A Guide to Captives

A Guide to Captives

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Airmic is grateful to Chartis for producing this guide to captive insurancecompanies. Airmic invited partners to select an area of expertise and producean introductory to intermediate level guide for the benefit of Airmic members.The intention of this guide is to provide Airmic members with an overview ofthe topic and provide information on the practical considerations whenmanaging this important insurance issue.

This guide has been written with a view to providing members of AIRMICwith support when faced with such questions as...

“What alternatives are available to buying cover in the commercial market?”

“Can we save on premium spend and can we take more control of our risks?”

“What do we need to do and what will it cost?”

If you already have a captive you may be asked to explain why and what itprovides that the commercial market does not.

This is by no means a definitive guide; however we hope it will go some wayto answer these questions and to help in your understanding of the world ofcaptives and how they may work for your organisation.

This guide will take you through the life cycle of a captive from initialconcept through to the benefit and uses and finally to exit strategies.

The following topics will be covered:

1. What is a captive?

2. Is it a legitimate insurancecompany?

3. Why set up a captive?

4. What types of companiesconsider captives?

5. How do you know if it is right foryour organisation?

6. What risks can it insure?

7. Advantages and disadvantages

8. Types of captive

9. When is a good time to set upa captive?

10. What would it cost to set upand manage?

11. Who would manage it?

12. How much would they charge?

13. Where to set up your captive?

14. Set up insurer or reinsurer?

15. Typical examples ofcaptive structures

16. What exit strategiesare available?

17. Case studies

EXECUTIVE SUMMARY

3A GUIDE TO CAPTIVES

The name “Captive” was coined in the 1950’swhen the concept was being brought intopractice for a mining company. A mine producingoutput which was being kept solely for thecorporations own use was referred to as a“captive” mine. When the mining companyincorporated its own insurance company, it wasreferred to as “captive” insurance as it wroteinsurance exclusively for the captive mines.

Today, a “captive” insurance company iseffectively an “in house” insurance providerformed primarily to insure its owner and affiliatedcompanies and can be viewed as a form offormalised self-insurance. They can write somethird party business but this is dependant on thejurisdiction and its definition of a captive.

Captives can operate as either insurance orreinsurance companies and as such issue:

• insurance/reinsurance polices

• bill and collect premium

Generally they have no employees so all typical“insurance company” functions are outsourced tothird parties.

Yes, a captive insurance company is a riskmanagement and financing vehicle that offers analternative to conventional insurance and also theopportunity to combine with an existing riskfinancing (insurance) programme. Captives areregulated entities within the domicile in whichthey operate. Captive insurance has become anintegral part of the global insurance market;

• There are over 5,000 captives worldwide

• Estimated annual premium flowing intocaptives is US$55bn-US$60bn per annum

• Captive (re)insurance companies have beenestablished in over 70 jurisdictions worldwide

• Typically non rated

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WHAT IS A CAPTIVE?

IS A CAPTIVE A LEGITIMATE INSURANCE COMPANY?

Active captives by European DomicileSource: Crain Communications Inc Sept 2010

Guernsey 41%

Luxembourg 23%

Isle of Man 16%

Ireland 9%

Sweden 6%

Malta 1%Switzerland 4%

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Captives are set up for 4 main reasons:

Cost gear premium levels to owngroup claims experience

Cover uninsurable or difficult to insure risks

Capacity hard and soft market cycles dictateprice and capacity

Control long term company strategy

If a company can answer “yes” to points 1 - 3 abovethen the next step would be to have a feasibilitystudy undertaken. The study is one of the moreimportant steps in determining the value of acaptive to its owners and provides a roadmap asto how a captive can be specifically used to meetthe insurance needs of its owners and relatedparties. The study will evaluate whether thecaptive is an optimal tool for business and willtherefore likely include:

• Financial projections – estimated capitalrequired to meet legal and cost requirementsof the captive

• Premium volume that will make the captivefinancially viable, for example this should be inthe region of £500,000

• Source of business e.g. country, subsidiary orthird party

• The risk and circumstances of the client

• Identification of classes of business tobe written

• Details of existing reinsurance programme

• Policy limits

• Advice on the most suitable structure forthe captive

• Where relevant actuarial reports –estimated loss experience

• Underwriting guidelines

• Domicile review

• Claims handling procedures

Companies that in the main want to control theirown destiny with regard to their insuranceprogramme and have a strong commitment to losscontrol. They will also:

1. Be willing to invest time and money to create acaptive i.e. have the financial ability to paycaptive premium and provide initial capitalisation

2. Have premium large enough to justify theannual operating costs

3. Have a claims history that is better than othercompanies in their class of business or haveimproved risk management processes that areexpected to improve its risk profile

They have been commonly established by theFortune 500 companies, large professional servicefirms, and other large organisations. However, withthe introduction of PCC’s and Rent-a-captives it isquite possible for small to medium sizedenterprises to economically establish their owncaptive programme.

