Captives are playing an increasing role in the provision of global employee benefits, writes Mike Matthews.
Global corporations are finding it still makes economic sense to pool the insurable parts of their employee benefit programmes in multi-national insurance networks. The networks - cross-border joint ventures between various international insurers, such as AIG and Winterthur - offer companies the advantages of covering all their employees around the world for life, disability and/or medical coverages.Industry experts predicted the demise of multinational networks once the European Union had fully harmonised insurance laws in Europe, an action that essentially permits an EU based insurer to write coverages anywhere in the EU without the need to obtain separate licences for each country. Although harmonisation now is in place and single EU based insurers can compete head-on with the networks, multinational pooling continues to be the most cost-effective means of insuring global benefits. The reason why is due to a lack of harmony in the area of European insurance related taxation. Protectionist regulations governing taxes in various EU countries make it less advantageous to buy benefit coverage from a single European insurer than to buy coverage from a network of them.
While the networks seem, for the time being, to have overcome the competitive threat posed by EU unification, they are losing a growing share of business to corporate-owned captive insurance companies. Several large multinational corporations are looking at using the networks only on a “fronting” basis - that is to issue the various local policies involved, handle administration tasks and so on. The actual risk, or part of it, however, is ceded by the networks to the corporations' captives.
Why use a captive?
When considering the use of a captive for employee benefits, it is helpful to go back to basics and question: “Why do we have a captive?” You then need to decide whether the same considerations apply when including employee benefits.
The main advantage of using a captive for employee benefits is one of improved cashflow. However, there are others:
• Higher investment yields.
• Cover and claims acceptance procedures, especially those relating to disability and healthcare insurances, tailored to meet each employer's needs.
• Inclusion of other risks to help diversify the existing captive portfolio.
• Control of costs and immediate access to financial and benefit information.
There can be problems in placing employee benefit risks in the captive, namely:
• Additional regulatory requirements may have to be met in the captive domicile.
• Surrender terms under existing insurance policies may be so penal, because of long-term agreements or the basis under which benefits are currently insured, as to make a change of insurer inappropriate and costly.
• There may be personnel problems, especially in relation to employee benefits for some affiliates, for example in the UK, where employees will see the captive simply as an extension of the employing company.
• Additional actuarial advice may be needed so that risks can be properly assessed.
Many of these problems can be overcome and the main ways in which a captive can be used effectively are discussed later in this paper.
The captive as insurer or reinsurer
Once it has been established what benefits can and should be financed through a captive, thought needs to be given to the way in which the captive should be used - as an insurer or reinsurer. Here are a few of the alternatives that we are involved with on some of our captive accounts:
Using a captive as the front insurer and reinsuring the whole or part of the risk gives the captive a high profile within the employing group. The captive can decide how much of the risk it is willing to accept (having obtained actuarial advice) and who will undertake local administration in each country. If it decides to reinsure with a multinational-pooling network, all pooling dividends generated by the network will automatically be paid to the captive.
Using a multinational pooling network as the front insurer, with the network reinsuring into the captive, offers the greater opportunity for profit (and loss). All local country administration and international co-ordination and reporting will be handled by the network. The captive will, via the network insurers, receive all premiums from the local companies and disburse cash to the networks.
It is important to select the benefits for captive insurance after a very careful investigation of past experience and to rely on actuarial advice in the establishment of premium rates. If, as hoped, premiums received exceed claims and if the entire risk has been reinsured with the captive, the network is reimbursed for the administration work it has undertaken with the entire retained premium remaining with the captive.
A significant advantage of using the multinational pooling network to act as the front insurer is that each local insurer within the network accepts the responsibility of ensuring that all local market regulations, practices and legislation are followed.
A third option, which does not involve the captive acting as either an insurer or reinsurer, is simply to insure all risks with a multinational pooling network and to use the captive to receive the pooling dividend. This can have an additional bonus in providing some foreign corporations with tax relief.
Which programmes to include?
If the multinational employer considers that the advantages of using the captive outweigh the disadvantages, then serious consideration needs to be given to the benefits that should be insured with the captive. These will be different for each country of operation.
Traditionally, long-term disability, accidental death and disability benefits are insured, as are lump sum death benefits and private medical cover provided by smaller companies. These are the benefits to consider for the captive (including self-insured risks for the larger companies if this would mean the success or otherwise of the captive).
Provision for pensions for employees working in most countries is driven by tax and local regulatory requirements. Depending on the country, retirement benefits tend to be either funded or unfunded, but unlike in the UK, funded benefits are usually insured. This also depends on the regulations of the appropriate country with some requiring insurance with a government-run agency.
