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CAPTIVE INSURANCE GROUPS
by Richard A. Pelletier, CPA
Introduction
There are over 25,000 formal Associations in the United States alone ranging from the small group of concerned citizens in rural America to the vast national associations with millions of members. The concept of homogenous risk-sharing is of course not new. Lloyd's of London started in exactly the same way, with ship owners believing that the sharing of their marine risks amongst themselves would lighten the load for all. By and large that worked although these days some would argue they should have stayed with the coffee drinking.
The explosion of the group captive concept in the late 1970's and its continued growth can provide significant economic benefit to the small to medium sized company, not otherwise strong enough to form its own self-insured vehicle such as the single-owner captive or in many cases, not willing to pay the high premiums demanded from time to time, in the
traditional insurance marketplace.
The Concept of Risk-Sharing.
The basic issue is that companies within the same industry or business should have a very good idea of the risks inherent in their own industry. Moreover, they should also be able to identify the good risk members from the bad risk members within their industry. If that is true the concept of risk-sharing should be investigated.
It should be noted here that the corporate community of the United States is much more open to information sharing about themselves than in most other developed countries of the world. Much of that may be caused by regulation including stock exchange requirements or Securities Exchange Commission mandates and so forth. The sharing of financial data and underwriting data and information is offered in the interests of the group at large - clearly there will be certain data not shared within the group due to sensitivity concerns but will be provided to the insurance underwriter charged with rate-setting for the group.
Members of group captives must be committed to covering each other's losses. The basic justification can be summed up by "you have either been hit with the large loss or you're due!! " It is one or the other. Thus you help your fellow captive member today, because he will be around when you need the help.
The major concern
Insureds who for one reason or another may be contemplating the formation of a group captive have one fundamental question and one only, "Why should I pay the losses of my competitor?"
The answer is you don't. What you will pay is your share of the losses of the group as a whole, which is made up of all the losses of all the members. The pre-screening process to determine who joins the group captive therefore should dramatically reduce this concern. If one member of the Association is known to have a horrendous loss history he just simply is not invited to join the group captive in the first place. Moreover if one member of the group captive does not pay attention to the loss control guidelines of the group captive after formation, he is either penalized with additional premiums or higher deductibles or at worst, ejected from the group captive. So in theory, while you do pay for the losses of others, they also pay for yours and on balance, should be no more (if not much better) than you would otherwise be exposed to with your own claims record if you stay in the traditional
insurance market. But the pre-screening and the ongoing monitoring is the foundation answer to the above question. Mathematical probability including actuarial assessment and loss forecasting also come heavily into play.
The Feasibility Study
The feasibility study prior to the formation of the group captive is crucial to its success. If your homogenous group does not, or will not, commission a feasibility study then DO NOT join the group captive. Simple as that.
A "feasibility committee" should be formed consisting of the following:
The former group evaluates the program from an insurance/reinsurance perspective while the latter brings the industry-specific dimension about how the industry works. If the Association has an executive management staff then representatives from that staff should also sit on the feasibility committee. Those people should have information about all members of the association and should provide such information in an unbiased fashion.
The committee, among other duties (discussed later) will in the early stages of its existence, determine which members should be invited to join the group captive. That can of course lead to disgruntled members and so forth (to say the least). However the committee should establish certain underwriting criteria at the outset, if the member meets the criteria he will be considered, if he doesn't meet the criteria he doesn't come to the party. Let them know the targets up-front and they'll be fine.
The feasibility process investigates each group or association member's underwriting information on their existing program of insurance including their loss history. This is supplied by the member or its existing insurance company (the feasibility team must be very
careful of the data received - which insurance company will be pleased to provide that
it intends perhaps to walk away from the insurance company and go self-insured in a group captive?)
The existing loss control procedures of each candidate member wishing to join the group captive. The industry members of the committee can provide serious input to this from their own intimate knowledge of both the industry and their own claims experiences. They know the issues involved in the operations of their trade including customer relations and the technical characteristics of that industry.
