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The issue of captive insurance is the subject of much debate in corporate boardrooms around the US, and with good reason. For every positive aspect – from creating tailored coverage to improved funding flexibility in underwriting and retention – there appears, on the surface at least, to be a corresponding potential negative, including more direct exposure to loss and coping with increased regulatory requirements.

Still, while it is true that senior management must acquire a full complement of new skills to manage them, captives can offer benefits far outweighing the possible risks. These centre principally on the critical issues of cost and control.

Captives enable companies to accumulate the investment income that reduces net-loss costs and to realise significant tax advantages, as well as providing direct access to reinsurance and reducing the initial outlay for coverage procured from the primary market. They offer greater control over claims and inspire new incentives for controlling loss, which results in further reductions in operational costs.

It is little wonder then that companies are increasingly choosing captive solutions to better meet their insurance needs. Industry analysts put the number of captives operating worldwide at over 4,000, with numbers rising every year.

In the US, where less than 1,000 companies operate captives, regulators are recognising the growing trend among companies to pursue captive insurance strategies, as well as the desire among those that do operate them to move their captives from traditional offshore centres like Bermuda and the Cayman Islands and bring them closer to home. From Maine to Nevada and from New York to South Carolina, a number of states are implementing legislation to allow captives to domicile within their borders, and challenging captive-friendly Vermont's lead as the domestic location of choice for US companies.

Although the strategic decision to form a captive may prove a source of uncertainty among senior executives, it is by no means the last decision they must make when pushing ahead with a captive strategy. In addition to selecting a domicile site, companies must determine which lines their captive will cover, its reinsurance and fronting arrangements, its capital structure, the way it will be managed, and the internal and external resources that will be used to facilitate its operations. Further, companies also must navigate a potentially demanding application process, assessing the operational implications of the captive and articulating their operational plans and commercial objectives to the domicile's regulators.

Of course, which tack a company takes largely will be dictated by its business, the management's strategic goals for the organisation, and the competitive environment in which it operates. After all, the needs of, say, a manufacturer are as different as those of the companies that supply it as they are to a company from an entirely unrelated sector.

Nevertheless, just as with the initial process that leads to the decision to form the captive, companies must weigh their options thoroughly when implementing their chosen strategy. Given the lack of familiarity with captives in most organisations, this often is best accomplished in partnership with an experienced adviser, whose expertise can significantly reduce the time it takes to bring a captive on-line.

Whether companies choose to work with trusted third parties or go it alone, it is imperative that they address the array of considerations surrounding captive formation. Only by evaluating the full range of possibilities can they ensure that the captive will operate at optimum efficiency and return the most value to the company and its shareholders.

Structuring for success
Because it offers a low cost alternative to sourcing coverage in the primary market, captive formation provides companies with powerful competitive advantages. Unlike coverage obtained from commercial providers, captives enable companies to meet insurance needs that are particular to their businesses and to do so with a self-funding mechanism that is not tied to the primary market's underwriting price cycles. In fact, it is the very prospect of a hardening primary insurance market that is causing many executives to rethink the captive option at the moment.

Captives create opportunities to improve risk controls, allowing companies to benefit from centralisation of their risk management function. By handling their own premiums and claims, companies can gain control over funds flowing through their organisations. And captives may allow companies to reap tax benefits from such things as accelerated write-offs of the premiums paid by the company and a possible reduction in state and local taxes. Although captives should never be created purely for tax benefits, it is wise to consult with a tax adviser to ensure that the company is getting the maximum tax benefit from the captive insurance arrangement.

Underpinning the issues of cost and control is a growing acumen among senior executives across the spectrum of industry about the risk exposures their companies face and the options available to manage them. And it is this increasing sophistication that is making senior executives more comfortable with the idea of self-insurance, thus further fuelling the trend in captive formation.

Yet just how much competitive advantage a captive can deliver is down to the structure the company creating it chooses to employ. Key structural issues for companies embarking on captive formation centre on the types of coverage the captive will provide, the losses the companies will retain and the reinsurance and fronting arrangements it will enter into, as well as the types of policies it will underwrite.

For most companies, workers' compensation and general liability (GL) are the most popular initial choices for inclusion into the captive simply because the loss levels are easiest for actuaries to predict accurately. But it is important for companies to look beyond these lines, to areas where the loss levels are more volatile.

Companies should evaluate their portfolio, examining whether the premiums they are paying are cost effective for the layers of coverage they are receiving. A captive can significantly reduce the costs of primary market providers, but companies must weigh how much they are willing to let the captive take on board. Often, this comes down to risk tolerance, and it has a direct effect on both price and the level of savings companies can expect to realise from captive formation.

Retention and reinsurance decisions go hand in hand. The decision a company makes about how much of each loss will be put into the captive in large part will be dictated by the reinsurance costs. The layer-by-layer evaluation – based upon loss predictability and costs of coverage – will reveal whether it is cheaper to source cover from the captive or the primary market. By retaining more of the losses in the captive, the company will see a corresponding drop in its reinsurance costs.

As with reinsurance, fronting arrangements also will affect the way a captive is structured. Often dictated by customer or regulatory requirements, fronting is an unavoidable cost. Thus, it is important to delineate which lines will be fronted and to seek out the best rates from primary market providers.

