbia
40
Source: www.iii.org/media/hottopics/insurance
Regulatory oversight in the offshore locations has increased recently allowing states such
as Vermont now to compete for these tax dollars. Vermont has enacted legislation requiring no
premium minimums, accepts most commercial insurance coverage, they have minimal capital
requirements, a favorable tax structure, and no investment restrictions.
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The differences in
oversight between locating a captive onshore or offshore may be insignificant enough that the
primary determination in location is if the insurance risks covered will be domestic or foreign.2
Costs of Forming a Captive
The implementation costs of setting up a small captive program can be approximately
$100,000 in the first year. These costs may vary depending upon the legal and professional
services required. Annual management fees to keep a program operating can run about $50,000
a year. These expenses may be prohibitive for smaller businesses to form a captive and require
companies to undertake feasibility studies before a decision is made to form a captive. Another
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consideration will be the amount of minimum reserves required to be deposited in a bank before
a license can be issued. Since the captive is considered an insurance company, ongoing expenses
for outside services such as auditing, accounting, and banking will be required. 4
Current Regulatory Environment and Legislation
The Sarbanes Oxley Act requires that captives owned by public companies need to
comply with all of the regulations and governance in this legislation. Sarbanes Oxley attempts to
provide better governance through accountability of board members to their shareholders.
Changes in regulatory rulings have been beneficial towards captives the past few years. The
Internal Revenue Service changed a ruling in June 2001 to allow premiums paid for captive
insurance to be tax deductible, which was contrary to their previous rulings. However, Insurance
practices became more scrutinized in 2004 when New York Attorney General Elliot Spitzer
began probing offshore operations of insurance businesses including captives. 1
Captive laws are now enacted in 23 states and the District of Columbia. Most states have
passed risk retention laws, which are now part of their state insurance codes. “One of the issues
is whether a state can require an insurer not licensed to do business in that state to comply with
its licensing laws. An increasing number of states now require a purchasing group insurer to
meet surplus lines insurer requirements before insuring members of the group and to file forms
and rates for regulatory approval.”1
Offshore captives such as the Bahamas are supervised through the Office of the Registrar
of Insurance Companies. There are guidelines to specify reporting requirements to comply with
regulations but the Registrar may have stricter standards for companies engaging in risk that is
considered higher than normal. 9
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Current Issues:
How are captives impacting taxing authorities?
Many companies may set up a captive insurance company to enjoy certain tax benefits.
Some of the current issues involve whether or not the captive is being used as a real insurance
company or is just a front so that the parent company can enjoy certain tax benefits on the
premiums it is paying. Also, in some states like Vermont the captive insurance company has
some other tax benefits.
Under Vermont law the premiums are taxed at a max of .4%. Also, the captive can invest
these premiums to make money for the parent company. The profits on the investment of the
premiums are not taxed by the state. The corporate income tax of Vermont is around 7% to 9%.
These tax breaks were set up by, then, Governor Dean to attract more captive insurance
companies to the state of Vermont. He wanted Vermont to become an “ onshore Bermuda.” 6
Under the U.S. tax code for the premiums to the captive to be tax deductible 50% of the
captives business must be unrelated to the parent company. The business must deal with risk.
Ways that the captive can do business with other entities is to offer reinsurance, or offer
insurance plans to employees of the parent company. The parent company cannot have anything
to do with the support of the captive insurance company. The premiums charged by the captive
cannot be excessively high or low compared to the rest of the insurance industry.11 There must
also be a clear shifting of risk from the parent company to the captive. If these two criteria are
not met it is argued that there isn’t enough diversification of risk. It has been argued that if a
captive gets over 50% of its premiums from the parent company then the company is not set up
for insurance. It would be considered a “sham corporation.” These corporations are only set up
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for tax purposes. To meet IRS requirements most companies will create multiple LLCs. These
are created to meet the over 50% premium requirement. The LLCs for most of these companies
are disregarded entities for tax purposes. To meet the 50% requirement the LLCs must decide to
be treated as their own corporations. This way the captive can claim that over 50% of their
business and premiums are dealing with other entities besides the parent company.12
Another major issue is the fact that many states believe that captives are causing many states
to lose valuable tax revenue. The federal government is also losing tax revenue due to the ability
to take federal deductions on the premium payments to the captives. Also, because Vermont,
certain other states and Bermuda offer tax breaks, many other states have to compete and create
tax breaks for the captives. In 1996 the Clinton administration tried to put a stop to the federal
tax breaks for companies who create captives. According to Michael Kranish of the Boston
Globe, if the Clinton Administration had their way, most of the captive insurance industry would
have been killed. Howard Dean opposed this plan and eventually got his way. 6
Are captives an effective risk management tool?