Projected premium volume individually and collectively. If the group captive volume is not large enough combined to attract quality reinsurance for example then the project will not fly.
The financial stability of the candidate member and his ability to contribute the required initial capital to the group captive.
The structure of the group captive addressing such issues as shareholders agreements, share distribution, dividend policy, and so forth.
The Advantages of the Group Captive
The ability to be rated for premium purposes within the confines of the members own industry and within the (even better) confines of a pre-screened "elite" group of similar insureds. Within the traditional markets, the insured is subjected to the impact on pricing caused by the wide variety of loss experience within the broad spectrum of good insureds to bad insureds. If you have "good" experience; the chances are that you will be dragged down
(pay more in other words) by the other insured clients of the insurance company having bad experience.
The reinsurance markets like to work with underlying insureds who have put together a well-thought-out business plan of risk sharing and have committed to putting their own capital into the project. This can result in better quality reinsurance and a more cost-efficient structure, thereby reducing overall cost of the entire program of insurance.
Profit participation. Rather than the profits of good underwriting going to the traditional insurance carrier, the group captive retains such profits for distribution to the membership or to offset future premium costs through such mechanisms as policyholder dividends or pro-active premium assessment.
Investment control. The group captive decides on its own investment policies and practices. Insureds are not exposed to the potential for bad investment decision by the traditional insurance company, which can have a serious impact on premium costs.
Cash flow can be improved. As a voting member of the group captive, each member has the ability to influence the flow of premium payments to the group captive. The group captive can decide whether incoming premiums should be paid at the start of the policy year or monthly or quarterly for example. Moreover, if one member runs into cash flow problems within his business, there is usually an ability to discuss premium flow to the group captive with his fellow members. Perhaps not palatable but practical, if needed.
Sharing of information. Loss control procedures and improvements can be discussed in a forum which is much stronger than academic discussion. Money is involved and the group will force all of its members to continually review and upgrade their individual procedures. This is good for one and good for all.
The group captive holds regular meetings (out with annual trade conventions and so forth) which can be of immense value in networking on issues affecting the industry in general.
The effect on pricing of the Group Captive
Group captives are typically more popular when a hard market exists than in the soft market part of the cycle.
It is imperative therefore that from the outset of the captive, members are totally committed to the concept. Obviously changes can occur which may result in one member going out of business or being taken over which may cause their exit from the group captive. However, if all else remains stable then they must be strongly encouraged to stay in the captive for the long run. The problem with that of course arises when traditional premium rates are much cheaper than the premium rates of the captive for any given underwriting year. Members have a choice obviously at that point.
Let's take a look at the following example:
Setting up the group captive in Year 1 looks fairly easy. Given a two-year projection at the outset to determine pricing, Year 2 stabilizes at $10 and thus the captive still looks good. Year 3, as the traditional markets gets harder, the captive looks even better although let's say reinsurance rates for the captive have increased such that the underlying rate has increased from $10 to $12. The captive still looks strong, in fact by this time more members of the Association who have not been in the group captive are clamoring to get in. Everything is rosy. Then the cycle turns (probably not as quickly and deeply as the example but it is only an example remember).
Now the captive rates are way above market. The problem is that it may not be that easy for the captive to cut back and compete with the market because of a build-up of prior years losses and maybe even policyholder dividends having been paid out all affecting the go-forward pricing structure.
The member of the group captive must therefore understand that, over time, his premium costs should be less than traditional market costs over the same period. Moreover he should be in a better position to project his insurance costs within his overall operating budgets for at least 1-2 years out through his much closer knowledge of, and influence on, the condition of the balance sheet of the insurance company which he now partially owns. He will be much
closer to the loss reserve position of the company as a whole, its investment prognosis and the general financial condition of the group captive.
Therefore a successful group captive maintains its membership base (with minimal disruption); understands longer-term underwriting projection and the need for price stability; looks at profit as a bonus not a requirement; and is prepared to demonstrate a clear need for loss control.
