The captive insurance industry is thriving. In the first part of a by nyut545e2


									 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                                       VAULT                                                        May/June 2002
       business within the captive insurance                             Single Parent Captives
       company .
     • 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
                                                                          e                                                    rIJ

 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                                       VAULT                                                                 May/June 2002
                                          Group/Association Captives

                Company 1                                         .Company 2                                                Company 3

                        I                                                                                                             I


                                                 e                                                   rI).

                                                 e                    Captive

                        I                                                                                                            I
                Reinsurer                                                                                                    Reinsurer

   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

May/June 2002                                                            VAULT                                           47

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