3WHY SET UP A CAPTIVE?

WHAT COMPANIES CONSIDER CREATING ACAPTIVE TOMANAGE THEIR RISKS?

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HOWDO YOU KNOW IF A CAPTIVE ISRIGHT FOR YOURORGANISATION?

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In principal any risk can be covered through acaptive structure.

Popular types of risk covered within a captivestructure include professional indemnity andother commercial insurance – property,business interruption, employer’s liabilityand environmental liability.

Instead of looking at the usual business risks,potential captive owners could consider risks notcovered by their conventional insurance policies.This raises the question of why a business wouldwant to insure additional risks that it wouldn’totherwise have to. Consider however, that thoseadditional risks were always there; they weresimply risks that were self-insured. In reality, mostbusinesses knowingly or unknowingly self-insure alarge amount of risk, including the following:

• Policy exclusions, such as mould and pollution

• High deductibles and self-insured retentions

• Operating risks, such as product recall

• Credit default

• Loss of key customers and suppliers

• Exclusions in disability insurance policies e.g.pre-existing conditions

• Types of insurance unavailable incommercial markets

• Natural disaster

• Construction defects

Generally the cost of self-insurance outside of avalid and qualifying captive structure is not tax-deductible. A properly formed and operatedcaptive may, however, deduct insurance premiumsthat are paid into a privately owned insurancecompany. Also claims are paid with pre-tax funds.If no claims are made, the captive retains thepremiums for future business risks or distributesas profits.

6WHAT RISKS CAN IT INSURE?

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ADVANTAGES:

• Cover for risks that are unavailable or expensivein the commercial market

• Ability to set aside separate fund for risks in amore tax efficient vehicle

• Smooth insurance prices over time

• Premium based on own experience

• Incentive for loss control

• Increases senior management’s awareness ofcost of risk and control

• Can be a negotiation tool during renewaldiscussions with the commercial market

• Direct access to the reinsurance market

• Underwriting profits and investmentincome retained

DISADVANTAGES:

• Formation can be costly

• Capitalisation is required creating anopportunity cost for the business

• Ongoing expenses incurred for operation ofthe captive i.e. governmental fees, legal fees,accounting fees (audits) etc.

• Increased management involvement required.Captive is not for the short term, there will bean ongoing time commitment from themanagement of the owner

• Exposure to underwriting loss

• Insurance premium tax when insuring apreviously uninsured risk

WHAT ARE THE ADVANTAGES ANDDISADVANTAGES OF OWNING A CAPTIVE?

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ARE THERE DIFFERENT TYPES OF CAPTIVE?

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Generally captives are set up in what is known asa “hard” market i.e. when the premium rates areso high that they are unaffordable and do notmake economic sense for the purchasingcompany. Alternatively, cover may not beavailable in the market for particular risks, thismay be because of bad loss experience in thepast or the risks to be covered are new orspeciality risks.

Usually market conditions will not be the onlyfactor which would dictate the point at which acompany should/might consider setting up acaptive. The parent company would need to be ofa sufficient size and at a point in its developmentthat makes sense to establish a captive.For example, as mentioned earlier its premiumspend should be in the region of £500,000 to beable to justify the additional operating costs andcapitalisation of the captive. Most importantly itwill need to be willing to assume risk.

WHEN IS A GOOD TIME TO SETUP?

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PURE CAPTIVE(also known assingle parent)

Yes, captives can take the following forms:

Captives can operate as insurers, providing insurancedirectly to the captive parent or reinsurers providingreinsurance to a direct writing insurer which in turnprovides cover to the captive parent.

The drivers behind the decision whether to set upan insurance captive or a reinsurance captive willbe discussed later under “Examples of captivestructures”.

Is a wholly owned subsidiary of its parent company and insures primarily the risk of theparent and its affiliates. In some circumstances it can extend cover to non owned thirdparties. Least costly type of captive to operate, outside of a cell in a PCC and providesmost flexibility in terms of programme design, operating structure and lines of cover.

Has many owners and insures the risks of these owners, and usually cannot extendto third parties. These enable similar or diverse businesses to band together to sharethe risk, cost and benefits of providing commercial insurance to their members.