Captives would appear to be effective in managing risk. Some of the reasons that a
company would set up a captive are to be more flexible in handling risk financing and to lower
premium costs. There are of course the tax benefits. When someone looks at the benefits of a
captive insurance company, they probably want to look at how the formation of this company
impacts risk management. With a captive the parent company can put away funds to use for
future insurance losses. Some other benefits would be the ability of the captive to provide direct
access to the reinsurance market and allows the company to generate other revenue by offering
insurance to 3rd party organizations.7
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It would appear to me that captives are effective for the companies that form them. They
are being formed at an impressive rate in the United States and in offshore domiciles. Perhaps
the most famous captive company would be Allstate. It is of course an independent company at
the present, but it was originally set up as a captive insurance company by Sears & Roebuck Co.
Other companies have captives as well. Caterpillar has formed their captive under their finance
arm. General Mills formed Gold Medal Inc. to be their captive insurance company. There are
now more than 3900 captive insurance companies and that number is continuing to increase.7
The state of Vermont has over 500 of those captives, but most reside on offshore domiciles.
Vermont has more captives than the other 49 states combined.6
Based on the fact that the number of captive companies is continuing to increase and the
fact that there are many benefits to form them, it would appear that they are effective risk
management tools. They allow a company to easily transfer risk to their subsidiary. Forming a
captive allows a company to easily put back money to save for losses and other types of risk.
They are also a good way to generate more revenue by taking on 3rd party insurance or providing
reinsurance to other insurance companies.
Monitoring risks?
Some of the issue surrounding captives are the fact that some companies create them
without them being properly capitalized. They are trying to create them for other purposes
besides insurance. There is the possibility of inadequate loss reserves. Some companies may
initially project losses and then create reserves and pay premiums to cover those expected losses,
but a lot of times the case can be that there is not adequate capital to handle unexpected losses.13
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The way that a captive is usually monitored is by the CFO or the Risk Manager of the
parent company. The company also will employ auditors to watch over the captives. They will
use their own internal auditors or they will hire an outside auditing firm, such as one of the big 5
accounting firms, to audit the company. Captives are required to provide audited financial
statements to their respective regulators on an annual basis.12
Other ways to monitor the captive company is to use another company. Companies such
as AON provide services for helping to set up captives. They also provide services, such as
auditing, helping to prepare financials and the types of investment vehicles that should be set up
for the captive. Other services they provide are legal assistance, help in forming the claims
procedures and will help in forming the insurance agreements.14
Another way companies can monitor the captive is by requesting that A.M. Best do a
rating analysis. This way they can make sure everything is in order with the captive and see how
they stack up with their rating. The first step is for the captive to make a request for an analysis.
This is only done on the initial rating analysis. A.M. Best will meet with the company’s
management, request financial documents and audit the company to form their rating. They will
then determine the rating and then release it publicly. After the initial analysis there is ongoing
monitoring and there will be public releases of the rating. There will be an assigned analyst to
the company. The analyst will keep a dialogue open with the company and they will work
together when there are big changes in anything the company does. This will allow an outside
independent and reputable agency to keep tabs on what the company is doing. It will make sure
that the company is doing everything correctly and also will ensure that everything is in order
with the financials and the way the company is being run. This also allows other companies,
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which may want to do business in the future with the captive, to maintain a watch on how the
captive is doing.15
Who Should Regulate Captives?
