The captive insurance industry is thriving. In the first part of a two-
part series, Charles Dillon explains how you can take advantage
By Charles Dillon
today's hardening insurance market,
n and writing more than US$20 billion in Since the beginning of the industry, new
I businesses and high-net worth
individuals are becoming more aware
of the steady rise of insurance premiums
This growth cycle is also marked by
ways of arranging captive insurance
coverage to provide access to a broader
base of different owners and users have
matched by an overall reduction in the established domiciles, such as Bermuda, been explored. There are now many types
scope of insurance coverage. the Cayman Islands and the Isle of Man, of different captives:
being joined by the likes of the British
But these problems are not the only Virgin Islands, Dublin, and, yes, even • Single-parent captives insure the risks
concems voiced about today's traditional Washington, DC. of the owner or subsidiary operations
insurance market. Bottom-line conscious of the owner.
premium payers also I010W that by paying While the greatest stimulus to the increase • Group captives are established to
annual up-front premiums, they lose utility of captives is rising insurance costs or insure risks of different entities and
of the money that would otherwise be limited availability of certain types of are owned by multiple non-related
invested. coverage, risk managers and finance shareholders.
directors value captives to such an extent • Association captives underwrite the
There is, however, good news. The captive that even when premium rates are low risks of members of an industry or
insurance industry is thriving and every day interest in captives continues to be strong. trade association.
these same organizations and individuals •Agency captives are usually formed
who thought they had no choice but to Types of captives by insurance brokers or agents to
remain content with paying more for less allow them to participate in the high-
are establishing or using captive insurance In its simplest form, a captive is a wholly- quality risks they control.
arrangements. owned, first-tier insurance subsidiary • Rent-a-captives provide access to
formed to insure some or all of the risks of captive facilities without the insured
The history of captives its parent. This type of captive is commonly having to form its own captive. The
referred to as a pure captive. All captives, insured will pay a fee to "rent" a
The industry's origin started with the birth however, are recognized as insurance captive's facilities and is required to
of co-insurance and mutual companies in companies for regulatory and reinsurance provide collateral to protect the rent-
the 19205 and increased substantially purposes. They are domiciled either a-captive from underwriting losses
through the use of offshore jurisdictions by offshore or onshore and represent the most suffered by the insured.
foreign parent organizations seeking aggressive, formalized and flexible form of • Segregated portfolio (accounts)
alternative insurance options. Today, there self-insurance. They also participate in the captives ensure an individual
are nearly 5,000 captives worldwide, with a underwriting of property, casualty, fiduciary insured's premiums are not exposed
total capital surplus of over US$50 billion, and specialty lines of coverage. to loss from any other entities doing
44 www.ofcpublications.com VAULT May/June 2002
business within the captive insurance Single Parent Captives
• Special purpose vehicles are used for
risk security, They are reinsurance
companies that issue reinsurance Parent
contracts to their parent and cede the
risk to the capital markets by issuing
Captives may be established to direct-write
policies to, and receive premiums from, Q.I
their insureds. Because of regulatory o~ rIJ
matters, however, many jurisdictions
require that only admitted insurers write e
certain risks. It is, therefore, usually easier ~ ~
for a captive to operate as a reinsurer ~
accepting the risks of its parent, which has
been insured by a licensed direct-writing
company-a fronting company-and then
ceded to the captive. The fronting
company will usually require service fees Captive
as well as a letter of credit to guaranty the
captive's ability to pay claims.
Reasons for forming a captive I I
A common belief is that the primary Reinsurer
reason for forming a captive is for tax
sheltering purposes. While this belief ,
likely results from the large number of
captives located in offshore domiciles, the
reality is captives are usually formed for until claims are paid. A captive the organization's activities, not as a
other economic reasons. Those economic allows for such premiums and cost centre.
reasons are mainly risk management and investment income to be retained
risk financing and include the following: within the controlled group and, o Accessing the reinsurance market.
under certain circumstances, the The international wholesalers of the
• Lowering your insurance costs. For investment income will be allowed to insurance world are known as
commercial market insurance accumulate on a tax-fee basis. reinsurers. Because they operate on a
premiums to result in net profits for lower cost structure than direct
insurers after meeting the cost of • Risk retention. An organization's insurers, they provide coverage at
claims, premiums will be inflated to desire to increase its own deductible substantially reduced rates. By
provide for overhead and profits. levels by retaining more of its own accessing this market, a captive buyer
This inflated portion of the premium risk may be hindered by lower-than- can more easily determine its own
can represent up to as much as 40% acceptable discounted premiums retention levels and structure its risk
of the entire paid premium. By because the insurer is unable to management program with greater
utilizing a captive, a parent may establish adequate capital reserves. freedom.