This is set up by a sponsoring organisation such as an insurance company or abroker. This organisation provides the capital for the facility and then “rents” thiscapital to participants who seek to establish their captive programmes as individual“cells” within the Rent-a-captive facility. It has all the benefits of captive ownershipwithout the initial capital contribution and therefore can be more suitable for theSMEs. Traditional Rent-a-captive operates on the same basis as a PCC (see below)but risks are segregated on a contractual as opposed to a statutory basis.

Similar to a Rent-a-captive but unlike a traditional Rent-a-captive it hassegregated cells for each user. The assets and liabilities of each user arelegally separated ("ring-fenced") from those of the other users.

GROUP CAPTIVE

TRADITIONALRENT-A-CAPTIVE

PROTECTED CELLCOMPANY (PCC)

INCORPORATED CELLCOMPANY (ICC)

Similar to a PCC, however each cell is a legal entity in its own right. Unlikewith a PCC cells can transact with each other. Allows greater flexibility in theway segregated accounts are operated.

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These will vary from a standalone captive to a cellwithin a PCC or Rent-a-captive. These costs aresplit between initial start up costs such as;

feasibility study, consulting fees, regulators andlegal fees, and on-going costs such as auditorsand directors fees and captive management fees.

WHATWOULD IT COST TO SET UP ANDMANAGE?

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The parent company itself could take the decisionto manage the captive if it has the time, resourcesand expertise to do so. More usually a CaptiveManager is employed. The company can benefitfrom the managers knowledge and expertise andthey will likely have an existing relationship withthe regulator, often crucial when setting up acaptive. In nearly all jurisdictions or domiciles thelocal regulatory authorities require that captiveinsurance companies are managed by experiencedand qualified insurance professionals.

WHOWOULDMANAGE IT?

11Captive Managers normally charge their fees ona time and expense basis based on the numberof hours to be spent on managing the captive.This will normally be estimated in advance and afixed annual fee proposed to the client.

Fees will therefore vary based on the complexityof the captive and the requirements of thecaptive sponsor.

HOWMUCHWOULD THEY CHARGE?

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Captive insurance companies are typically formedin countries that have laws allowing for theestablishment of a captive insurance company.These locations are known as domiciles.

The choice of domicile for the incorporation ofthe captive insurance company will depend onmany practical considerations affecting thebusiness concerned.

Domiciles in the EU such as Ireland, Luxembourg,Gibraltar, Sweden and Malta or in the US such asVermont, South Carolina and Hawaii can havevery different benefits and drawbacks to “off-shore” domiciles such as Guernsey, Isle of Man,Switzerland, Bermuda, Cayman and Barbados.

When making this decision the factors to beconsidered are numerous, these include:

• Whether the captive is to write direct orprovide reinsurance

• The regulatory environment including thesophistication and reputation of the regulatorsfor example – Solvency II, regulatorsresponse time

• Costs of creating and running the captive

• Minimum capitalisation requirements –can vary widely from £100,000 to £3m

• Taxes (local premium tax, federal excise tax,double tax treaties)

• Investment restrictions on the captive’s surplus

• Type of cover to be offered (whether aparticular domicile offers unique advantagesregarding a particular type of cover)

• Convenience – ease of travel, time zone

The ultimate decision should be based on theparent company’s overall risk managementobjectives and the direction it wishes the captiveto take and also how comfortable a parent feelswith respect to the overall regulatory approach ofa particular domicile.

WHERE TO SET UP YOUR CAPTIVE?

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We spoke about captives operating as eitherinsurers or reinsurers earlier. What influencesthis decision?

Generally, a company must be licensed to dobusiness in the jurisdiction in which a policy isissued. A captive licensed as such will most likelytherefore write insurance directly. In some caseshowever, captives lack the required licenses to dobusiness and, therefore often must use a frontingarrangement in order to do business in a countryin which its parent's risks are located.

This is where a “Fronting” insurer is needed.A fronting insurer is a licensed carrier that issuesthe policies that a captive cannot issue with theintent of passing all or most of the risk to thecaptive by way of reinsurance. In that case thecaptive will operate as a reinsurer.

WHAT INFLUENCESWHETHER A CAPTIVEOPERATES AS AN INSURER OR A REINSURER?

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CAPTIVE(Reinsurer)

FRONTER(Insurer)

RETROCESSIONAIRE

CAPTIVE PARENT(Insured)

CAPTIVEMANAGER

Premium

Claims

Collaterale.g. LOC, Trust

Dividend payments

Fronting Carrier Retains:Fronting FeeTaxesXOL Cover Premium (optional)

REINSURANCE

RETROCESSION

Captive retains:Underwriting ProfitInverstment Income

XOL Covere.g. cat cover

A typical fronting arrangement

The decision to operate as an insurer or reinsurer is not solely driven by licensing requirements butcan be driven by other factors such as administration requirements, readiness of the parent companyto be hands on and cost of fronting etc.


