April 1999 Issue

CAPTIVE
Insurance Companies

YOUR RISK MANAGEMENT ANGEL

By Lewis Kenneth Shayne

In Brief

Doing Your Own Thing

Companies are always evaluating the options available to meet their insurance needs, and more and more organizations are seeking alternatives to traditional coverage. A captive insurance company offers a number of advantages and may provide a tempting alternative to purchasing insurance from conventional insurance companies. Captive insurance companies are often less regulated than conventional insurance companies, and domestic captives are taxed differently for both Federal and state purposes. Businesses considering forming captive insurance companies have to analyze the tax and financial consequences of such a move, select a location that best suits their needs, and determine whether establishing a pure or group captive is more appropriate.

A captive insurance company is a closely held insurance company whose business is primarily supplied by and controlled by its owners. Captives are insurers owned by the insureds and organized for the main purpose of self-funding the owners' risks. The shareholders/insureds actively participate in decisions influencing the underwriting, operations, and investments of a captive insurer. Most jurisdictions allow two types of captives:

  • Pure captives, entities wholly owned by one parent and its affiliated companies, and

  • Group captives, entities owned by a small number of substantially sized, unaffiliated entities that are generally in the same type of business, e.g., accounting firms.

    Advantages of Captives

    As the worldwide business community becomes more sophisticated in analyzing and understanding risk exposures and the available alternatives for risk management, captives can often provide an attractive alternative to purchasing insurance from conventional insurance companies.

    Captives can be organized for any number of reasons. They are used by many Fortune 500 companies and some much smaller enterprises. Captives' parents are engaged in all types of business activity: industrial, energy, medical, retail, and professional.

    Some of the reasons for forming a captive include the following:

  • To meet unique insurance needs;

  • To provide a self-funding mechanism;

  • To reduce the impact of the insurance industry's underwriting price cycles;

  • To take advantage of the favorable experience and thereby reduce the cost of managing their risk. Conventional insurers may not take into account the full effect of an insured's good experience when pricing risk. Companies with low loss ratios on property risks may pay premium rates very similar to those of their competitors with high ratios;

  • To provide opportunities for the organization to improve risk controls by centralizing the risk management function; and

  • To increase control over funds flowing through the organization, through possible tax benefits and a reduction in the cost of risk management.

    Regulation

    Captives are generally subject to less regulation than conventional insurance companies for the following reasons:

  • The owner of a pure captive must be a large sophisticated financial entity--measured by a minimum net worth and meeting other application criteria.

  • Captives are self-insurers: They exist to cover the parent company's risks.

  • Captives cannot sell direct coverage to persons or entities other than their owners and affiliated entities.

  • Captives cannot provide direct coverage, even to their parents and affiliated companies, if such coverage is required by law (e.g., workers' compensation or automobile liability).

    Current State of the Captive Market

    The total amount of premiums written through the captive insurance market is sizable and growing. Based on the captive insurance directories issued by Tillinghast-Towers, in 1997 total premiums were $18 billion, capital and surplus were $45 billion, and investable assets were almost $104 billion.

    The number of captives continues to grow. In 1989, there were 2,760 captives operating worldwide. By 1997, the number had grown to 3,966, a 43.7% increase. In the United States, domiciled captives grew even faster, increasing from 380 to 586, a 54.2% increase.

    Some U.S. organizations with offshore captives have repatriated them to the United States, and many others are investigating the possibility. This trend has been caused in part by the maturation of the U.S. domicile market and favorable loan-back provisions in U.S. captive laws, as well as an increase in the Federal excise tax on nondomestic captives. In addition, states such as New York have amended their statutes to permit organizations meeting their requirements to establish captives.

    Taxation

    The tax treatment of insurance companies in general and captive insurance companies in particular is different from that of any other enterprise. Any domestic captive qualifying as an insurance company is taxed under IRC Subchapter L. Generally, insurance companies can defer the unearned portion of gross premiums and can also deduct reserves for unpaid losses, including a reserve for incurred but not reported claims. If the captive is a qualified insurance company, the premium payments made by the parent and affiliates should be treated as ordinary and necessary business expenses under IRC section 162.