Captives are regulated differently compared to other insurance companies. A regular
insurance company, who serves the public, is different than a captive that is basically just serving
its parent company. “When insuring the general public, the insurer must conduct itself with a
view to matters that the captive owner need not concern himself with such as discrimination in
rates and forms, availability to all qualified applicants, and participation in required pools.”8 Just
like regular insurance the captives are also regulated on a state-by-state basis. The states that
generally regulate the captives are the domiciles that they are headquartered in. They must meet
their regulations first of all.
There is currently a push among some to go to federal regulation of the insurance
industry instead of a state-by-state thing. There is a fear among captives though, that if it goes to
federal regulation, that the federal government will decide to over regulate the captive industry.
The captive industry believes that they are too diverse to be put under one regulatory authority.
One captive may be in existence for different reasons than another captive.8
State-by state regulation would probably be good for captives. This puts everything more
on a regional basis. Certain captives are headquartered in certain domiciles for many different
reasons. State-by-state would allow the captive to still choose which domicile they wish to work
in. Also, if there was a national regulation instead of state-by-state a lot of the captives my go
offshore so that they don’t have to deal with any rigidity that might happen.
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Conclusion:
There appears to be no end in sight for captives. Captives are created for many reasons.
Some are created for tax reasons and others are created because the company needs a cheaper
source of insurance. Captives, in the United States, are growing and becoming stronger. There
is also a push among captives to do more business with other companies besides the parent. One
captive that eventually became a full multi line insurer would be Allstate. Based on the literature
review it would appear that the direction of captives is more towards the Allstate model. Several
captives are now offering insurance to other companies. The new tax laws have forced this
issue. The IRS decided in 2005 that for a company to enjoy the federal tax benefits on premium
payments that the captive had get at least 50% of its premiums from some company other than
the parent company.
This is because the IRS believed that before there was not enough
diversification of risk. Parent companies have gotten around this by forming LLCs.
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References:
1.“Captives & Other Risk-Financing Options”, www.iii.org/media/hottopics/insurance/test3
January 2006
2.“Captive Insurance: Benefits and Responsibilities”, Jay Adkisson and Chris Riser
www.assetprotectionbook.com/captive_insurance.htm
3. “Captive Insurance Companies – What Are They” By Martin Eveleigh ACII
www.captive.com/service/kpmg/kpmg_article2.html
4. “The Need for Captive Insurance”
www.cyberhaven.com/offshorelibrary/captive.html
5. “Vermont, The Largest Onshore Captive Domicile:
http://www.vcia.com/vtdomicile.htm
6. “US: For Dean, 'Captive' Insurance a Vermont Boon”, Michael Kranish, Boston Globe,
December 12th, 2003
7. “Why Dream of Captives in Today's Insurance Market?, Nathan Shpritz and Alison
Calder; Liberty Mutual Group
8. “Regulation of Captives: Who? Why? What Next? Michael R. Mead, M.R. Mead &
Company, LLC, August 2005, www.irmi.com/Expert/Articles/2005/Mead08.aspx
9. “Captive Insurance in The Bahamas”, Source: Registrar of Insurance Companies
www.bahamas.gov.bs/BahamasWeb/businessandfinance.nsf/Subjects/Captive+Insurance!
10. “Return of the Company Store”, David M. Katz, CFO.com, May 2003,
www.cfo.com/printable/article.cfm/3009118?f=options
11. “Tax Update & Impact of Latest IRS Captive Rulings”, Thomas M. Jones, Bermuda
Captive, Sept. 2005, www.bermudacaptive.bm/2005-archive/attendees-presentations/TaxUpdate.ppt
12. “Captives: Here to Stay”, Rosemary M. McAndrew, McAndrew Risk Management, Inc.,
December 2003, www.businessforum.com/RMM_01.html
13. “Captive Overview”, Captive Insurance Alternatives LLC, Sept 2004, www.captiveinsurance-alternatives.com/l_overview.htm
14. Captive Management Services, AON Inc, www.aon.com/as/en/risk/captive/mgmt.jsp
15. “AM Best’s Rating Methodology for Captive Insurance Companies”, Henry K Witmer,
A.M. Best, November 2005, www.ambest.com/ratings/methodology/domesticcaptives.pdf
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