The most typical and simplest example of acaptive structure is that of insuring with thecaptive the deductible or self-insured retention(SIR) of the parent company. The insured parentcompany transfers the liabilities related to thedeductible layer from itself to the captive insurerup to the limits of the deductible or SIR.

This ensures that funds are built up evenly overtime and are available to pay claims when needed.Also claims within the deductible may not be taxdeductible, from a parent company perspective,until actually paid.

If the deductible claims are “transferred” to acaptive, the captive will be able to deduct boththe paid claims and the accrued unpaid claims fortax purposes.

WHAT ARE SOME TYPICAL EXAMPLESOF CAPTIVE STRUCTURES?

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GROSS LINE PROGRAMMEWe have discussed how a captive generallywould reinsure 100% of the risk of the frontinginsurer. The captive may decide that it will retainonly part of this risk and therefore it will cedethe “excess” to a reinsurer - this is known as“Gross line”.

The benefit of a Gross Line programme is thatthe captive has more flexibility in its insuranceprogramme and it controls the primary rates andreinsurance rates it pays.

However, the disadvantage is that it is morelabour intensive. Also the fronting fees andsecurity requirements may increase as theFronter has no control over the reinsurancebought by the captive and therefore may viewthis as an additional risk. This would be moresuitable for a captive that has been running formany years and has built up the expertise to takemore control over the captive programme.

CAPTIVE(Reinsurer)

FRONTER(Insurer)

RETROCESSIONAIRE


Pays premium

Premium less fronting fee(e.g. between 4% - 10% ofpremium) and taxes

Issues policy for £50min the aggregate

Issues policy£30m xs £20m

Pays reinsurancepremium

Issues policy for £50m in theaggregate and indemnifies forall loss payments and providescollateral (LOC, Trusts)

An example of a Gross Line programme

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NET LINE PROGRAMMEAn alternative to the Gross Line programme is a“Net Line” programme which is more suitable fora company in a start up situation.

In this case the captive only insures that portionof the risk it wishes to keep net. The fronter willdetermine with the captive the level of risk thefronter itself will retain, if any, and what is to bereinsured in the commercial market. Cessions tothe captive are net of all costs and expenses tothe fronting company i.e. fronting fees, taxes,any other overrides and cost of cover above thecaptive layer.

It has the benefit of being much less labourintensive then the Gross line programme withfewer security issues. However the captivescontrol of the programme is reduced and the costof reinsurance is often higher as the captive, inthis scenario, does not have the option toapproach the market itself.

CAPTIVE(Reinsurer)

FRONTER(Insurer)

REINSURER


Pays premium

Pays premium less fronting fee,reinsurance costs and allother costs

Issues policy for £50min the aggregate

Issues policy excess of£800k up to £50m limit

Pays reinsurancepremium

Issues policy for £800k in theaggregate and indemnifies forall loss payments and providescollateral (LOC, Trusts)

An example of a Net Line programme


Captives are typically long term vehicles andmany are around for decades. However for avariety of reasons, including merger & acquisitionactivity or changes in risk managementphilosophy, some owners may wish to close downor sell their captive vehicles.

The options available to owners seeking to exitcaptives are:

• Commutation (with the fronting insurer)

• Portfolio transfer or novation(with another insurer)

• Restructuring of liabilities (through a PCC)

• Selling the captive to a third party(as a going concern or as a run-off vehicle)

All of the above options require consultation withand/or approval from claimants, regulators,auditors and actuaries in order to achieve asatisfactory exit solution.

WHAT EXIT STRATEGIES ARE AVAILABLE?

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COMMUTATION On fronted policies, fronting insurers are often happy to commute captivereinsurance reserves for a reasonable margin that should compare favourablywith the full costs of run-off to expiry of all liabilities where the captive is toclose down completely.

NOVATION This involves replacing the captive with another organisation as party to theinsurance contracts. Typically this would be another insurance company. Themain drawback to such arrangements is the need to obtain full agreement of anyfronting insurers. However, where the fronting insurer is unwilling or unable tocommute, this can be an effective solution.

In cases where a fronting insurer is not amenable to a novation of the subjectbusiness to another insurer, the captive can reinsure its liabilities with an insurerthrough a portfolio transfer. The captive will retain credit risk against the insurerproviding the portfolio transfer reinsurance, and collateral supporting theliabilities to the fronting insurer may not be released. However, this mechanismwill largely achieve the objective of removing the insurance liabilities from acaptive and will potentially enable a release of any excess capital.

