Overview

The material in this treatment focuses on the formation of captive insurance companies. It presents the factors that should be considered when forming captives, as well as general information about them.

Topics covered: Reasons to form a captive Types of captives Fronting companies Steps to forming a captive

Chart of captive domiciles

Reasons to Form a Captive

Captives can provide numerous risk management and financing benefits to an organization, some of which are:

1.tax savings;

2.operating cost savings;

3.program stability;

4.program control;

5.access to reinsurance;

6.enhanced program flexibility;

7.increased cash flow and better utilization of capital; and

8.access to multi-national programs.

Each of these benefits requires further comment.

Tax Savings. Captives can be structured to reduce the insured's total taxes, including premium taxes, fees, and income taxes. However, the tax question is extremely complex. For example, premiums paid to a captive may not be deductible expenses in the year they are paid. A single-parent captive may not be permitted to fully deduct premiums as a business expense in the year they are paid if the captive insures only its parent's risks. In Rent-A-Ctr., Inc. v. C.I.R., 142 T.C. 1 (2014), January 14, 2014, the U.S. Tax Court concluded that it may be advantageous for a corporation to operate through various subsidiaries for a multitude of reasons. These reasons may include State law implications, creditor demands, or simply convenience, but "so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity. [Moline Properties v. Comm'r of Internal Revenue, 319 U.S. 436, 63 S. Ct. 1132, 87 L. Ed. 1499 (1943)]

Thus, if a corporation gives due regard to the separate corporate structure, the tax court will do the same. The issue presented in these cases is ultimately a matter of when, not whether, Rent–A–Center is entitled to a deduction relating to workers' compensation, automobile, and general liability losses. Because the IRS has conceded in its rulings that insurance premiums paid between brother-sister corporations may be insurance and the court determined that, under the facts and circumstances of these cases as found by the Judge who presided at trial, the policies at issue are insurance, Rent–A–Center is entitled to deduct the premiums as reported on its returns. The tax question is extremely complex. For example, premiums paid to a captive may not be deductible expenses in the year they are paid. A single-parent captive may not be permitted to fully deduct premiums as a business expense in the year they are paid if the captive insures only its parent's risks.

Operating Cost Savings. Many organizations form captives to reduce the cost of their insurance premium. In Donal A. Carty, 38 T.C. 46 (1962) the tax court dealing with a non-insurance captive found that the comparatively low operating costs and consequent high margin of profit made possible by a captive operation, and the cost factor normally utilized guaranteed a better operation and a profit. The captive's arguments, however, over value of equipment was not allowed. Using a captive insurer, even like the captive creamery in Donal provides a clear and recognized source of savings by the elimination of the profit margin earned by the insurance company. Another source relates to investment income. The income normally earned by an insurance company as it invests premium dollars until they are needed to pay losses accrues to the benefit of the captive. Cost savings can also be realized when a captive is able to operate with a lower expense ratio than an insurance company.

It should be noted, however, that periods exist during the underwriting cycle when insurance companies do not make an underwriting profit on the insurance coverage they write. Their only profit, if any, accrues from the investment income. There are also times during the underwriting cycle when an insurance company may sell coverage for less than a captive must charge for the same protection in order to remain solvent. Thus, the money saved by using a captive can vary significantly during the underwriting cycle. Because there are almost certain to be times when using a captive is more expensive then buying insurance, cost savings alone is never a good reason to form a captive.

Nonetheless, using a captive permits an insured to directly benefit from good underwriting results because it knows better than any independent insurer what the risk faced by the owner of the captive is and gives it an ability to manage those risks without the need an independent insurer has to make a profit from the premium collected. The captive may not benefit from low losses when pooled with other insureds in an insurance company. Of course, if the firm's losses are high, using a captive will result in an immediate cost increase through higher premiums or a decline in the captive's value.

Stability. Many organizations form a captive to get off the underwriting roller coaster. As mentioned, there are periods when the premium for insurance company coverage may be less than the captive's cost. Yet when insurers raise premiums in a hard market, the increases can be staggering. By forming a captive, the cost of insurance can be stabilized. The captive may flatten the peaks and valleys of wild premium fluctuations that exist in some areas of the commercial insurance market. . In Carnation Co. v. C. I. R., 640 F.2d 1010 (9th Cir. 1981) the parties entered into two insurance contracts: an agreement between Carnation and an unrelated insurer, and a reinsurance agreement between the captive and the unrelated insurer. The unrelated insurer expressed concern to Carnation about the captive's financial stability and requested a letter of credit or other guaranty. Carnation refused to issue a letter of credit or other guaranty but did execute an agreement to provide, upon demand, $2,880,000 of additional capital to the captive. The tax court held that the parent-subsidiary arrangement was not insurance because the three agreements (i.e., the two insurance contracts and the agreement to further capitalize the captive), when considered together, were void of insurance risk. Furthermore, the Court of Appeals held that the key was that the unrelated insurer refused to enter into the reinsurance contract with the captive unless Carnation executed the capitalization agreement. Therefore, to have stability, it is necessary that the agreement is truly an insurance agreement with no side agreements.

