Investment Income—Usually an organization can earn investment returns on only funds it controls. In a wholly-owned captive, for instance, the owner controls the disposition of the loss funds (within certain parameters) until they are paid out in losses. In some off-balance sheet vehicles such as cell captives, the cell captive owner determines the extent to which the policyholder benefits from investment income on its loss reserves. Sometimes the cell captive owner will provide a guaranteed rate of return; other times it might guarantee a range of rates within which the return might fall. The point is that if the organization is going to take advantage of off-balance sheet risk financing there are certain trade-offs, one of which is the amount of investment return. 

Usually only one or the other is purchased. So in this sense, if an organization has a formal risk financing program such as a captive, there is a choice.

Flexibility as to Form and Rates—This benefit generally applies only to non-fronted captives. Fronting insurers dictate rates and forms. Regardless of the underlying financing arrangements, fronting insurers remain ultimately responsible for two things: underwriting and claims handling. 

Underwriters generally require that the captive adopt their filed coverage forms as their good name is on the policy declarations page. Rates are generally determined by the market in the beginning of any formal risk financing program, but, as time goes by, the captive's loss experience begins to influence its program's rates. Direct (non-fronted) programs actually do provide a fair opportunity for the captive to devise its own forms and rates.

Control—Control is a concept that is rarely associated with insurance, but it is one of the most powerful and important benefits of forming or being a part of a captive. For many companies, the expenditures for event risk financing (such as the cost of insurance) seem to disappear into a black hole. Captives and other formal financing arrangements wrest a degree of control away from the commercial insurance markets and allow the policyholder to take an active role in how it pays for the primary-level, reasonably predictable losses. But so does the large deductible or self-insured retention approach; however, that kind of control is temporal. It starts anew each year, and the policyholder gains no ground. In a captive the control grows commensurate with the captive's assets. The larger the captive's loss reserves, the greater its ability to assume responsibility (control) for greater amounts of risk over time. 

Insurance Accounting and Premium Tax Deductibility—Insurance companies and most captives enjoy a particular tax advantage as compared with a non-insurance company. A company's annual earnings are subject to U.S. federal income taxation. So are the earnings of insurance companies, but because insurance companies' products consist entirely of a promise to pay for losses, it must have sufficient reserve funds to fulfill this promise. Thus, loss reserves are allowed to accumulate untaxed until they are taken as earnings (those not paid out for losses). This allows the parent company to pay its captive a premium and realize what is tantamount to an accelerated tax deduction, assuming the circumstances permit. 

Enhanced Loss Prevention and Claims Management—In the absence of these critical activities, no captive or any other formal risk financing program will succeed. However, for any type of captive, establishing and maintaining high loss prevention and claims management standards and protocols always pay dividends in the long run. 

Premium and Loss Allocation—Captives, especially the single parent variety, can be wonderful tools to consolidate and manage the administrative side of financing event risk.

Defensive Strategies—Not all captives are formed to take advantage of the usual and customary benefits. Sometimes there are special circumstances that a captive can effectively address. Captives can be employed to create a formal system of ring fences around a pool of funds designed to pay for certain types of claims. These circumstances usually include the potential for heightened legal activity due to an environment that, correctly or not, encourages the emergence of potential plaintiffs filing suits against the organization. The most prevalent of these situations involves product liability and occupational disease. 

A risk manager's budget is under pressure. The company grew rapidly over the last several years and was paying more than $2 million for liability insurance.

Rate/Loss Disparity—Is the organization paying insurance premiums based on its industry's collective loss experience when the organization's loss experience is far better than that of the industry? If so, the risk manager might want to consider retaining significantly more risk, in a captive or otherwise, as illustrated by the following example. 

The company's general liability loss experience was far better than the industry's experience. The company had not paid a loss in excess of $100,000, with the vast majority of claims settling below the $50,000 self-insured retention (SIR). 

An actuary calculated expected losses within three optional per-occurrence retention levels, $50,000 (the current SIR), $100,000, and $250,000. At the $250,000 retention, the combination of captive premiums and premiums for insurance excess of the captive (up to $20 million) was $1.5 million, an immediate savings of $500,000 over the previous program's premium. The expected losses at the $250,000 retention were only marginally higher than the expected losses at the $50,000 SIR. 

Expected losses at the $50,000 SIR were $800,000, but at the $250,000 level, only $900,000. The company obtained insurance cost proposals for coverage excess of $100,000 retention and $250,000 retention. The excess insurance premium at the $250,000 level was $800,000, and at the $100,000 retention it was $1.1 million. The combination of the loss funding and the costs of excess insurance at the $250,000 retention appeared to make the most sense. 

