Formation Decision Issues
Why Form a Captive?
To reduce or stabilize insurance costs
Financing risk in a captive makes sense for a smaller, more homogenous group of insured businesses with more favorable claims experience than the broader insurance market. Captives may benefit from other cost savings through lower premiums, elimination or reduction of broker commissions, and lower administrative costs.
To increase capacity to offer tailored products and access to reinsurance
Businesses insured in the traditional market are limited to coverage, deductibles and limits offered by insurance companies. In some cases, needed coverage is not offered or is too cost prohibitive to obtain. This is partly due to the fact that they are based on the needs of a broader market and therefore may not meet the specific needs of each insured. In other words, insured businesses are limited in the traditional market by a more “one size fits all” mentality. Conversely, companies may not be able to properly finance desired insurance coverage, deductibles and limits under a self-insurance arrangement because they cannot access the reinsurance market. A captive can access the reinsurance market and has the flexibility to tailor products for a specific insured. As a result, a captive may have increased capacity compared to other alternatives.
To control insurable risks
Traditional insurers are subject to the cycles of hard and soft insurance markets. During hard markets insurance coverage is more limited and prices are higher. A captive is less susceptible to these fluctuations and offers the insured more control over underwriting and claims settlement activities.
To establish better-than-average claim experience
Because premium levels are directly impacted by claims experience, a company that has established a favorable claims history relative to the average market is a prime candidate to consider establishing a captive to avoid subsidizing other insured businesses with less favorable claims experience. Since there is a direct financial benefit for improving claims experience in the captive market companies will put greater emphasis on controlling claims costs. As a result, companies may take a more direct role in safety programs and other favorable practices. Since a captive is a more formalized form of self-insurance, the captive may provide better tools for gathering data for cost control efforts.
To capture investment income and accelerate/manage cash flow
There is a difference in the timing of when the insurer receives premiums and when claims are paid to the insured. Because of this difference, premiums collected are invested and reserved until claims are paid. Corporate systems retain the benefit of investment earnings on premiums paid, where as in the traditional market this benefit is forfeited to an independent, third party insurer.
Potential tax advantages
Primary tax advantages for captives include the potential deductibility of premiums and deferred taxation of insurance income. Under certain circumstances, an insured may deduct premiums paid to a captive that are not otherwise deductible under a self insurance arrangement. Due to complexities of tax law it is best for captives to seek qualified tax and legal advice before establishing a captive. Tax issues can be a major consideration in forming a captive, but it should not be the sole reason for establishing a captive. If tax sheltering is the driver, the captive may not withstand the scrutiny of taxing authorities.
Safety and soundness for risk management programs
The captive insurance market is more formalized than self-funding insurance risk and has a regulatory framework to support the captive (for example, a requirement for annual audits and actuarial opinions on adequacy of reserves). This may provide a higher probability (whether perceived or real) of success. Alternatively, the formalized framework still allows for insureds to work within a flexible environment to meet unique and specific needs.
Is a Captive the Right Course for My Organization?
There are a myriad of things to consider in determining whether a captive is right for an organization. As a result, there are no hard and fast rules. However, the following questions should be considered in determining if a captive is right for you:
1) How does your claims experience compare to the average pool of insureds covered in the traditional market?
If your company’s claims experience is better than average it is likely current premiums paid to a traditional insurer are higher than is necessary for its risk, as covered in the commercial market, and you may want to consider a captive. In other words, you are probably subsidizing the higher risks of other insured businesses and could potentially benefit from lower premiums in a captive. Costs to operate a captive (including fronting and reinsurance costs) usually comprise about 35-40% of captive premium. Given this general guideline, if your current claims experience is less than 60-65% of total premium paid then you should take a closer look at the captive option.
2) Is your current claims experience consistent and predictable?
Captives work best for programs that have predictable losses. The more predictable and consistent the losses, the greater the confidence with which premiums and reserves can be set for the captive program. Volatile lines of coverage can be problematic for captives as they are difficult to quantify. Also, lines of coverage with short claims development patterns can also be problematic as the ability to hold reserves against potential future losses is limited.
3) How well do you know your insurable risks and which risks would you like to move from the traditional market?
Before you consider a captive, an organization must have a good understanding of its insurable risks. In some cases questions 1 and 2 above may be answered differently depending on the risk. A captive may make sense for one risk but not another. There is nothing that says an organization must ensure all of its risks in a captive if established. However, the organization must be able to identify those risks for which it makes sense, and there must be sufficient premium volume from those risks to support a captive operation.
If you have a good understanding of your insurable risks and your gut feeling is that there is a more cost effective way to address those risks, you are probably on to something and should dig a little deeper into a possible captive.
4) How much do you currently pay in premiums?
A minimum level of premium volume is required in captive programs to provide stability, absorb the operating costs of the captive, and provide a return on the capital invested. Generally, to make a captive program viable, an organization should have at least $750,000 in annual premium for a pure captive and $1,000,000 in annual premium for a group captive. Remember that a group captive is owned by more than one insured and therefore each insured may only contribute a portion of the $1,000,000 in premium volume.