Control. A captive gives organizations the ability to control insurance operations in at least three areas where control is important.

First, claims costs often can be reduced when a captive is more aggressive than an insurance company in its claims-handling practices. The captive can be more aggressive because there is no benefit for the insured or its captive to become involved in claims of the tort of bad faith. All that is needed is a professional assessment of the claim and resolution favorable to both parties. Second, although insurers have developed many excellent risk management programs, it is not financially feasible for them to develop a program for every type of business client. Captives can develop specialized risk management programs to reduce their costs designed for the specific risks faced by the insured who sets up the captive. Finally, using a captive permits an organization to control its insurance operations. Captive insurers can tailor their programs to provide the specific services their insureds need, such as in-depth loss reports, specialized legal talent, targeted loss control programs, and expert underwriting. The captive can also, if needed, insure risks that might otherwise be considered uninsurable in the commercial market.

Reinsurance. When an organization establishes a self-insurance program, it may encounter difficulty obtaining excess coverage. By forming a captive, access to reinsurance markets becomes available to meet the captive insured's need for protection against large losses. Direct access to reinsurance has another advantage: providing a captive with an opportunity to develop specialized coverage not available in the standard market.

The insurance marketplace is known for underwriting cycles that produce significant price fluctuations and coverage restrictions. By using a captive, a firm or association can often lessen the price fluctuations and assure that some coverage will be available. However, captives also can suffer during hard markets, because reinsurers are likewise subject to the underwriting cycle. There may be times when captives have difficulty getting reinsurance. Therefore, it is important for captives to develop a strong relationship with several reinsurers so, when a hard market develops, they are less likely to be deserted.

Enhanced Flexibility. A captive offers flexibility in underwriting and coverage design. It has the capability to design underwriting guidelines and new coverages that are geared to a particular line of insurance or industry. This advantage is particularly important for hard to place, unusual risks. There are some occasions when a captive will write a manuscript policy that provides coverage against risks of loss that are unavailable in the insurance marketplace.

Increased Cash Flow and Better Utilization of Capital. Since special premium payment plans can be worked out, a captive arrangement may provide additional cash flow through deferred premiums. Any improvement in cash flow can result in improved utilization of capital.

Capitalizing a captive can actually reduce the cash flow in the short run, but the impact can be dampened. For example, many jurisdictions permit letters of credit to serve as part of the required capital or surplus. The letters of credit must be backed by actual assets or the insured may have difficulty with the regulators and taxing authorities.

Multi-National Programs. Captives can offer international insurance packages that are not available from other insurance companies. This permits the development of special coverage arrangements that can provide wrap-around coverage or meet special requirements for a particular country.

Types of Captives

Captives may be categorized according to ownership, the needs of the insured, or by their operations.

Ownership. Captives can be divided into four ownership categories: single owner captives (commonly referred to as pure captives), multiple owner captives, rent-a-captives, and profit centers.

As their names imply, single owner captives insure the risks of their parent and its affiliated companies. Multiple owner captives insure the risks of their several owners and their affiliates. This will allow for a greater spread of risk and fixed costs among the members of the group. One popular form of multiple owner captives is the association captive, which is owned by an association comprised of the captive's members. It insures the risks of its members and their affiliated companies.

A rent-a-captive serves businesses that are unable to form a captive on their own, but are willing to share a portion of the risk, underwriting profit and investment income. This class of captive insurer is usually organized by an insurer or reinsurer who sponsors the programs offered to its clients. Profits are shared by the sponsor and the clients. Rent-a-captive organizers form the captive and handle its operations, including claims payments. An organization insuring its risks through a rent-a-captive pays a premium to the captive. It may also be required to deposit securities or post a letter of credit to support the premium it places with the captive. The rent-a-captive organizer runs the insurance operation and purchases reinsurance for the risks placed by the clients. At the end of the accounting or policy period, the insured is paid a dividend, the size of which depends on its losses. If its losses are too high, its securities or letter of credit may be drawn down by the captive. Rent-a-captives can also be structured so that the underwriting results of all insureds that purchase coverage from the captive are pooled.