    Sometimes, the IRS determines that premium payments are not deductible, claiming a captive is an insurance company in form, but not in substance. The IRS may maintain that the risk of loss has not been shifted and premiums paid to the captive are nondeductible reserves for self-insurance. In such instances, any payments from the captive would be treated as a dividend to the parent to the extent of the captive's available earnings and profits. Payments to other affiliates would be considered dividends to the parent and capital contributions to the affiliates. Any losses actually incurred by the parent or its affiliates would be deductible under IRC section 165 as a loss not compensated for by insurance to the extent that the risk of loss was retained by the captive and not reinsured with an independent company. Essentially, the captive in these circumstances would not be considered a separate corporation, but rather a division of the parent.

    Avoiding Adverse Tax Consequences

    According to the Federal Taxation of Insurance Companies reference handbook, published by Research Institute of America, the following steps should help a captive and its parent avoid the adverse tax consequences mentioned in the previous paragraph:

  • Establish business objectives and purpose

  • Use adequate capitalization

  • Get managerial expertise

  • Comply with local insurance regulations

  • Follow conventional investment strategies

  • Use risk-transferring insurance
    contracts

  • Assure sufficient risk distribution

  • Transact business at arm's length pricing

  • Insure unrelated risk

  • Acquire insurance-related companies

  • Consider multiownership.

    For state purposes, captive insurers, like other insurers, generally do not pay any taxes except premium taxes. The specific premium rates for selected states are shown in the Exhibit.

    Reporting Requirements

    Most jurisdictions, including New York, require audited financial statements on a GAAP basis. There is no requirement for an annual statement on statutory bases. For example, section 7006 of the New York captive law requires all captive insurance companies to annually submit to the New York State Insurance Department, on or before March 1, a statement of their financial condition for the preceding calendar year, verified under oath by two of its executive officers. The statement shall report the financial condition of the company in conformity with GAAP. In addition, all captive insurance companies must have an annual audit by an independent accountant and must file an audited financial report with the New York State Insurance Department on or before July 1 for the preceding calendar year.

    For practically all jurisdictions, information regarding specific requirements to establish captives is available on the Internet. A comprehensive captive insurance website is www.captive.com, managed by Virtual Insurance Management, LLC. It has links to various captive domiciles and service providers, information on conferences and seminars, and research materials. In addition, most domiciles have separate
    e-mail addresses that could be utilized for electronic inquiries and exchanges of information.

    Setting up a Captive

    Careful preparation and planning are essential ingredients in the process of creating a successful captive. The preliminary step should be a feasibility study. Such a study usually consists of financial analysis, legal research, actuarial projections, tax projections, domiciling options, comparisons, and an insurance issues analysis.

    The next step is a more detailed analysis focusing on the geopolitical implications of possible domiciles for a future captive. This should include finding answers to the following questions:

  • How might political instability affect the captive's ability to function?

  • Would the time spent traveling to and from the location be difficult to manage?

  • Could capable employees or management companies be found at a reasonable cost?

  • How friendly and sophisticated is the regulatory body of the considered domicile?

    Once the site of the captive is decided upon, a line of communications should be established with regulators. Regulators should be consulted on the most appropriate captive structure. Detailed regulatory financial requirements should be obtained. If a foreign country is selected, currency deposit requirements should be determined. Any information on the licensing and incorporation process obtained through the Internet should be confirmed with regulators and attorneys.

    Most licensing applications ask for the following:

  • Biographical information,

  • Financial information such as capital requirements, letters of credit, and method of funding,

  • Names of service providers, such as actuaries, CPAs, management firms, and attorneys,

  • A business plan. This would usually include an actuarial report, summary of risks to be insured by line of business, identities of fronting companies to be used, anticipated annual premiums, maximum retained risk, rating program, and reinsurance program,

  • A copy of the proposed charter and bylaws, and

  • Financial reports of the parent.

    The next step is to submit a completed license application form to the regulators. It is advisable to e-mail completed forms initially, followed by personal delivery or mailing.

    Usually, after an initial review of the application, executed copies of the charter and bylaws have to be filed with the regulators. In most domiciles, upon a determination that the applicant has complied with the domicile's law and regulations, a certificate of authority is issued to the captive insurer.

    Once a captive is licensed, officers of the captive or a manager of the captive would market any insurance or reinsurance for the captive. At that point it is essential to verify that the capitalization not only meets legal requirements but also takes into consideration initial and anticipated reserving needs of the captive. *

    Lewis Kenneth Shayne, CFE, CPA, is a principal insurance examiner with the New York State Insurance Department.

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