5) What are the demographics of your risks (i.e. international, national, or Utah only)?
The demographics of your risks may make a difference in your risk management or portfolio. You will need the assistance of a qualified risk managers, captive managers, accountants, and attorneys to determine the best options for your company.
6) What is the financial stability of the parent organization?
An organization considering a captive will need sufficient financial resources to support the capital investment and the posting of collateral behind the captive program.
7) Are you willing to commit to the captive as an alternative to the traditional market?
Captives are a way for companies to reduce reliance on the commercial market and provide stable, long-term risk financing. Captives will not be the lowest cost option in all years, so to be successful one will need to be committed to the process long-term. Short-term premium savings should not be the overriding reason for starting a captive. Generally speaking, an organization should be willing to commit at least 3 to 5 years to a captive arrangement.
Beyond just taking a long-term approach, the parent of any captive must be committed to the overall process and providing support to the captive management team.
Although the above questions are by no means comprehensive, they should provide some initial sense about the feasibility of a captive. If, after answering the above questions, a company believes a captive might be the right choice, it should retain a qualified service provider to conduct a feasibility study.
Will a Feasibility Study Help Determine Whether a Captive is the Right Risk Management Tool for My Organization?
Costs for a feasibility study can vary depending on the size and complexity of the organization being studied, as well as the service provider retained. Indications from some service providers appear to be in the $12,000 to $24,000 range for a mid-sized captive company. Costs are typically higher for feasibility studies on group captives than pure captives. A Feasibility Study will generally look at the following issues:
| Quantitative Factors: | Qualitative Factors: |
|---|---|
| Coverage & Program Structure | Ownership |
| Loss Analysis & Rate Development | Governance |
| Capital & Surplus | Domicile |
| Claims Projections & Pro Forma | Management |
| Reserve Requirements | |
| Fronting & Reinsurance | |
| Investment Income | |
| Taxes |
Where Should A Captive be Organized?
If the results of the feasibility study show that the captive is a good alternative, and the organization decides to proceed, they will need to select a State in which to domicile the captive. To meet with the Utah Insurance Department to discuss the business plan for the Captive, and to receive instructions regarding the licensing process, contact the Department’s Captive Division at (801) 538-3800 to set up an appointment to meet with the Captive Insurance Director.
What Tax Issues Are Involved in Organizing a Captive Insurer?
There are generally four areas of tax consideration related to captives. They include Premium Taxes in the state of domicile, U.S. Federal Excise Taxes, U.S. Income Taxes (includes deductibility of premiums paid and income tax considerations), and Internal Revenue Code (IRC) § 953(d) elections. Each is briefly discussed below:
Premium Taxes:
In Utah a $6,125 annual fee and $250 e-Commerce fee constitutes the sole tax or fee. However, personal and real property owned by the captive in Utah will be subject to property tax that funds the Uniform School Fund.
Federal Excise Taxes:
This tax would not be applicable for any captive domiciled in the United States, including Utah.
Placing insurance risk with an off-shore insurance entity is viewed as the importation of a service and therefore is subject to Federal Excise Taxes (FET). For P&C companies the tax is 4% for insurance transactions and 1% for reinsurance transactions. For a life business it is 1% whether direct or reinsurance. This tax does not apply if the U.S. has a treaty with that jurisdiction (for example Ireland and the U.K.). However, you cannot run the business through a jurisdiction with a tax treaty and then transfer it to a non-treaty location. If it ends up in a non-treaty location, it is subject to the FET. You will need to consult with appropriate tax and legal consultants and a qualified captive manager to navigate these tax issues appropriately.
Deductibility of Premiums Paid to Captive:
Premiums paid to captives are not deductible unless some or all of the following factors exist:
- The transaction is a bona fide insurance transaction, with the captive taking some risk, under a defensible business plan.
- The captive’s ownership is organized such that subsidiaries, not the parent, pay premiums to the captive under a “brother-sister” relationship.
- The captive writes a substantial amount of unrelated business. You will need to consult with appropriate tax and legal consultants and a qualified captive manager to navigate these tax issues appropriately.
Income Taxes:
On-shore captives may consolidate its earnings with the parent, if it is a pure captive, for tax purposes. If it is a group captive, it is treated as a taxable entity in its own right. You will need to consult with appropriate tax and legal consultants and a qualified captive manager to navigate these tax issues appropriately.
IRC § 953(d) Election:
Foreign insurance companies can elect to be treated as a domestic company for U.S. Federal tax purposes.
This information regarding tax issues is not complete. Persons or organizations will need to consult with their tax consultants to obtain complete and up-to-date information to comply with the federal and state tax laws involved in the organization and operation of a captive insurance company. You will need to consult with appropriate tax and legal consultants and a qualified captive manager to navigate these tax issues appropriately.