retain this profit within its controlled By using a captive, these problems
group rather than pay it out to an can be resolved. • Running a separate profit centre.
outside insurer. In addition, a Besides insuring against its parent's
captive charging a premium that • Securing unavailable coverage. risks, a captive has the flexibility to
more accurately reflects the parent's When an organization is unable to operate as a separate profit centre by
loss experience may reduce receive coverage for certain risks or writing outside risks.
insurance costs. where the price quoted is
unreasonable, a captive may be used • Significant tax benefits. The
• increasing your cash flow. It is not to provide the cover required at a minimization of taxes generally
uncommon for the annual investment reduced premium rate. should never be the sole reason any
income of a captive to account for business ever plans a transaction.
about 10% to 15% of its annual • Risk management. A captive can The two main benefits to forming or
assets. While premiums are usually centralize the risk management and using a captive are: the accumulation
pre-paid, claim payments are treated risk financing activities of its parent of tax-free underwriting and
exactly opposite. Their payout is organization. An effective risk investment earnings, and the ability
often over a longer period of time. management program will ultimately to utilize foreign tax credits before
As a result of this delay, the result in recognizable profits for the they expire if one decides to use an
premium is available to generate captive. Risk management should be offshore or foreign domicile. Please
investment income for the insurer viewed as a potential profit part of remember, however, there are many
46 www.ofcpublications.com VAULT May/June 2002
Company 1 .Company 2 Company 3
complex tax rules regarding captives. Because evaluating the appropriate captive The exit
There is also considerable anti- arrangement requires the insured to
avoidance tax legislation in countries evaluate non-traditional costs and services The decision to establish or use a captive
such as Germany, Japan, the United not normally considered when purchasing should be made with long-term goals in
Kingdom and the United States, so traditional insurance-such as reinsurance, mind. In the event one decides to shelve
expert advice must be sought before claims handling, actuarial, funds one's captive and re-enter the traditional
incorporating a captive. management, underwriting and loss insurance market, however, exiting a captive
reserving-the feasibility study should is not as easy as non-renewing a policy.
Taking the next step-completing a always be prepared with the understanding
feasibility study that the final reconunendation should also Open claims must continue to be adjusted
include the option of remaining in the and paid and reinsurance claims need to be
While there are many benefits to forming or traditional insurance marketplace. handled. In fact, the capital contributed to
using a captive, deciding to do so is a big establish a captive will not be released until
step for most organizations. Before By entering into the captive market, an all liability is released and the captive is
committing to a captive-directed path, it is organization should be willing to make a officially closed.
important to investigate as much as long-term commitment for the effort and
possible to ensure the endeavour will be expense to ultimately be cost-effective. While the decision to enter into a captive
worthwhile. arrangement must carefully be made, it is
Selecting the appropriate domicile not without its risks. With almost 5,000
The first step is the feasibility study, which captives up-and-running worldwide,
should evaluate all possible insurance If an organization decides establishing or however, many people realize the overall
alternatives. A thorough feasibility study using a captive is a cost-effective way of economic benefits make it worthwhile.
will meet at least five criteria: establish a risk assumption, the domicile in which the
financially viable capitalization and captive will be located must be chosen. lf your insurance goals consist of reducing
premium volume; determine whether there Some of the most important things to look your annual premium payments, while still
is efficient risk management and loss for include: ensuring your insurance coverage remains
control; determine if a reliable fronting adequate, captive insurance might be the
arrangement and good quality reinsurance • Political and economic stability. solution for you. •
is available; evaluate whether a • Advanced judicial and regulatory
commitment exists from the parent framework.
Charles T Dillon is an attorney with the
organization's management to operate the • Sophisticated banking, business and Maryland, USA law firm of Hodes, Ulman,
captive; and ensure that the parent management. Pessin & Katz, P.A., where he concentrates in the
organization is willing to commit to • Accessibility. area of business and lax planning, asset
provide the captive with adequate financial • Modem communication infrastruc- protection and offshore strategies. He may be
support and expertise. ture. reached bye-mail firstname.lastname@example.org.
May/June 2002 VAULT www.ofcpublications.com 47