The growing sophistication of insurance markets is giving a boost to the captives market. According to insurance experts, not only are captives becoming more popular, but more of them are moving onshore. Of the approximately 5,600 captives, about half are now domiciled in the United States, according to Arthur Koritzinsky, who heads the captives practice for Marsh Inc.

“I definitely see a huge increase in captives,” concurred Terry Campbell, managing director-global risk management at Arthur J. Gallagher.

Even smaller companies are getting involved through micro-captives or rent-a-captives. “That happens when the price of buying insurance is higher than the cost of self-insuring. What you’re seeing is some insurance prices go up. But more than that, companies have to face the economic reality; they have less cash, less money to spend on insurance up-front,” Campbell explained. “By funding a captive over time, they get around that hurdle.”

Large companies are turning to captives especially to protect less easily quantifiable risks, like reputation harm and third-party contingent liability. “Buying supply chain risk and contingent liability risk is expensive, particularly for very large companies that have a big risk. The captive allows companies to retain a bigger portion of that risk,” Campbell said.

Onshoring captives

While Bermuda used to be the offshore domicile of choice for captives, more companies are setting up captives domestically—and even moving previously offshore entities onshore. This reflects the fact that more states in the United States now offer attractive captive legislation. Currently, 36 states and the District of Columbia offer tax and other benefits for U.S. companies. Dick Goff, managing member at the Taft Cos. LLC, a boutique captive consultancy based in Towson, Md., said the mood in Washington is clearly playing a role. Under the Obama administration, there’s been a pushback on offshore structures. At the same time, “Bermuda has become extra expensive,” Goff said. “Our focus today is 100 percent on domestic domiciles. What we’re seeing is a push for states that have developed captives’ legislation to pursue companies that are based in their states.”

Two recent additions to the domestic domicile list are Tennessee and Connecticut, according to Harry Rodgers, director of business development at another captive consultancy, Kane Group. However, he’s also seen large companies maintaining dual structures, in Bermuda or Cayman Islands, as well as in their home states.

Indeed, some companies find that they need to maintain two entities in order to insure global risk. Many countries outside the U.S. have provisions under which insurance companies are authorized to write coverage within those countries’ jurisdictions. So, if a U.S. captive covers overseas risks, it will employ a fronting company and then reinsure to the U.S. captive. When companies have two, e.g., one in the U.S. and one in Bermuda, one acts as the reinsurer of the other.

Key benefits

At the heart of the decision to form a captive is a strong business case. While tax savings often get top billing, the captive has to make sense on a much bigger level:
- Risk discipline. The key business case for captives is that “they offer a disciplined approach to taking risk management,” Marsh’s Koritzinsky explained, “and force companies to pre-fund their losses and create a policy and an infrastructure to handle claims.” Captives have their own boards and many companies like the additional scrutiny and oversight as opposed to having large uninsured retentions.
- Risk control. “Captives give companies control over their own destiny,” Taft’s Goff added. As long as the captive makes business and financial sense, “control is the biggest issue,” he said.
- Risk culture. In addition, when companies pay premiums to their captives there’s often an internal process of budget allocation to business units that’s indicative of each unit’s contribution to the overall risk of the organization. “Those who have losses pay a bigger share,” Koritzinsky said. “It gets business leaders to understand that the risk is controllable and pay attention to preventing losses and managing losses to mitigate cost.” By tying loss prevention to lower premiums and compensation, “captives force a different risk culture.”
- Tax benefit. Absent such business reasons, the captive may not make sense. But the tax benefits for some companies can play a major role. A captive can treat its loss reserves as tax-deductible, regardless of the timing of the loss. That’s not the case for self-insurance. Those reserves can run into multimillions, such as, for example, against old workers’ compensation claims. “As long as the captive meets IRS rules, it swaps out the deferred cash assets for cash,” Koritzinsky explained.

Companies need to look at their specific situation to make the determination of whether a captive is the right solution. When one technology company decided to self-insure against some of its risks, it did consider a captive as an option, but decided that the cost of setting one up and running it did not make business sense. According to the treasury risk manager at the company, who asked not to be named, captives make sense in situations where there are a lot of claims, and there’s an additional tax and premium benefit to justify the management costs.

In that specific case, losses were expected to be improbable and infrequent, and the company hasn’t actually had many claims in the past, so treasury decided that going through administrative costs of setting up an entire infrastructure didn’t make sense. In addition, “captives work better in high-interest rate environments, when there’s a benefit to collecting the interest income,” she said. Ultimately, Marsh’s Koritzinsky says, “[the captive] has to make business sense.”

For more information on captives and insurance risk, download a copy of the CTC Guide, The Emerging Risk Management Discipline: The New Face of Corporate Insurance : http://www.corporatetreasurers.org/guides

This article appears in the May edition of Exchange (http://www.afponline.org/exchange/)

By N. Essaides
Association for Financial Professionals
www.afponline.org

Published: 2013-05-02