Capital Requirements
There are two basic structures for the determining of initial capital (other than regulatory requirements):
(b) In proportion to premium.
It is not the intent of this Paper to discuss the incorporation procedure apart from to mention that a shareholders agreement is probably essential and that good legal counsel in the country of origin of the group and the offshore domicile should be used to work with the feasibility committee from the outset.
Operations of the Group Captive
Quality personnel are needed in the following disciplines:
It is unlikely that the members of the Association itself will be qualified to provide active management within any of the above. Thus in most cases, third party personnel are utilized either on a dedicated basis (employed by the group captive itself) or through outsourcing. The "captive manager" can provide most of the required functions. Typically
this would be an insurance management company resident in the domicile of the group captive e.g. Bermuda. They would satisfy all the needs of the group captive either through their own in-house, locally based staff or through sub-contract arrangements with their "onshore" colleagues or other service-providers. Outside assistance is usually required for legal, actuarial and investment management. It is however worth noting that not all captive
managers have the mind-set to manage group captives. Too often the captive manager, who is typically used to the demands of the say Fortune 500, single-owner captive simply cannot abide the frustrations of working with a group of plumbers or electricians for example. Group captive management is different and needs experienced personnel in that area of the captive arena. A much more hands-on management style is needed for the group captive.
The group captive should appoint sub-committees of the board of directors in such areas as underwriting, audit, investment, loss control and of course an executive committee to act as the "core" of the Board. In most cases, a representative of each member of the group captive will be invited to join the Board, which in the case of a large captive can become cumbersome. Each committee therefore should work closely with both the captive manager and
the relevant outside service-providers.
A strong President, appointed from the membership is also crucial. He cannot be swayed by emotional outburst (and that happens); or favoritism (and that happens); or dare we say it, even by a show of hands on any given issue. He must show common sense, fairness, objectivity and above all else, he must be prepared to take the heat. Too often, group captive meetings, turn into one-man shows where the loudest voice or biggest player just wants to rule
without having the democratic authority. The funny thing is of course, that in many cases what he says is good and should be considered (he may even be an experienced and successful businessman otherwise) but if it is not in the best interests of the group as a whole, he should be quieted, otherwise subdued or ejected. So who wants to be President?
Classes of Business
The group captive can write any class of business it so chooses. In the case of the offshore group captive wishing to write Workmen's Compensation coverage, an approved insurance company within each state of the United States must issue the policies of insurance. Typically the offshore group captive will not be so approved or "admitted". Therefore in the case of Workmen's Compensation, there will be the need for a U.S. carrier to issue the policies and for the offshore group captive to reinsure the admitted carrier through a contract of reinsurance. This arrangement is referred to as "fronting" and is perfectly acceptable. Certain statutory rules and regulations apply to fronted programs such as the provision of a Letter of Credit from the offshore group captive in favor of the US admitted carrier amounting, in essence, to the loss reserves carried by the admitted carrier which are reinsured by the offshore group captive. The fronting carrier may or may not retain a small part of the risk but will certainly always take a fronting fee for the use of its name and its administration of the program.
The offshore group captive may write most other classes of business on a direct basis i.e. where the offshore group captive issues the policies of insurance directly to the member-insured. In the case of the offshore captive, the serious offshore domiciles will
require a detailed business plan to be submitted including discussion of the classes of business and the reinsurance thereon.
Why offshore?
Bermuda is the leading offshore captive insurance domicile in the world. There are approximately 2,800 captives globally (all types and structures) of which Bermuda handles almost 50%. The infrastructure and quality regulations developed over the years in Bermuda have created both a professionally reliable reputation and a "comfort level" with the island's international insurance industry. In terms of premium volume and business transacted, Bermuda rivals Lloyd's of London.
The offshore domicile such as Bermuda provides a well- defined structure of law, rule and regulation which has been specifically designed to accommodate the vast and intricate demands of the risk management business these days.