The rent-a-captive market also includes segregated portfolio or protected cell companies. This structure allows an insurance company to segregate the assets and liabilities of participating shareholders and offers many of the benefits of a group captive but with lower startup costs. The Protected Cell Captive (PCC) isolates each participant's assets and liabilities as if they were a separate company. A firm usually joins a PCC by purchasing non-voting preferred stock. The funds generated by the sale of stock serve as equity to offset the premium that is placed with the PCC. The insured places its coverage through a fronting company, which reinsures it with the PCC. Sometimes a PCC will enter into a retrocession agreement, reinsuring some of the business it receives. The fronting company pays claims and handles most of the administrative details although the PCC may provide some services. When claims arise, the fronting company contacts the PCC to be reimbursed for the claims it has paid. (For more on reinsurance, seeReinsurance. Print subscribers may find this treatment on the R- pages of the General tab.)

At the end of the policy or accounting period, the PCC calculates the underwriting results for each insured owning the non-voting preferred stock. If the reinsured coverage for that insured has been profitable, a dividend is paid on the stock. PCCs and rent-a-captives are similar enough so that it is often difficult to distinguish between them.

Rent-a-captives and PCCs are used to deal with the premium tax deductibility problem. As pointed out earlier, premiums cannot be deducted unless there is a transfer of risk to the captive. Advocates of rent-a-captives and PCCs contend that they provide the needed risk transfer mechanism.

Type of Insured. Captives can be categorized according to their relationship to their insureds. The categories include related and non-related insureds.

Captives that provide coverage only for related insureds are restricted to writing coverage for their owners. This category includes single and multiple parent captives. Risk retention groups are a subset of related insured captives. Non-related insured captives may or may not write coverage for their owners, although they generally do. However, they also write coverage for companies that have no ownership interest in them.

Operations. Captive insurance companies can also be classified by their method of operating. They can write direct coverage, they can write reinsurance, or they can participate in pools. They can also be involved in any combination of these operations.

Fronting Companies

Fronting policies have no transfer of risk associated with them. They can be used to transfer claims handling responsibilities or to satisfy financial responsibility laws. One example of a fronting company arrangement occurs when a captive's parent company (the insured) buys coverage from a licensed insurer (the fronting company), which then reinsures the coverage with the insured's captive.

A fronting company may reinsure all of the coverage placed with it by the parent or it may retain a portion of the coverage as its own risk. Fronting companies generally require that letters of credit or assets be posted by the parent to ensure that its captive will pay the claims it reinsures.

If, instead of using a letter of credit, assets are paid to the fronting company to be held in a bank account, the fronting company may agree to use a bank selected by the parent. This enables the parent to use the funds as compensating balances with its bank.

Another funding alternative is for the parent to place the funds directly into a trust account in favor of the fronting company. Again, the funds can be used to meet any compensating balance requirements the insured parent might have.

The fronting company issues a policy to the insured parent, pays its claims, and frequently, handles the captive insurance company's administrative functions. The fronting company is paid a fee for these services (usually a percent of the premium). The fee varies depending on the amount of work performed by the fronting company, the amount of coverage it retains, and the amount of security provided by the parent. Fees can range as high as 10 percent, but they are more likely to be from 3 to 6 percent.

Fronting companies are usually licensed insurance companies that are approved by state insurance departments, whereas a captive insurer may not enjoy that status. Thus, the fronting company serves as a way for a captive to get paper, that is, to write insurance coverage on policies that are acceptable to state regulatory authorities.

For example, elevator contractors in one state are required to place their liability insurance with a licensed insurer. Should an elevator contractor insure its liability risks through a captive that is not licensed in the state, the insurance afforded by the captive would not be acceptable to the state's regulators. However, an approved fronting company can be used to provide an acceptable liability insurance policy for the contractor's operations. The fronting company provides the paper and reinsures the coverage with the contractor's captive. The contractor gains the advantage of providing to the state regulators an insurance policy written by a licensed insurer while still buying insurance from its captive.

Steps to Forming a Captive

There are several steps involved in forming a captive. Their order may vary depending on the jurisdiction where the captive is formed and on the incorporator's objectives.

