captives slideshare

AN EXECUTIVE SUMMARY FOR RISK PROFESSIONALS

AND THE C-SUITE

ARTOFCAPTIVESCONSULTING

CAPTIVE INSURANCE

WHAT, EXACTLY, IS A CAPTIVE?

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A Special Purpose, Licensed, (Re)insurance Company; formed to (re)insure the risks of its owner(s); in accordance with IRS safe harbor guidelines


•  A Bona Fide Insurance Company, GAAP and Statutory accounting; financials consolidated with owner’s

•  A Subsidiary designed to hold and manage the owner’s risks



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Allows Management to Quantify and Evaluate the performance of every risk management initiative when financed through the captive



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A Tool for Allocating premiums and deductibles across operating units, divisions, subsidiaries, etc.



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WHY SHOULD I CONSIDER A CAPTIVE?

•  Reduce and Manage the long-term cost of risk

•  Successfully Compete in today’s dynamic (re)insurance marketplace


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Captives Allow a Better Match between premiums and historical losses (very important in a hard market)



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•  Coverage & Capacity for hard-to-place or impossible-to-place risks

•  Access to Reinsurance, (very important & underrated)



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•  Earn Investment Income on captive

reserves (Interest rates are on the rise!)

•  Convert the Risk Management Department into a profit center



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Create a Risk Platform where all (or most) of the company’s risks either reside and / or pass through to reinsurers; this is the ultimate control



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Captives: Unique Among Risk Financing Options:

•  No other RF program builds corporate value over time

•  No other program creates financial statements that measure the effectiveness of risk management expenditures

•  No other program creates favorable (and legal) tax outcomes 11

•  You Are Unable (or unwilling) to commit at

least 3 years to the venture

•  You Cannot Afford the loss of short-term cash flows

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YOU CANNOT FORM A CAPTIVE IF...

•  The Start-up and Annual Operating Costs are too expensive

•  Your Company Cannot meet minimum eligibility criteria

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•  You are Unable or Unwilling to allocate the

necessary capital & surplus

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•  Your Loss History provides little or no actuarial credibility (Industry data may help alleviate this)



The Golden Rule of Risk Management:

Never Risk a Lot for a Little!

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YOU MUST REMEMBER...


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Coverages with Small Premiums that provide large limits; e.g., crime, inland marine, etc. should not be considered captive-eligible *See Slide 15

YOU’RE FORMING A CAPTIVE, BUT...


New Captives Should Not cover weather-related catastrophic risks unless they are designed to do so and are adequately capitalized

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YOU’RE FORMING A CAPTIVE, BUT...

TYPES OF CAPTIVES

•  Single Parent (Pure)

•  Group (Owned by the Membership)

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•  Risk Retention Groups

•  Agency (Broker Owned Captive)

•  Rent-a-captive / Cell Captives

•  3rd Party Business

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TYPES OF CAPTIVES

•  Fronted (by a US Licensed and Admitted insurer)

•  Non-admitted Direct-writing

•  IRC 831(b)

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TYPES OF CAPTIVES

SINGLE-PARENT CAPTIVES

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Direct Captive

Parent

Captive

Premiums Claims Payments

Reinsurance

Premiums Claims Payments

Reinsurance Premium

Fronting Fees and Claims

Captive

Insurance Company (front)

Parent

A fronted captive is actually one of the front’s reinsurers. These captive are often referred as “reinsurance” captives


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Premium

Fronted Captive Group

Members

Captive (Reinsurer)

Premium Claims

Claims

Collateral

Direct Captive

Claims

Premium

Premium

Claims

Reinsurer

Captive (Insurer)

Group Members

Fronting Insurer

GROUP EQUITY CAPTIVES In this context, equity means that the

members own the captive’s stock.


•  $2.2 Max Annual Premium; earnings not taxed, only investment income is taxed

•  There are Significant Restrictions on captives making this election

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SMALL CAPTIVE IRC 831(B)


RISK RETENTION GROUPS

•  Regulated under federal jurisdiction

•  Can only write liability lines of risk

•  Writes direct – no front

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Risk Retention

Group

Reinsurer A

Member B

Member C

Member A

Reinsurer B

Reinsurer C

Capital

Premiums

Surplus Assessments

Reinsurance (if any)


RISK RETENTION GROUPS

CELL CAPTIVE

Cell owners’ assets are segregated by statute

Unincorporated cells are not legal entities

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Captive Owner

Captive

Cell B Cell C Cell A

Reinsurer Reinsurer Reinsurer


MOVING RISK ON-BALANCE SHEET

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Captive

Funded Self

Insurance

Large Deductible w/Stop Loss

Retro Plan/ Experience

Rated

Guaranteed

Cost/ Fully Insured


•  Moving Risk On-balance Sheet allows control…pricing, service providers, reinsurance, and administration

•  The Goal is to Convert fixed expenses into variable expenses

MOVING RISK ON-BALANCE SHEET


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TYPICAL CAPTIVE RISKS

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•  Professional Liability (Med Mal, E&O, etc.)

•  Workers Compensation

•  Extended Warranty


•  Property & Business Interruption

•  General / Products Liability

•  Terrorism (TRIPRA)

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•  Environmental Impairment Liability

•  Auto Liability and Physical Damage

•  Medical Stop-Loss (MSL)

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•  Captives Rarely, if ever, assume a significant limit of liability

•  For Any of the Risks Identified here, the primary $250K would be a typical captive limit, (with the possible exception of medical malpractice, which would be higher)

HOW MUCH RISK SHOULD A CAPTIVE INSURE?


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Excess of the Captive’s Limit of Liability, e.g., $250K, the captive buys reinsurance, or the parent purchases excess insurance

LIMITS ABOVE THE CAPTIVE


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•  Gross Written Premiums should be paid, in cash, in full at policy inception; exceptions exist

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CASH FLOW IMPLICATIONS


•  The Capital & Surplus (C&S) pay-in schedule must mirror that of the premiums

•  The Captive may Loan a portion of its cash, back to the parent company

•  Loan Backs are short-term commercial

loans, and must carry a market interest rate


LOAN BACKS


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Adequate Funds Must Remain in the captive to pay projected losses without having to renegotiate the terms of the loan


LOAN BACKS


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•  Self-insured (non-captive) Losses are usually paid over time, often many years

•  Self-insured Losses are tax-deductible only when paid

•  0

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TAX AWARENESS


A Captive that Conforms with the IRS safe harbor(s), may convert projected self-insured losses into an annual premium, which is tax-deductible in that year

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TAX AWARENESS

Captive Loss Reserves may be deductible in current year if eligible to use insurance accounting; these involve risk shifting and risk distribution per IRS safe harbor revenue rulings and certain case law

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TAX AWARENESS

Offshore Captives that Insure US risks are classified into one of 3 categories:

•  Controlled Foreign Corporation •  Non-controlled Foreign Corporation •  Taxed under the 953(d) election

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TAX AWARENESS

Earnings are Untaxed, but each US shareholder’s portion of the earnings are taxed at their corporate rate

CONTROLLED FOREIGN CORPORATION (CFC)


TAX AWARENESS

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Restrictions on Doing Business in the US; ETB rules (ETB: Engaged in Trade or Business)



TAX AWARENESS

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•  Potential for Branch Profits Tax of up to 30% of earnings if ETB rules violated

•  CFC Status is the default tax position for offshore captives unless another option is elected



TAX AWARENESS

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US shareholders (US persons owning 10% +, of voting stock) cannot own or control more than 25% of the voting stock

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NON-CONTROLLED FOREIGN CORPORATION (CFC)

TAX AWARENESS

Captive Earnings Taxed at dividends received rate only when repatriated into the US


NON-CONTROLLED FOREIGN CORPORATION (CFC)

TAX AWARENESS

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•  Allows a CFC Captive to be taxed as if it were an onshore captive

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•  Onshore Captives have no choice but to pay US income taxes

THE IRC 953(D) TAX ELECTION


TAX AWARENESS

To Avoid ETB Restrictions – no business may be conducted in the US if the captive remains a CFC; shareholders pay tax anyway

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WHY WOULD A CFC CAPTIVE ELECT TO BE TAXED?


TAX AWARENESS

Performance metrics are the various solvency and operating ratios that reveal your captive’s financial performance.

PERFORMANCE METRICS

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Each Ratio Measures different aspects of financial performance; Major categories: •  Liquidity

•  Leverage

•  Profitability

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PERFORMANCE METRICS

These ratios measure a captive’s ability to meet its short-term funding needs •  Reserves-to-Liquid Assets

•  Assets-to-Liabilities

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LIQUIDITY


PERFORMANCE METRICS

These ratios measure the amount of risk against financial resources

•  ROIC (Return on Invested Capital)

•  Premium-to-Capital & Surplus

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LEVERAGE


PERFORMANCE METRICS

•  Loss & Expense-to-Earnings (Combined)

•  Investment Income-to-Capital

•  Operating (combined –investment income ratio)

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These Ratios Reveal Profitability

PROFITABILITY


PERFORMANCE METRICS

FRONTING & COLLATERAL

•  Fronting Insurers Convey their licenses and credit ratings onto captives

•  Captives are Usually Licensed only by their domicile, with no credit rating

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Fronts are Necessary when a counterparty requires certification that your insurance meets the counterparty’s requirements

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You Are Not Required, nor are there moral or ethical reasons, to divulge the fact that you own a FRONTED captive to counterparties

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Because the Captive is (usually) only Licensed in its domicile, and it (usually) has no credit rating, the front requires collateral to secure the loss reserves

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There are two prevalent forms of collateral

•  Letter of Credit

•  New York 114 Trust

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Often Preferred by Captives (captives’ parents) due to investment flexibility as the captive retains use of the funds

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LETTER OF CREDIT



The LC is the Front’s Preferred form of collateral, as it provides an immediate source of cash if needed

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LETTER OF CREDIT


Assets May be Drawn any time to reimburse the front for paid claims, and to cover reserves for any reason

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LETTER OF CREDIT


The Front has a Unilateral Right to withdraw funds. Captive must restore the security balance within 10 days.

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LETTER OF CREDIT


•  The Trust’s Annual Costs are close to LCs at low levels; they become less expensive at higher fund levels

•  The Front is the Trust’s beneficiary

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NY REG. 114 INSURANCE TRUST



•  The captive’s reserves fund a Trust Account

•  Fund assets often equal 102% of the captive’s liabilities

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NY REG. 114 INSURANCE TRUST


CAPTIVE DOMICILES

All captives, whether onshore or offshore, must be formed in a jurisdiction that has specific enabling legislation


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All Captive Domiciles Require that certain professional service providers be resident of the domicile

•  Captive Manager •  Attorney •  Auditor

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DOMICILE SERVICE PROVIDERS


CAPTIVE SERVICE PROVIDERS

•  Tax Counsel •  SEC Attorney* •  Actuary

*Only if needed for a group captive

•  Captives Consultant •  Broker

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CAPTIVE SERVICE PROVIDERS

NON-DOMICILE SERVICE PROVIDERS


MAJOR ONSHORE

•  Vermont •  Washington DC •  South Carolina •  Hawaii

And about 25 more states

•  Delaware


CAPTIVE DOMICILES

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•  Bermuda •  Cayman •  BVI •  Panama

•  Luxembourg •  Ireland •  Isle of Man •  Guernsey


MAJOR OFFSHORE

CAPTIVE DOMICILES

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Q. I only care about how low I can force insurance premiums each year.

Does a captive make sense for me?

A. No

QUESTIONS & ANSWERS


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Q. What are the start-up costs and annual operating costs of a captive?

A. Start-up costs can run from $150,000 to $500,000+. Annual operating costs can run from $100,000+


QUESTIONS & ANSWERS

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Q. How much capital will I need?

A. For many captives, a 5:1 premium-to-capital & surplus ratio will suffice. Some fronting insurers require 3:1


QUESTIONS & ANSWERS

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Q. As a captive owner, what’s the most money I could lose in this venture?

A. Your capital contribution and the captive’s expenses are the most you can lose.


QUESTIONS & ANSWERS

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Q. How long before I can realize any dividends from the captive?

A. Assuming the Board declares a dividend, about 3 years


QUESTIONS & ANSWERS

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Q. What are the minimum premium qualifications to form a captive?

A. For a single parent captive, about $1.5 million in ceded premium. For a cell captive, about $750,000.


QUESTIONS & ANSWERS

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Q. The insurance markets are pretty soft; is there any reason to form a captive aside from a hard market?

A. Absolutely. See Slides 6-11


QUESTIONS & ANSWERS

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Q. I hear that captives can earn underwriting profit – how does that work?


QUESTIONS & ANSWERS

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A. The captive must sell insurance to unrelated 3rd parties to earn profits; excess premium payments are often incorrectly thought of as profits

A. Direct captives are free to write anything. Fronted captives must conform to the conventions of the fronting company.

Q. What is the captive’s relationship with insurance coverages?


QUESTIONS & ANSWERS

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SUMMARY OF STEPS TO CAPTIVE FORMATION

1. Feasibility Study (Captives Consultant + Actuary)

2. Domicile Selection


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3.  Engage Captive Manager (will immediately run due diligence on you, the captive’s parent)

4. Engage the other Domicile Service Providers



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5. The Consultant and Captive Manager will write the business plan and complete the application to the regulator

6. Attorney will draft the company’s legal documents

7. The Manager then submits the application

to the regulator



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8. Once the regulator approves the application the captive is formed and the client deposit the capital

Please Note: The captive formation process is far more detailed than this summary portrays.



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Contact Information

Donald (Don) J. Riggin CPCU, ARM President, The ART of Captives, LLC

+1.978.594.8762 Office +1.978.880.8805 Mobile

[email protected]


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