More acceptable levels of initial capitalization ; regulations more geared towards the captive concept ; a tax neutral status ; an established reinsurance market ; a close working relationship between Government and the industry ; a base of English common law with well- established avenues of legal practice such as the appeal process, if needed ; a solid structure of highly- experienced captive managers and reinsurance brokers (including the
captive management subsidiaries of all of the major international insurance brokerage houses), public accountants (all of the Big Six and more), lawyers proficient in insurance and reinsurance set-up and ongoing requirements, a strong banking industry, systems support firms and all other support facilities to ensure the smooth operations of the offshore group captive.
Taxation Issues
When establishing a captive insurance company, various tax considerations should be addressed. These considerations include but are not limited to, the deductibility of the premiums paid by the policy-holders for tax purposes, the payment of federal excise tax on insurance premiums, the tax status of the captive and the tax ramifications to the shareholders.
In general, the premium payments made to a captive by the policy-holder are only deductible for tax purposes if the underlying contracts (in the case of a US-owned group captive) qualify as insurance contracts for United States federal tax purposes. In addition, a federal excise tax equal to a percentage of the premiums paid is imposed on premium payments made to a foreign insurer for insurance coverage for risks wholly or partly located in the United States. The amount of this tax varies from 4 percent to 1 percent depending on the type of insurance coverage and whether the policy is a policy of insurance or reinsurance.
The ownership and business activities of a captive will generally determine the tax status of a captive. A captive may be considered to be a "controlled foreign corporation ("CFC"), a foreign personal holding company or a passive foreign investment company. A captive may be deemed to be engaged in a US trade or business or elect to be taxed as a domestic insurance company. The tax status of a captive may have significant ramifications to the shareholders of the captive. The tax filing requirements of the captive and its shareholders may also be dependent on the ownership and business activities of the captive.
While the single-parent captive may be vulnerable to the Internal Revenue Service self-insurance attack, several captive arrangements involving group or associations of unrelated insureds have been upheld as bona fide insurance arrangements. While no specific guidelines have been established regarding the number of members or shareholders the group captive must have to be considered a bona fide insurance company, the IRS has recognized on several occasions that risk shifting and risk distribution can be present where the
captive is multi-owned (i.e. the group captive).
In addition, while many group captives have been formed in foreign jurisdictions to qualify an non-controlled foreign corporations, the new "related-person insurance income" rules introduced by the (U.S.) Tax Reform Act of 1986 effectively subject most group captives' profits to current taxation.
To sum up therefore, premiums paid to the group captive will generally be treated as a deductible expense for tax purposes however the corporate profits of the group captive itself may be taxable either directly or indirectly through the individual tax filings of the shareholders themselves on a pro rata basis. Tax planning, from the outset is therefore crucial.
Investments
The investments of the group captive are very important to its financial stability.
An Investment Committee should be formed early on in the life of the group captive to set policy, determine guidelines and benchmarks. The captive manager will not take on the position of investment manager, thus an outside manager should be appointed. Any idea that one of the members (or even worse his brother-in-law) investing the funds of the group captive should be rejected before the idea has been formulated !!
It is becoming increasingly more important these days that asset-liability management techniques should be adopted. This addresses the correlation between the insurance liabilities and the corresponding way in which the assets should be invested to be able to settle the liabilities when they become due yet maximize the investment return.
And finally, the big question!
Once the group captive is up and running and the first group meetings have taken place the question which will always get the most air-time at such things as Annual General Meetings is "So, where will we hold next year's Annual Meeting and when will it be?" Vast amounts of time will be consumed by " well I'd like Acapulco in June." "No that won't work, that's graduation time for us." "OK, so how's about going to St. Maartens?" and on and on it
goes.
Patience is indeed a virtue. And with the group captive you will needs tons of it. Otherwise they can be very worthwhile for the members; provide solid insurance at reasonable and predictable rates; perhaps even make an overall profit; and maybe most importantly can be very enjoyable for everyone involved.
Take a close look at the group captive - it can be a very valuable risk management tool.
[26 Nov. 1999]
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