Is your organization a good candidate for utilizing a captive insurance platform? What are the proper steps for establishing a captive insurance company that will help an organization to achieve its risk management goals?
Of the many issues to be addressed when integrating captive insurance into a company’s business strategy, these two key points are among the first that must be considered. As noted in the previous articles within this series exploring captive insurance, organizations examining captive options typically look at two key financial metrics to make a cost/benefit determination. Those metrics are annual business insurance premiums and overall annual facilitation cost for the captive. While there are some variances depending on industry, a good candidate for a captive insurance platform is a group or company that typically pays in the neighborhood of $300,000 in premiums per year for its current commercial coverage, and the organization should have better-than-average claims experience for its industry.
In addition to premiums, the group or company utilizing a captive must be prepared to cover claims administration fees, actuary fees, captive manager fees, audit fees and taxes. As an example of what it takes to properly initiate a captive, consider the start-up funding needed to establish a captive in the state of Tennessee. A captive insurance program in Tennessee is generally going to require an initial capital commitment of $250,000. Additionally, it will likely take $80,000-plus to facilitate the setup with a feasibility study and the other informational needs related to the legal work.
Feasibility Study: The First Step in Establishing a Captive
If an organization meets the criteria for annual insurance premiums and is well-positioned to meet the capital funding required for establishing and maintaining a captive insurance platform, the first major step is conducting a feasibility study. While there are many reasons to engage in a formal feasibility study, the most valuable purpose of this process is to allow a company to clearly project the potential benefits and possible issues related to initiating a captive insurance strategy.
As part of the feasibility study, an organization will need to gather historical data about its claims experience with respect to the risks of the insurance to be provided by the captive. The necessary historical claims information can usually be obtained from loss-run reports maintained by the commercial insurance carrier. For those companies which are self-insured, the historical data needed for the feasibility study should be available from the third-party administrator (TPA) the company already has in place, or it can be found within the company’s internal claims data base – if the claims administration is performed in house.
In some cases, companies may have difficulty gathering the necessary information. But with frequently occurring types of risks, the historical data needed for a feasibility study is likely going to be available. For those companies seeking to establish a captive for low-frequency risks, such as cyber-risk or loss of major customer, the relevant claims history or experience may not exist.
The claims history will be utilized by the actuary, who will be involved in the feasibility study to determine the premium funding levels required for the captive. If the company does not have historical data for the risks being insured, the actuary will use relevant industry data to project expected losses. With cyber-risk, for example, the actuary will review the case history of cyber attacks and actual losses for companies of comparable size within the specific industry.
Through the feasibility process, the collective costs of establishing the captive and operating the captive well into the future are examined. As part of the feasibility study process, the captive manager will provide a pro-forma financial statement, which will show the projected results of operating the captive. The pro-forma is based on certain assumptions made concerning the expected premiums to be funded, costs of necessary service providers, investment income and amount of expected claims to be paid in the pro-forma period.
The pro-forma will also project the income tax results from a captive arrangement. One scenario for a captive platform could be a situation in which a company wants to reduce premium volatility and build some reserves. Another scenario might be a company owner wanting to build reserves outside his or her estate for purposes of a wealth transfer to beneficiaries. Under either scenario, the prospective captive owner will want to know the income tax effects of establishing the captive versus not establishing the captive.
Ultimately, the primary objective of the feasibility study is to provide company leadership with a proper evaluation of whether or not a captive platform will benefit the organization. It is the time to carefully consider all possible costs, the management resources required and the potential outcomes from establishing a captive.
The Formation & Operation of the Captive
Once the decision is made to establish a captive, a captive attorney will create the legal entity. The formation of a captive is essentially the foundation of a new corporate entity which will be responsible for issuing insurance policies and paying premiums. Typically, the legal team meets with company officials during the feasibility study to discuss the optimal ownership structure in order to achieve the objectives of the captive arrangement. In most instances, the captive manager assists from the beginning of the process, including securing the attorneys and the other service providers who are part of the overall operational team.