In Germany, for example, the most common method of financing pensions benefits is the use of book reserves (the company promises to provide benefits to employees, but retains their liabilities within the company balance sheet). For larger companies, there is no fear of potential cashflow problems following a claim. Smaller companies, however, may reinsure benefits with an insurer to ensure their future liquidity. One of the alternative methods of financing pensions in Germany is by means of a pension fund (pensionskasse). This is constituted as an onshore captive insurance company, subject to the federal insurance supervisory board (ISB).
The regulations relating to the pension fund investment are very stringent and, as a result, this route is unlikely to be adopted for new plans. It is very likely that ISB would approve the use of the onshore captive for the provision of benefits to non-German employees without significant changes being made.In the Netherlands, the existence of industry-wide schemes has decreased the scope for private occupational pensions. If a private scheme does exist, the funding vehicles available are insurance policies or direct investment in the stock market. In both cases there are strict investment requirements.
Whether or not to use a captive to insure employee benefits is a decision based on the same criteria applied to establish the benefits to be insured through a multinational pool. In any event, it is essential to carry out a global audit of existing benefit plans to establish what employee benefits are currently provided, their cost, the penalties imposed, should insurance (or investment) contracts be surrendered, and whether benefits are already insured with a pooling network. It is also useful to establish the typical benefit practice in the various countries to ensure that the benefits provided meet the company objectives. This gives the company an opportunity to consider whether or not it is appropriate to make any changes to benefits.
The use of captives for insurance of employee benefits is still in its early days. More and more multinational companies are now considering how to use their captive to the best effect. Examples of some of the client programmes that we are currently managing are outlined below:
The client uses its Dublin based captive to reinsure the entire risk portfolio relating to life insurances, accidental death and disability benefits. Where the captive does not want to hold all of the risk for a particular country or line of cover it will reinsure it on a stop loss basis.
The client uses its Bermuda based captive solely to receive the multinational-pooling dividend, out of which it can retain a stop loss premium. In years when losses are experienced, the accumulated dividend is used to settle the additional premium charged by the pooling network. In this way the captive retains none of the risk.
Practice varies greatly and often depends on factors such as:
• company policy on centralisation of control of worldwide employee benefits
• the ability of the captive to adapt to new lines of business
• volumes of suitable insurances
• willingness to work closely with a multinational pooling network.
Each multinational company will present its unique set of problems requiring a unique solution.
Some final thoughts
Captive premium deductibility: US risk managers know that unless a captive writes substantial third party business, property/casualty premiums paid to it are in general not tax deductible. Following the Odeco decision, which seemed to suggest a figure of 30% was acceptable, the US Internal Revenue Service (IRS) issued a ruling on 26 October 1992 that employee benefits will be considered third party business, provided the captive does not also insure the risk of the employer whose employee benefit business it handles.
ERISA: The US Employment Retirement Income Security Act (ERISA) was enacted in 1974 and applies to all tax-qualified plans, including health and welfare benefits - which typically are associated with insurable third party business (death, disability and medical risks, for example). ERISA prohibits transactions with parties in interest - such as captives - unless the law specifically exempts them.
Limited statutory exemptions are available for benefits that insurance companies offer to their own employees, and the Dept. of Labor (DOL) expanded this exemption in 1979. However, both the statutory and expanded exemptions apply to direct writers only and not reinsurers. US employee benefit business will be problematic for captives until the DOL can be persuaded to change direction.
While ERISA prohibits party-in-interest transactions, other countries have no such restrictions. For example, a multinational company may enter into a reinsurance arrangement with an admitted carrier in Spain to cede premiums on pre-retirement death and disability risks. Since the insured benefits in Spain cover employee risk, they are technically qualified under IRS ruling 1992/93. The key is to add enough of these locations to meet the threshold for significant third party business.Summary
The captive scenario in employee benefits will only work if a corporation has size and market leverage. The critical mass generally equates to a minimum of 3,000 employees covered and $750,000 in premiums.
While ERISA may be a continuing stumbling block to US based employee benefit programmes, real opportunities for using captives exist in the largely uncharted territory of international employee benefits. Important reasons for captives to fund and insure international employee benefits include:
• If the captive's business plan is tax driven, reinsuring to a multinational pooling arrangement can help reach the 30% threshold for non-related business. The same is true for insuring benefits offered to international expatriates.
• Income realised by a captive may benefit the parent company if the money is used to finance the internal operations. It will certainly guarantee higher returns on investment than can be realised from traditional insurers.
• With tax regulation eventually harmonised, a direct-writing captive based in Dublin will position a multinational to better control employee benefit costs and services within the EU.
While employee benefits may not quite be the Holy Grail, clearly it can be a profitable source of business for captives.
Mike Matthews is regional director Europe and Asia for AIG Insurance Management Services (AIMS), which groups the worldwide captive management capabilities of the member companies of American International Group Inc. (AIG). It is currently actively managing a number of employee benefit programmes from client portfolios.Tel: + 353 (0) 1 283 7788; fax: + 353 (0) 1 283 7821; e-mail: email@example.com