Structural issues also manifest themselves in the types of policies that the captive will write. Because reinsurers typically follow form when agreeing to the provisions of the underlying policy, the captive can provide coverage that is more precisely tailored to the needs of the business. As a result, the captive can deliver more broadly based coverage without raising premium charges for the increased levels of protection.

Location, location
Just as with the structures the captive employs, the jurisdiction in which it is domiciled goes a long way in determining the value a company can expect to generate from captive formation. Regulatory and tax differences impact directly on capital costs, as well as on regular operational outlays.

In the US, companies can choose between domestic and foreign domiciles. In general, foreign centres like Bermuda and the Cayman Islands are more flexible in terms of their regulatory requirements than their onshore counterparts. Lower capitalisation levels enable companies to spend less to set up their captives, while the fact that these centres do not require such annual exercises as actuarial reviews means that companies can save on annual operations.

Nevertheless, some US companies with offshore captives are repatriating them. They see favourable loan provisions in US captive laws, as well as an increase in the Federal Excise Tax on non-domestic captives, as operationally advantageous. Meanwhile, more conservative firms tend to keep their captives onshore.

The state of Vermont has had the most success by far in attracting captives due to its sophisticated infrastructure and strong government support for the industry. A host of dedicated service providers operate in the state, enabling those seeking to form captives to source management, legal, technical and advisory expertise in the local market.

More recently, Maine, Rhode Island, South Carolina, Nevada and New York all have implemented legislation that allows companies to set up captives in those states. Further afield, companies with a high degree of continental exposure have made Dublin the pre-eminent captive centre for US corporations seeking to domicile in Europe.

When deciding the location of their captives, companies should analyse the tax and financial consequences of such a move, and select a location that best suits their needs. Once that determination is made, companies can begin the application process that will enable the captive to become operational.

Regulators in most domiciles require a business plan, usually containing the corporation's annual report and a written narrative that breaks down the company's business. Companies also should include their rationale for forming the captive, its risk management philosophy, areas of coverage and program structure, including fronting and reinsurance arrangements.

Applicants must also detail the measures that will be taken to control losses and handle claims. While loss controls are largely internal initiatives, companies can outsource claims handling to a third-party administrator or other provider, or create the infrastructure to handle claims internally. The decisions they make will be based on cost and complexity, with many finding it more cost effective to outsource relatively straightforward claims processing.

Companies must outline the capital structure of the captive. In most cases, this is determined by regulatory requirements and usually comprises a combination of cash and letters of credit from the company to the captive. Increasingly, assets such as company equity or intangible assets are being accepted as part of the capitalisation. However, in general, higher overall capitalisation levels must compensate these less liquid assets.

Most regulators are also interested in how the captive will invest its assets. When crafting an investment strategy that government overseers will find palatable, it is important to remember to take a conservative approach early in the cycle. Once a surplus is built up, investment in more speculative vehicles can take place. In some cases, the captive may transfer a portion of the surplus to the corporate, usually in the form of loans. This strategy enables the company to keep the capital working within the organisation. Companies may be required to conduct an actuarial forecast at the time of application and provide an annual independent assessment of the health of the balance sheet. They also could be asked to submit pro forma financial statements - generally three to five years of estimated premium income and loss ratios, balance sheet and cash flow statements. In addition, some regulators – notably Vermont – require an actuarial forecast every year. In practice, this is a good idea regardless because it provides management with a picture of the captive's liabilities.

The company should also provide personal information on the composition of the captive's board of directors. In some cases, the regulators require that a local resident maintain a seat on the board.

Finding the right providers
In order to ensure that decisions affecting the captive's operations are taken locally, most regulators require that the company install a local captive manager. Primary market providers, as well as reinsurers, brokers and specialist independents, offer the service, and best practice dictates that the captive manager act as secretary to the board of directors.

A local legal representative can also be a feature of the regulatory landscape, as well as a useful agent in steering the captive through the approvals process. Some companies seek to install the local legal representative on the captive's board of directors. However, this can create a conflict of interest and is best avoided if possible.

Further, many domiciles mandate regular audits, which are best conducted by a local auditor to speed data gathering. Cost efficiencies dictate that the local auditor be a branch of the overall corporate auditor. In addition, a local banking relationship is required, and it is often best to secure that through the branch office or correspondent with the company's corporate bank, if a local affiliate is available.

Companies should also obtain an investment manager. This may be an in-house professional. However, most are willing to outsource this vital function to professional asset managers, either from their primary or reinsurance carriers, or from independent specialists, depending on the complexity of their programs.

One way to ensure that the service providers the company contracts with facilitate the smooth functioning of the captive is to visit the domicile. This process serves several benefits. First, it enables direct communication about formation processes, as well as outlining integral operational issues for running the captive trip into the local market also provides an opportunity to discuss with regulators the state of the market and the captive's position in it. What's more, it provides a comfort level that the company is interested and involved in the captive and its success.

The final step in the formation process is the captive's initial board meeting. This includes adoption of articles of association, the election of board members and the signing of insurance agreements.

In general, the entire formation process can take up to four months to complete. However, companies can expedite the process by partnering with an experienced adviser. The key to success lies in proper preparation. That means the decision-making process should not stop with the decision to create the captive. It should continue right through its formation.