 Over time, the captive investment created the following outcomes:

• Since the company assumed significantly more risk than it did under the previous arrangements, the risk manager paid more attention to loss prevention and claims management. 
• In succeeding years the captive's assets grew to the point where the company could afford to take additional risk. So at the end of the third year, the risk manager increased the retention to $500,000, resulting in a reduction in the cost of the excess coverage with little additional loss costs.
• At the end of the fifth year, the captive declared a dividend, as its capital and surplus position was more than adequate based on the relevant solvency ratios.

Potential Risks or Drawbacks Associated with Captives

Opportunity Costs on Dedicated Funds—One of the problems with any formally funded risk financing scheme is the fact that the loss reserves are just that: reserves put aside to pay for losses. Yes, there are a wide variety of investment vehicles through which a captive's assets can earn a decent rate of return, but there are all manner of potential uses that could certainly produce better returns than that of a captive. 

Inexperienced Management—Inexperienced management is often disregarded as immaterial because almost all of the captive's services, including captive management, are usually outsourced to professionals. The potential risk involved with inexperienced management applies to the captive's executive officers and board members. With the exception of rental and cell captives, most captives are run by people who have never before managed an insurance company. Single-parent and group captive directors and officers must rely on the knowledge and experience of consultants. 

Excessive Expenses—Captives can become the equivalent to an ATM for a wide range of interests. Group equity captives, which are formed by third-party promoters, often add a wide range of expenses designed to pay a variety of so-called stakeholders, including the promoter, the insurance broker, the association (if the captive is formed for a particular association or affinity group), and various consultants. As a rule of thumb, captive expense ratios should be no higher than 30 percent exclusive of excess insurance or reinsurance. 

Underemployed Capital—Like every other company captives require capital. A company's capital structure should be as efficient as possible. The same logic applies to a captive, but its capital structure usually consists of only one source: equity. 

Most captives are formed with the minimum amount of capital allowed (or suggested) by the domicile regulators. Over time, the captive accumulates earnings (excess loss reserves) and uses it to bolster the capital account. 

Inability to Achieve Insurance Accounting—While insurance accounting is a positive and often necessary consequence of captive ownership/participation, it should not be one of the reasons for forming the captive. However, the inverse of this argument is usually not true. Often the inability to comfortably assume that the captive will qualify for insurance accounting kills the deal before it gets off the ground. The heart of insurance accounting is the ability to deduct loss reserves from income taxes. Only when excess reserves become earnings are they subject to U.S. federal taxation (for most captives with U.S. owners). In the absence of insurance accounting, the captive must use deposit accounting. 

Substandard Returns on Investment—Whether a substandard return on investment exists depends on the parent's definition of substandard. Gauging a captive's value primarily on its ability to earn a minimum ROIC is a faulty analysis. However, if the parent company mandates that the captive's capital must meet or exceed the company's hurdle rate and/or provide positive returns within a relatively short timeframe, perhaps, three years, a captive would not be indicated. 

Short-Term Cash Flow—In insurance parlance, cash flow means the organization's ability to hold onto its money until it has to pay a loss. In a large deductible plan the organization keeps the loss funds until they are paid. Conversely, captives force the policyholder to monetize those loss reserves in the form of a premium payable over the twelve-month policy term. While this disadvantage is usually overshadowed by a variety of benefits, it is nevertheless real.

Insufficient First-Year Premiums—Many group captives start out with the best of intentions but also with insufficient premiums, relying on the notion that, as the year progresses, they will successfully attract additional members. This assumption is exacerbated by the fact that, in order to open the captive, they need to contribute enough capital and surplus on day one to support the marketing plan—the business they believe will materialize within the first year. 

Legal and Regulatory Risks—All formal self-insurance arrangements are built on a legal and regulatory framework that are assumed to withstand the vagaries of the political landscape. These risks are real and can emanate from a variety of sources: the IRS, the Financial Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC), state departments of insurance, foreign governments, and the U.S. federal government. Regulations are changed partly due to ideology and partly due to lobbying pressure. Unfortunately, many politicians and regulators remain skeptical about the validity and public policy implication of captives. In early 2008, the onshore captive industry was threatened with an IRS ruling that most observers believed would have effectively destroyed onshore captives, sending the majority of that business to offshore domiciles. The industry fought back, and the IRS relented. It withdrew its proposed ruling, an unprecedented move by the IRS. Next time (and there will be a next time) the industry may not be so lucky.

Risk Sharing (Distribution)—Risk sharing is one of the pivotal requirements, as per the IRS, for a captive to qualify for insurance company status. The problem is that risk sharing can be an extremely uncertain proposition. Its most potent application is in small group captives. For example, risk sharing among group captives with seven to ten members is a major determinant of the captive's ultimate success. Risk sharing, fortunately, does not have to be all-encompassing. Usually, only a certain portion of a group captive's risk is shared, the rest stays with the individual member. Even so, assuming a portion of another company's risk reduces or eliminates direct control over loss prevention and claims management. 

The content in this publication is not intended or written to be used, and it cannot be used, for the purposes of avoiding U.S. tax penalties. It is offered with the understanding that the writer is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought.