Captives: To Have or Have Not Captive insurance companies have long been to risk management what exotic sports cars are to automobile dealerships. A lot more people kick the tires than actually buy.

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

Many organizations struggling to find affordable coverage in the current hard market are being forced to confront the question of whether or not to start captives. Fortunately, there are specialists in captive requirements and formation willing to offer guidance and specialized expertise.

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

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

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

Bill McIntyre, chairman of Dallas, Tex.-based American Contractors Insurance Group Ltd., a construction industry group captive, suggests that the $2 million premium figure is closer to reality these days. He pointed out, however, that the minimum also depends on the type of captive and lines of coverage to be written.

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

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

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

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

Ms. Westover noted, “Rental captives are not affiliated with any particular insured company, but are accessed by participants that want the benefits of a captive but do not have the required premium level.”

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

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

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

“These expenses must be compared to those involved in having guaranteed cost, high-deductible and retroactively-rated policies from traditional insurers,” he said. “All of which requires a thorough review of past and anticipated losses.”

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

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

Mr. Mead also pointed out another possible benefit of captive ownership: the potential for the captive to become a profit center.

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

Deciding on a domicile for the captive is another critical part of the process. Along with stalwarts such as Bermuda, the Cayman Islands and Vermont (the top three in number of captives according to the Minneapolis, Minn.-based Captive Insurance Companies Association), a host of other offshore and onshore domiciles have joined the bandwagon.

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

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

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

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

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

Also, several domiciles have developed a reputation for specializing in certain types of companies and organizations. For instance, 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 for hospitals and other healthcare-related companies.

Geography is also a factor, as some companies want captives that are in the state where their home office is located, or reasonably close by.

“For example, Montana, one of the newest domiciles, might appeal to companies headquartered in that state,” Ms. Westover offered. Also, companies in certain parts of the globe may gravitate toward geographically convenient domiciles, such as European companies choosing Guernsey or Luxembourg, or Japanese companies favoring Hawaii.

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

“Some domiciles require potential captive owners to meet personally with regulators, while in others it is voluntary,” she noted.

This is also the time for the organization to scope out captive management firms, investment advisors, and fronting and reinsurance arrangements that need to be in place before the captive commences business.

Mr. McIntyre noted that choosing service providers is a key advantage of having a captive. “You get to unbundle the services, so you have the provider that you want delivering safety, claims and other services, instead of the providers that your insurance company assigns to you,” he explained.

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

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

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

Ms. Westover acknowledged the possibility of a conflict of interest in the way these offshore domiciles handle the application process.

If the application is approved, the captive is formally incorporated by the local attorney. The directors approve a charter and bylaws, elect officers, and agree on a regular meeting schedule, Ms. Westover explained. She also pointed out that some domiciles mandate that directors meet a certain number of times per year. Assuming the necessary capital has been raised and any required collateral has been posted, a license is issued by the regulatory authority.

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

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

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

(For additional information on the start-up costs and other requirements 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 serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.

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Captives: To Have or Have Not

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