The selection of an experienced captive manager is crucial to the structuring of any captive insurance arrangement. Typically, the captive manager is responsible for keeping the accounting records of the captive and serving as a liaison with the service providers and with the state on compliance filings and other issues. Most states require that the company disclose its selected service providers when the application to establish a captive insurance company is submitted.
Choosing the domicile of the captive is another important step. The domicile is most often decided during the feasibility study, as the company will have considered the projected costs for establishing and maintaining a captive in a particular jurisdiction. As noted in previous articles in this series, a number of states have added or updated laws in recent years that have made domestically-based captives quite attractive for companies. Offshore jurisdictions can offer greater asset protection, or they can perhaps offer additional tax advantages for high-wealth individuals seeking to transfer money outside of their estates. There are distinct advantages to utilizing a captive management firm located in the same state or jurisdiction where the captive is domiciled. Typically, captive managers will not only be familiar with the policies governing captives in their respective states, but they will often have considerable experience working with local insurance regulators and will understand the nuances of the bureaucratic processes in a given jurisdiction.
The experience of the entire service team involved can be a significant factor in realizing the full potential of the captive. When considering a captive manager and the accounting firm, there should be a high value placed on the experience of having previously worked with captives of similar size and within the same or a comparable industry. Other service providers that will be necessary will include the captive attorney, the actuary and the claims administrator.
Along with a strong service team, one of the most important components for the success of any captive is the organization’s fundamental commitment to risk management and claims prevention. As noted previously in this series, the captive allows companies to keep the money from the premiums paid into the captive that are not used for operations or to pay claims. Through a dedication to mitigating risk and preventing claims, companies utilizing captives can build a substantial amount of savings during the life of the captive.
Liquidity of Reserves and Other Concerns
As noted here and in the previous articles within the series, a captive insurance strategy is best suited for companies with strong, consistent cash flows and a healthy financial state. The operation of an effective captive is based on a long-term strategy that is executed over a number of years. When operating a captive, it is imperative that companies effectively manage reserves gained off the savings realized and remain appropriately liquid with investment strategies.
In terms of investment options, reserves within a captive should not be illiquid to the point where they cannot be accessed when claims must be paid. High-frequency risks, such as those with worker’s compensation or professional liability policies, typically require a captive to utilize an investment strategy that is highly liquid, such as money market funds or cash. A worker’s compensation policy through a captive will likely necessitate a company to enter into a fronting arrangement with a third-party commercial insurance carrier, and the fronting company (as noted previously in this series) will require a significant deposit to be held in escrow to secure payment of claims. A captive writing low-frequency risks may have greater latitude in investing its reserves and may choose to hold some equities and bonds that are readily accessible should a catastrophic event occur.
During formation, the legal team will work with company officials to establish an appropriate investment policy. The investment parameters will provide the broker with guidance on making the decisions about where to place the funds. Brokers who are experienced with captives are familiar with the particular liquidity needs and will utilize appropriate strategies. Communication with the investment broker is an important key to a successful investment strategy. Captives should be mindful to avoid potential conflicts of interest between the captive management firm selected and the investment broker chosen.
As a final note on cash reserves and investment management, it is crucial to the success of the captive platform that the captive itself be treated as a third-party insurance company – discrete and at arm’s length of its parent. Reserves established in the captive are not available to the parent company or the insured for working capital loans or other advances – although distributions can be taken of excess reserves if approved by the Department of Insurance where the captive is domiciled. Premiums should be funded annually as determined by the actuary. Maintaining this clear separation of the assets and operations of the captive from its related parties is also a condition to being recognized as a legitimate captive insurance company by the Internal Revenue Service.
We Can Help!
Elliott Davis Decosimo has assembled a strong team of experienced professionals who can help your company initiate a feasibility study and walk you through every step of building a strong captive insurance program for your business.