“Those offshore domiciles like Bermuda that have sound, transparent regulation, and have cooperated with and received the endorsement of international institutions like the Organization of Economic Cooperation and Development, will prosper,” according to David McManus, president of Arthur J. Gallagher & Company (Bermuda).

The Enron aftershock will bring a healthy questioning of whether and how a corporation goes about creating any off-balance-sheet accounting, Mr. McManus said.

“There will, of course, be very legitimate reasons to do so, and an offshore insurance program, properly structured in a good domicile, can be effective,” he said.

“If youre going to create an offshore subsidiary, you need to think it through carefully,” he said. “If you create an offshore subsidiary that causes the parent company discomfort as a result of Enron-type concerns, then you have to question whether the risk manager is utilizing a mechanism to solve a problem but creating a whole new batch of problems at the same time.”

Henry Good, director of insurance at Rohm and Haas Company in Philadelphia, said his companys Bermuda captive provides tax and economic benefits, although these certainly arent the only reasons for maintaining a captive.

“The captive enables us to self-insure a lot of our risk outside the U.S. We use fronting carriers that issue policies to transfer the high-level risks to insurance companies, while the low-level risks are transferred to the captive,” he said in an interview.

However, despite the advantages, CFOs are questioning whether a captive is proper in the post-Enron climate, he warned.

Indeed, because of the Enron situation, senior management is asking a lot more questions about captives, he added. As a result, he said that he has had to bring company management up to speed about what an insurance subsidiary can do and what it means for a chemical company like his.

During a speech at the World Insurance Forum in Bermuda in February, he discussed some of the questions he has received from his companys chief financial officer about the Rohm & Haas captive.

“The first question from the CFO was, Remind me again why you have to go to Bermuda for a business trip,” he said. “The answer there is we buy a lot of insurance and we have this insurance captive in Bermuda.”

This leads to the CFOs next question, given that Rohm and Haas manufactures chemicals, “Why do we own an insurance subsidiary? Why do we need this insurance subsidiary?” Mr. Good recalled.

“The answer there partly is, well, there are certain insurance companies that will sell insurance to our captive but will not sell insurance to the parent company,” he said, which he indicated is an answer that is met with incredulity.

The CFO then asks what other reasons the company has for an insurance captive.

The reasons are that Rohm & Haas can put reserves on a captives books that cant be put on a parent companys books, he said.

In todays environment, the next followup question from the CFO is: “What are we hiding from whom? How can this be legal that you can put something on a subsidiary's books that we cant put on a parent's books?”

“We go through the explanation: Well this is an insurance companyandwell, trust me, its legal,” he said.

Another reason to have a captive is the quota-share program, Mr. Good said. In the companys property quota-share program, all the insurers participating on a particular layer feel they have to get the same price, he explained to his CFO. “So you get through to the point where you have most of them agreeing to a price, then you put your captive in there to fill [in the coverage gaps],” he said.

Then the CFOs next question is: “Wait a minute, are you sharing price information among suppliers? Thats a violation of our code of conduct.”

“To which the answer is, yes, I am sharing it, and yes, I know its a violation, and dont you remember that exercise I have to go through every year with the general counsel and chief operating officer [to get] an exception to our code of conduct?” he said.

In the meantime, captives arent always the solution for the risk needs of a company, Mr. McManus warned. “What the customer who buys a quarter-inch drill wants is a quarter-inch hole. And we in this industry from time to time, or maybe all the time, think that what he wants is a drill, or a captive,” he said.

“The customer is actually saying that he wants an efficient way to manage and retain risk, and we as the captive industry automatically pressure that customer into a captive,” he told National Underwriter.

“We tend to view risk retention as being synonymous with creating a wholly-owned captive, when there are many other alternatives that need serious consideration before determining that a captive is the right solution,” Mr. McManus said.

“Its conservative to say that about 20 percent [of captives] should never have been formed in the first place,” he added.

During a speech at the World Insurance Forum in Bermuda, he cited three reasons not to form a captive:

First, the captive was just “purely useless and pathetic from the beginning,” because someone wanted a trip to an island somewhere, or it was an ego exercise on the part of the risk manager.

Second, the captive is underutilized in the risk management program to such an extent that the captives role is useless. He cited the example of a corporation that deals in risks measured in billions of dollars, but takes a retention of $100,000.

The third category is that the corporation hasnt seriously considered other options besides a captive.

Mr. McManus questioned whether the drivers that created the 4,000 captives that exist in the world today will continue to exist in 2002. He further questioned whether the textbook reasons for forming a captive are still valid.

He listed some of these textbook reasons for forming a captive and then commented on the validity of each point:

To have a formalized funding vehicle.

Mr. McManus said this is another way of saying that the only way to get a vehicle to fund losses in an organized way is by creating a captive.

To get control of claims and loss prevention.

This appears to indicate that it isnt possible to do loss prevention unless you have an insurance company, he continued.

To create capacity and coverage availability.

He questioned whether a captive truly creates capacity in a real sense.

Access to the reinsurance market.

In fact, with the number of reinsurers now doing business directly with buyers, this is clearly an invalid reason, he explained in the interview.

Diversified profit center.

He suggested that insurance captives are formed without any desire to enter the insurance business; they are simply formed to help corporations manage risks, he said. If corporations want to get into the insurance business, theyll buy an active, traditional insurance company, he noted.

Cash flow.

He said there are alternative ways to gain the benefits of the cash flow that come from creating loss reserves and holding on to premiums until claims are paid.

The idea of a captive, like the idea of reinsurance being the shock absorber that is going to smooth out the rough loss years, “only works if its really funded and financed with a long-term view to smooth out the subsidiarys results,” he said.

Discussing some of the alternatives to captives, Mr. McManus pointed to:

Self-insured retentions.

Finite and enterprise risk programs, which are contracts intended to smooth out a companys operating results over multiple years.

Promissory notes and other reimbursement programs, which are side agreements with insurance carriers to reimburse the insurer for losses sustained up to an agreed level.

Rent-a-captives, which are vehicles that allow risk retention without the need to capitalize and run an independent insurance entity. Running a rent-a-captive can also deliver significant tax advantages over a wholly-owned captive, he suggested.

However, there are minimal tax motivations for a parent corporation to insure risks in its wholly-owned insurance subsidiary under current Internal Revenue Service codes, Mr. McManus said.

For example, while Bermuda doesnt tax a captives profits, the parent company likely will have to account for the profits of its subsidiary within its U.S. tax return, he said.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, April 29, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.