Captives: To Have or Have Not Captive insurancecompanies have long been to risk management what exotic sports carsare to automobile dealerships. A lot more people kick the tiresthan actually buy.

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Whether an insured company should remain atire-kicker or drive out of the showroom in a shiny new captive canbe a gut-wrenching decision.

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Many organizations struggling to find affordable coverage in thecurrent hard market are being forced to confront the question ofwhether or not to start captives. Fortunately, there arespecialists in captive requirements and formation willing to offerguidance and specialized expertise.

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The first hurdle in making the decision is determining whetherthe insured company spends enough in annual premiums to make acaptive financially viable.

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“Single-parent captives [those owned by one insured company]should have at least $1 million in annual premiums in order tojustify the fixed costs involved in start-up,” noted Kate Westover,president of Captive Advisory Services, an Argonaut Group companybased in Colchester, Vt. Ms. Westover is a consultant who assistsprospective and existing captive owners structure theirprograms.

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“Some say $2 million is the minimum, but I've worked withcompanies with $1 million in premiums and a captive significantlystabilized their cost of risk,” Ms. Westover said.

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Bill McIntyre, chairman of Dallas, Tex.-based AmericanContractors Insurance Group Ltd., a construction industry groupcaptive, suggests that the $2 million premium figure is closer toreality these days. He pointed out, however, that the minimum alsodepends on the type of captive and lines of coverage to bewritten.

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“For a captive that will write only property coverage, $1.5million in premium may be acceptable as a minimum, whereas $3million in premium may be the suggested minimum for workers'compensation,” Mr. McIntyre said.

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“Some reinsurers won't do business with a captive below acertain premium level, so that's also a consideration,” Ms.Westover added.

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Ms. Westover and Mr. McIntyre pointed out that even companiesthat don't reach the suggested minimum premium levels can joingroup captives or enter into a rental captive arrangement.

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“Group captives are owned by multiple companies in a particularindustry,” Mr. McIntyre explained.

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Ms. Westover noted, “Rental captives are not affiliated with anyparticular insured company, but are accessed by participants thatwant the benefits of a captive but do not have the required premiumlevel.”

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Assuming the premium requirement is met, a feasibility studywill be undertaken to determine whether a captive is the best wayto handle some or all of the company's insurance program.

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“Management will go to an independent consultant which, jointlywith the company's agent or broker, will develop a 'pro forma' ofthe anticipated expenses,” Mr. McIntyre said.

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Such expenses include the fronting fee (cost to have a licensedinsurer issue the policy), captive management company fees, claimsstaff salaries, safety services and reinsurance, he added.

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“These expenses must be compared to those involved in havingguaranteed cost, high-deductible and retroactively-rated policiesfrom traditional insurers,” he said. “All of which requires athorough review of past and anticipated losses.”

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While one potential benefit of forming a captive is thatpremiums paid by the insured company to the captive (as opposed tocontributions to a self-insurance fund) may be considered atax-deductible business expense, consultants generally agree thatthis should not be a key consideration.

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“Never go into a captive with the prime motivation being the taxissue,” advised Michael R. Mead, president of Chicago-based M.R.Mead & Company LLC, an insurance intermediary specializing inalternative risk financing techniques. Captives are a riskmanagement tool, not a tax tool, he indicated.

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Mr. Mead also pointed out another possible benefit of captiveownership: the potential for the captive to become a profitcenter.

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“Profits may be derived from underwriting (when premiums exceedlosses and expenses), investment income, and writing insurance fororganizations other than the parent company,” he noted.

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Deciding on a domicile for the captive is another critical partof the process. Along with stalwarts such as Bermuda, the CaymanIslands and Vermont (the top three in number of captives accordingto the Minneapolis, Minn.-based Captive Insurance CompaniesAssociation), a host of other offshore and onshore domiciles havejoined the bandwagon.

