In the search for added value for clients, innovative entrepreneurs are turning to captive insurance vehicles, explains Warren Cabral. This development marks a sea-change from the traditional use of a captive as a single shareholder or group vehicle for risk control and risk financing purposes. The new uses of captives by manufacturers, banks and retailers are by far the fastest growing sector in the captive industry.

Last year in Bermuda, the world's largest captive domicile, Class 3 or third party insurers were the fastest growing group with many of these third-party insurers being, in fact, wholly owned by a group insuring its own clients. Thus, these are not "captives" at all in the true sense, but rather companies operating as profit centres in relation to the clients of the owner. In essence, entrepreneurial business enterprises are forming captives to make a profit by solving the business problems of their own companies and clients using an insurance vehicle.

The effect is to enhance their product and to cover the risk exposure of the clients on the products which they sell. The range is far and wide, from beer to tools to mobile homes to mortgages to package delivery services and mobile telephones. The insurance lines which are being offered vary. For example:

* A captive owned by a computer manufacturer is issuing product warranties whereby purchasers of computers can obtain insurance coverage to finance the disaster recovery charges should the computer fail.

* Manufacturers of mobile telephones can provide replacement cover to their clients through a captive owned by the manufacturer.

* Makers of mobile homes can cover property/casualty and liability.

* Banks can cover loans with credit life policies.

Indeed, anyone offering credit can attach insurance coverage. Thus, retailers, utilities or anyone with a billing system can sell insurance coverage to protect both themselves and their clients against the burden of outstanding receivables. In the franchise business, hamburger or pizza outlets, clothing chains and beauty product distributors can enhance their core products, namely the franchise system, by adding insurance against property/casualty risks or worker's compensation and other insurance lines to the mix.

The dealers, suppliers and subcontractors or other folk with whom a manufacturer has a relationship which is capable of being enhanced by an insurance product can benefit from coverage brokered to them by the manufacturer out of his own captive. Coverage can extend to credit risks or property cover for equipment out on sale or return.

Tax issues

Aside from the client programmes, captives are also being used by US companies who face two tax issues. The first and more problematic one is the sheltering of profits, which, with minor exceptions, cannot ordinarily be done these days. The second is the deductibility of premiums, worth about 6% of casualty programmes, where much of the effort of the captive sponsors turns on IRS acceptability of the captive, particularly if there is no unrelated business.

Thus, in relation to profit sheltering, captives look for ways to write non-related business so as to build up profit in the captive offshore in a structure which passes the non-controlled foreign corporation tests (see purpose trust). In relation to deductibility, most companies take the deduction and wait to be challenged.

One way of writing third party business is to write one's own employment benefits. Employees are "not related", because the beneficiary is the employee and not the employer, so that advantage can be taken of the deduction. The matter is, however, complicated by the ERISA legislation in the US. Effectively, the party purchasing the employee benefits cannot do business with a "party of interest", that is where the provider is more than 50% controlled by a related company. Therefore, any employee benefit arrangement needs examination by the US Department of Labor. The good news is that it is possible to obtain clearances or exemptions from the Department of Labor specifically at PTE79/41 Exemption.

Where it is not possible to provide for US based employees, it may nevertheless be possible to do so for the international work force of multi-national corporations. Thus, pensions and employee incentive schemes can be run from an offshore based captive. This has been done by UK banks and manufacturers and, increasingly, by multinational conglomerates.

Estate planning

Analogous with benefit schemes is estate planning for private individuals. This can follow either of two routes. The first is a private scheme set up by the individual himself or a commercial arrangement whereby the individual purchases policies from a stand alone offshore benefit provider. In the private scenario the individual, who is seeking to protect his estate from the ravages of current income tax and subsequent inheritance tax, would want to set up a non-controlled foreign corporation to issue a life policy or a fixed or variable annuity. The benefit of such a policy could then be put in a trust for the heirs of the settlor to further minimise inheritance taxes.