PORTFOLIOTRANSFER

RESTRUCTURINGOF LIABILITIES

Typically this involves the novation of liabilities into a PCC cell, financed througha combination of reinsurance and non-cash capital. This has the advantage ofsegregating the captive liabilities in another vehicle and has reduced operationalcosts and management commitment. Again it will need the agreement offronting insurers.

SALE OF CAPTIVE An alternative to closing down a captive is to sell it to an insurer or a third partywhich can either continue to use the captive as an ongoing vehicle or can put itinto run-off.

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CASE STUDIES

Property Cover inan Irish CaptivePROBLEM:Deductible too large for individual affiliates

Liability risksPROBLEM:Premium rate increase

ABC Company, a large global manufacturingcompany insured its property and businessinterruption risks in the commercial market.However, the policy has a deductible feature forthe first £500k for each claim. The affiliates weretoo small to absorb a single large claim so thecompany established an insurance captive toindemnify and reimburse the affiliates for anylosses within the deductible. Premium of £5mwas paid based on actuarial analysis of theexposure; this cost was spread overapprox. 40 affiliates according to turnover.

The captive was set up in Ireland based primarilyon its proximity to Europe and US, its ability toaccess the EU on a direct basis and the favourablecorporate tax rate of 12.5%. Minimum capitalrequired under the EU Insurance Directiveis €2.3m.

A large drinks company set up a reinsurancecaptive in a soft market cycle to retain a portionof its own risk. A fronting company was used toprovide cover from ground up to £550m. Theprimary layer £800k per occurrence and £4m inthe aggregate was ceded 100% to the captive.Layers in excess of the captive’s layer wereretained net by the fronting company.

The captive loss experience over a number ofyears was good with loss ratios in the low 40’sleading to profits which were retained within thecaptive. As a result a large surplus above therequired solvency margin was built up.

Following a bad loss year the fronting companysought a sizable increase in premium and higherattachment point for the excess layers.Quotations from alternative insurers alsoindicated a general hardening of the market.

Due to the surplus built up in the captive it was ina position to take on this greater risk by increasingthe captives aggregate and per occurrence limits -allowing the fronting company to attach higher inthe programme with a resultant reduction inpremium for the excess layers.


Motor CollisionDamageWaiver (CDW)PROBLEM:Take over of another car hire company meant fee incomefrom CDW cover was substantially increased.

Following the take over of another hire companythe owner of the company recognised that it wasan appropriate point in time to formalise the feesreceived in relation to CDW using an insurancestructure. In doing so the company would havevarious tax advantages and would be able to buildup a fund to finance future losses.

The structure utilised had to be as simple and lowcost as possible and be set up swiftly to meetother company commitments. The structurechosen was that of a cell in an existing PCC inGuernsey. This meant no capital had to bedeposited above that required to meet the cellsolvency requirement. Cost of running the cellis lower than a standalone captive and thetimeframe to set up the cell was a matterof weeks.

By establishing the cell the company now has theadvantage of not paying VAT on the CDW feeincome, fees are now converted to premium andtherefore tax deductible, any claims paid wouldtherefore be funded from pre-taxed funds andthere is no requirement to release the surplusfunds as profit each year.

AI427653 12/11

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ROBERT M. GAGLIARDISenior Vice President & Worldwide DirectorTel: +001 802 419 [email protected]

IVY JERMYN-BUCKLEYInsurance/Underwriting Manager – EuropeTel: +353 1 802 [email protected]

Chartis is a world leading property-casualty and general insurance organisation serving more than 70 million clientsaround the world. With one of the industry’s most extensive ranges of products and services, deep claims expertiseand excellent financial strength, Chartis enables its commercial and personal insurance clients alike to manage riskwith confidence.

Chartis Europe Limited is authorised and regulated by the Financial Services Authority (FSA number 202628).This information can be checked by visiting the FSA website www.fsa.gov.uk/Pages/register. Registered in England:company number 1486260. Registered address: The Chartis Building, 58 Fenchurch Street, London, EC3M 4AB.

Chartis Europe Limited (“Chartis”) disclaims all warranties, expressed or implied, relating to the informationprovided. Chartis does not warrant or make any representations regarding the information provided in terms ofits correctness, accuracy, usefulness, completeness, reliability, or otherwise. Neither Chartis nor any membercompanies of American International Group, Inc. accept any liability of any kind for any direct or indirectloss arising from the use of this information.

This brochure is intended as general information only and is not intended to provide specific professional advice.It is strongly recommended that you seek your own professional advice from suitably qualified professional advisers.

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A Guide to Captives