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“Take a 'TRIP' to determine the best domicile,” Ms. Westoveradvised. No, that doesn't mean a personal visit, although many riskmanagers wouldn't mind a round of tropic island hopping. “TRIP”stands for Taxes, Regulation, Infrastructure and Perceptionthe “bigfour” in domicile decision making.

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Taxes are generally lower and regulation is less burdensome inmany of the offshore domiciles, which is part of their appeal, Ms.Westover indicated.

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On the other hand, some of the newer offshore domiciles may lackthe necessary infrastructure, such as banks, attorneys, accountantsand other service providers with captive experience, she added.

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Perception is the fuzziest of the considerations. “Somecompanies just don't want to be offshore, and some want to go whereeveryone else is,” Ms. Westover explained.

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“The amount of capital needed to start the captive is thebiggest consideration for many companies,” Mr. McIntyre said. “Somedomiciles require as little as $250,000 in initial capital.”Companies with limited financial resources may be attracted tothose domiciles, Mr. McIntyre indicated.

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Also, several domiciles have developed a reputation forspecializing in certain types of companies and organizations. Forinstance, the District of Columbia's niche is trade associations,as many are based there, Ms. Westover pointed out. Another example:The Cayman Islands has a reputation for expertise in captives forhospitals and other healthcare-related companies.

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Geography is also a factor, as some companies want captives thatare in the state where their home office is located, or reasonablyclose by.

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“For example, Montana, one of the newest domiciles, might appealto companies headquartered in that state,” Ms. Westover offered.Also, companies in certain parts of the globe may gravitate towardgeographically convenient domiciles, such as European companieschoosing Guernsey or Luxembourg, or Japanese companies favoringHawaii.

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Once a domicile is chosen, company officials generally meet withthe regulators and submit any required formal application, businessplan and financial information, along with the necessary fees, Ms.Westover said.

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“Some domiciles require potential captive owners to meetpersonally with regulators, while in others it is voluntary,” shenoted.

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This is also the time for the organization to scope out captivemanagement firms, investment advisors, and fronting and reinsurancearrangements that need to be in place before the captive commencesbusiness.

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Mr. McIntyre noted that choosing service providers is a keyadvantage of having a captive. “You get to unbundle the services,so you have the provider that you want delivering safety, claimsand other services, instead of the providers that your insurancecompany assigns to you,” he explained.

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Claim services are especially important, stressed Mr. McIntyre.“In my experience, about 50 percent of companies join or formcaptives because of frustration with insurer-provided claimservices.”

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The application approval process is where onshore and offshoredomiciles differ significantly, said Ms. Westover.

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“Onshore domiciles generally have an independent actuary reviewthe application and accompanying data. In many offshore domiciles,an advisory board consisting of representatives from captiveindustry service providers reviews the application,” she said.

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Ms. Westover acknowledged the possibility of a conflict ofinterest in the way these offshore domiciles handle the applicationprocess.

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If the application is approved, the captive is formallyincorporated by the local attorney. The directors approve a charterand bylaws, elect officers, and agree on a regular meetingschedule, Ms. Westover explained. She also pointed out that somedomiciles mandate that directors meet a certain number of times peryear. Assuming the necessary capital has been raised and anyrequired collateral has been posted, a license is issued by theregulatory authority.

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The captive is then officially in the insurance business.Whether that is good news or bad news, only time will tell.

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“You have an insurance company on your hands. You have to dealwith fronting, reinsurance, regulators and other issues,” said Mr.Mead “The control over your risk dollars and other benefits youexpected in some cases may prove illusory.”

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Some exotic new sports cars bring years of driving pleasure.Others spend more time in the shop than they do on they road.

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(For additional information on the start-up costs and otherrequirements of the major onshore and offshore captive domiciles,visit the CICA Web site, www.captiveassociation.com.)


Reproduced from National Underwriter Edition, March 10, 2003.Copyright 2003 by The National Underwriter Company in the serialpublication. All rights reserved. Copyright in this article as anindependent work may be held by the author.


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