The principal difficulty with the private arrangement is the controlled foreign corporation rules of the US and other jurisdictions. With respect to the US, the settlor would need to have 11 grandchildren or other close relatives as the beneficiaries of the arrangement. They would together form the non-controlled foreign corporation with no one person holding more than a 9.9% interest. Such a structure enables the settlor to shelter the profits of the programme from taxation. The resulting insurance company is not, of course, a captive but rather a "third party" insurer providing life and annuity programmes to the settlor, the benefit of which accrues to a trust for the children and grandchildren.

Purpose trust

An untried solution to the inelegance of such a structure is to use a Bermuda "purpose trust". Essentially, there is an insurance company owned by a purpose trust and this may present one way of effectively divorcing the ownership of an insurance company from its underwriting function. This has relevance both for taxation and for structuring unique reinsurance where the principals need to operate at arm's length but within a closely controlled structure.

A purpose trust may be created under Bermuda law under the provisions of The Trusts (Special Provisions) Act 1989, which came into force in Bermuda on 31 January 1990. A purpose trust is unique in that, among other things, it has no beneficiaries. Indeed, it must not have any. It exists only to pursue its stated purpose, which may be a commercial one. The purpose must be specific, reasonable and capable of achievement, and not immoral, contrary to public policy in Bermuda or unlawful in accordance with Bermuda law.

With careful tax planning, a purpose trust may accomplish the following:

(i) an ownership structure which may enable a Bermuda insurance company to be incorporated and operated achieving "non-controlled foreign corporation" status for US tax purposes in respect of its relationship with its "promoter(s)", i.e. the party(ies) providing the start-up capital;

(ii) deferral or avoidance of taxable distributions to the parties which will ultimately be entitled to the "profit derived from the operation of the insurance company, for the period during which this ownership structure is in place".

The structure involves the establishment of a purpose trust whose purposes may be, for example, "to incorporate, or procure this incorporation of, an insurance company in Bermuda and to acquire, hold and otherwise deal with the shares and other securities of that company".

The act permits a purpose trust to last for up to 100 years, although it is not unusual for provision to be made for an earlier termination, for example, by reference to a specific event.

The trustee proceeds to incorporate and licence the insurance company with a view to it engaging in a specific insurance business plan. It is likely that the business plan will need to be such that the company either carries no risk (for example, because the policies issued limit risk to premiums paid) or the loss history indicates predictably low ratios against adequate capital and surplus.

The commercial solution to the estate planning problem is found in such entities as the newly formed Annuity Re, which recently went public and raised $250 million to offer offshore life and annuity products. There are some 20 similar operations in Bermuda, most dedicated to high net worth individuals.

New risks

Equally recondite are the wholly new risks which are being underwritten by captives for their parent companies. These risks include international tax leveraging, whereby companies are taking advantage of the different tax rates applicable to the multinational operations of the parent. Some jurisdictions, for example, do not attack the deductibility of premiums into a captive. Thus, for example, a group with a German operation would put premium into the captive which would only be taxed at the US tax rate in circumstances where the German equivalent tax would be higher.

Some captives are also writing foreign exchange risks, whereby a multinational protects itself in its FX exposures using a captive to access the reinsurance markets. Likewise, multinationals can seek protection for commodity pricing or the economic damage caused by loss of licences in overseas markets which, of course, is analogous to other forms of political and export credit risks. Just as risky, of course, are self insurances against product recall and environmental pollution.

A final and highly esoteric new use of a captive is in the realm of securitisation where captives would serve as a vehicle for consolidating their parent group's risks which would then be securitised and taken to the capital markets with the group history serving to justify pricing and risk profile for a bond issue or an equity investment.

In summary, Bermuda is seeing varied developments of traditional captives. These developments seek to convert risk into reward and involve entrepreneurs in trade and commerce, knowing their customers and their own insurance risks, and finding a business solution for which a captive can "capture" the profit.

Warren Cabral is head of insurance practice, Appleby, Spurling & Kempe, Hamilton. Tel: 1 (441) 295 2244; Fax: 1 (441) 292 8666; e-mail: wcabral@ask.bm.