Feasibility Study—Step 1. A feasibility study should be done before beginning the formation of a captive. A feasibility study generally looks into the desirability of forming a captive by providing the hard information needed to make the decision. However, rather than drawing a firm conclusion, it often leaves the final decision up to the client. The feasibility study normally focuses on the following:

1.the structure and type of captive ownership;

2.the funds needed to form a captive (these are funds for expenses and do not include capital and surplus requirements);

3.the type of coverage to be sold;

4.the conditions in the insurance marketplace;

5.the availability of actual loss data on the risks to be covered (or the existence of industry loss data that can be applied to the risks to be covered);

6.the amount of reinsurance to be purchased;

7.the use of a fronting company;

8.the sale of coverage to third parties, where applicable;

9.tax issues;

10.captive locations;

11.the provision of services; and

12.the capital and surplus that will be needed.

The interdependence of these factors should be considered. For example, the amount of coverage that can be written will be a function of the amount of equity available, the amount of reinsurance that can be purchased, and coverage limitations imposed by the captive's expected domicile.

To avoid a conflict of interest, a company interested in forming a captive should hire one firm to do the feasibility study and another to actually form the captive if one is feasible. The firm conducting the study should be made aware that it will not form the captive.

Legal Counsel—Step 2. A law firm should be retained if a captive is going to be formed. It can assist the captive in meeting the regulatory requirements of the state where it is to be formed, and create and file the necessary paperwork, application and other documents required by the state.

When a captive is to be formed in a jurisdiction outside the United States, a United States lawyer and a lawyer from the foreign jurisdiction should be retained to handle the application. Some jurisdictions require the use of a local lawyer or management company. Regardless of whether the requirement is mandatory, however, it is always desirable to engage a local contact who is familiar with the regulatory process.

Visit Regulator—Step 3. The formation of a captive insurance company receives more scrutiny than the establishment of a workers' compensation or automobile self-insurance fund. While some jurisdictions do not require those interested in forming a captive to meet with the regulatory authorities, it is always recommended that a meeting be arranged. Such a meeting provides an opportunity to get a feel for the process, and it gives the regulators an opportunity to evaluate the captive's organizers. Several state insurance department websites recommend this step as one which should be taken early in the planning process; this will avoid unnecessary delays.

Incorporation, Business Plan, Management—Step 4. Many states and jurisdictions outside the United States require that a certificate be obtained from the insurance regulatory authority stating that the formation of a captive will benefit the state or jurisdiction. To become incorporated, the certificate is filed with the appropriate regulatory party along with the incorporation papers. In the United States, the appropriate state regulatory authority is usually the secretary of state.

Along with preparing the incorporation papers, the incorporators should develop a business plan of operation. Much of the information needed for a business plan is developed as the feasibility study is prepared. A business plan usually contains the following items:

1.a list of the types and amounts of coverage to be provided;

2.an estimate of premium by line of coverage;

3.a history of the organization or individuals forming the captive (biographical affidavits are normally required for directors, officers, and in some cases, stockholders.);

4.a statement showing that there is adequate expertise to run the captive, or the name of the management company to be used. In some jurisdictions, the regulators require the use of a management company. When this occurs, the management company usually works with legal counsel to form the captive;

5.an underwriting plan indicating what types of risks will be written;

6.a description of rates and rating classifications (including the development of loss data, if available);

7.a description of the marketing strategy;

8.a description of fronting arrangements;

9.a description of any intermediaries;

10.description of the retention levels and the type of reinsurance that will be purchased;

11.an audit;

12.a projected financial statement; and

13.a description of the amount of capital and/or surplus to be raised and their source.

The premium estimates and the financial statements may have to be projected for as many as five years into the future. The management company should be hired no later than when the incorporation process takes place. However, it may be better to decide on using a management company and to select it earlier in the process, as is discussed in Step 2.

Selection of Auditor, Actuary, and Service of Process—Step 5. Once the incorporation process is complete, it is necessary to select an auditor, an actuary, and someone who can be served legal documents. Some jurisdictions list the names of acceptable auditors and actuaries and some accept auditors and actuaries who are members of their respective professional organizations. Alternatively, an applicant can file the names of its own auditor and actuary for approval.

Application and Capital/Surplus—Steps 6 and 7. The next step is to file the application for a license. The license is usually issued subject to the payment of the applicable fees and the development of the required capital and/or surplus. While it is not recommended that a prospective captive wait until a temporary license has been issued to raise capital, many jurisdictions will license an applicant subject to the raising the capital and/or surplus. One problem with waiting to raise capital or surplus until the licensing process is finished is that many regulators will revoke a temporary license if the captive does not commence business within one year from the date it is issued. If the capital cannot be raised quickly enough, the captive may have to go through the licensing process a second time.

Once the fees are paid and the capital and/or surplus raised, the captive can begin operation.

Chart of Captive Domiciles