The role of captive insurers in the insurance and risk financing market - Essay Example

?Topic3. Critically evaluate the role that captive insurers play in the insurance and risk financing market. Background Introduction Captive insurance has been in practice since the mid-19th century. Not satisfied with the insurance and costs involved, companies in the mid-19th started operating their own insurance resources. To cite some examples, there were the American ship owners, not content from the insurance services of the Lloyd’s of London and created Atlantic Mutual in the 1840s. Later in the 1960s, there came a boom period for captive insurance when a number of American corporations jumped into insurance business by creating their individual insurers. By 1990s and 2000s the captive insurance business thrived with the hardening of insurance market, reporting innumerable malpractices in medial and professional responsibility area (Skipper and Kwon, 2008). Growth in the captive insurance business has been unprecedented, fuelling their demand need globally. Taking it from the Swiss Re reporting of 2003, in 2001 the insurance premium paid by 2,500 of the major world corporations represented 13% business of the global commercial insurance but the share of captive insurance in that was 80%. Presently, captive insurance is not just reserved to private entities; even government organisations like the U.S. Federal Emergency Management Agency (FEMA) have entered into forming their own captives (Skipper and Kwon, 2008). Business of captive insurance grows rapidly in such domesticates worldwide where there are lenient regulatory controls in comparison to fully grown developed market economies. There are special legislations for such captives in lenient jurisdictions, not asking for initial high capital injection and also offering tax benefits along with making available developed infrastructure in the form of fully functional capital markets and human resources (Skipper and Kwon, 2008). Impact of captives on the commercial insurance market is huge, as they carry on a worldwide shift by commercial entities that desire a more effective and logical tool of financing the risks. Kloman and Rosenbaum (1982)) pointed out that the growth in captive businesses even in the 1980s was because of the unending pressure from the ever-increasing line of sophisticated risk managers to differentiate and verify each and every aspect of routine insurance transactions. It was also said that many big global companies have just outgrown their risk financing capabilities of the routine insurance market, thus strengthening the deficiency of insurance supply through captive and other options of financing arrangements (Skipper and Kwon, 2008). What is Risk Financing? Risk financing is a process to find the most effective way to finance a known risk. In case insurance is easily available through the traditional marketplace at suitable costs, it is preferable but in case of non-availability of insurance at desired costs, risk financing is the right way of insuring risks. It may include researching alternate ways like self insurance by creating a captive insurer (Capstone Associated Services, 2011). What is a Captive Insurance Company? A Captive Insurer company fulfils primarily the insurance needs of its owners or their associate entities. The parent pools in the growth of the captive that can offer both underwriting profit and investment return. The Captive Insurer not only provides conventional insurance coverage but at the same time covers risks normally not insured in the traditional market. The risk-financing programme of a captive provides flexibility, stability and control (Hodgins, 2012). Companies not in the insurance business get their loss exposures financed by captive insurance entities, the past and most practised type of ART. In captive insurance, the risk gets shifted from the company to the affiliated insurance firm of the company. Such captives are small firms, controlled by specialist captive managers. Captive firms may be simple in structure but their offerings are critically crucial for the interests of their representative companies (Skipper and Kwon, 2008). The Advantages of Forming a Captive Captives are formed for various benefits other than tax savings. Captives serve the parent company’s business interests planned by captives, which are practised because of genuine business needs, authenticated by a feasibility research on the role of the captive company in the concerned business group’s insurance programme. The leading purpose of a captive insurance company is to minimise the long-run risk costs of the parent company. Generally, captives’ costs are lesser than what traditional insurance companies charge (England et al., 2007). A Few Points about Captives The very presence of a captive offers a parent company strategic advantage in settling terms with the commercial insurance market—a significant financial leverage of captives, as it is a pointer to the insurance market that the parent (and associates) have some insight in the functioning of an insurance company and the method of expanding, changing or customising the coverage for the parent group’s comprehensive insurance needs (England et al., 2007). A captive insurance policy can decide insurance policy rates by using market-prevailing premium quotes on an “arm’s length’s basis” for its proprietor-insured customers. In other words, a captive can cover for loss expectancy for possible liabilities on the lines of an independent insurance company although a totally owned subsidiary could provide insurance services to the parent company at reduced rates. The remaining surplus can be used as relevant to insurance company traditions (England et al., 2007). Captives also facilitate their parent companies to act fast to shifts in the commercial insurance market, whether the market strengthens or weakens. A parent company with a captive can take quick action to market ups and downs by having the capability to fund higher holding levels (England et al., 2007). A captive insurance can provide costly or out of reach coverage on easy terms to the parent company or its affiliate group, which could be very expensive in commercial insurance market otherwise (England et al., 2007). A captive by its presence can alert and increase the consciousness level over impending losses to an organisation and can develop a better and effective loss control programme for associates of the captive’s insured group (England et al., 2007). Rogers (1993) discusses a hybrid risk financing option by combining large deductible plan with captive insurer for comp cover because of providing the plus factors inherent in self-insurance. Large deductible employees’ compensation plans do not fully cover the risks attached to financing employees’ compensation if not partnered with captive risk financing. Combined plans have a number of benefits such as the company remains the master of the programme through increased keeping of risk to itself. It also minimises residual market loadings, premium taxes, additional charges and appraisals. Employers are more interested in reducing losses, as it provides leverages from desired loss experiences. In comparison to self-insurance, where the employer needs to adhere to regulation for self-insured rank in each state where it has offices, there could be administrative hurdles, political directions and unpredictable rules. It can become difficult in such cases crossing a state boundary to manage collateral needs of various regulators. Scope of red tape is lesser in large deductible plans insured by a licensed insurer but if taken through a captive, called the captive/deductible plan, risk controlling costs can be distributed better and costs drawn better. The captive offers wise, sound funding for the final losses. A captive/deductible plan, thus, offers not only savings but also serve as a strategic risk managing tool (Rogers, 1993). In the context of employee benefit, captives have been managing business risks with the employers reinsuring their employees’ benefit programmes through captives. Such an arrangement offers the captive diversification of its risk portfolio, enlarging the risk-taking capability of the captive. It is also cost-efficient on benefit provision. Captive can maintain its separate identity by getting third party business for tax saving purpose (O’Donnell, 2008). The Chinese Captive Insurance Market Although worldwide captives have not only been successful in holding the ground but entering new arenas but it has not happened in China where there was no captive until 2000 and only a single captive insurer company has been doing insurance business because the Chinese insurance law comes in the way. Article 69 and Article 72 of the Chinese Insurance Law states: “An insurance company shall be established as either: (1) a stock company with limited liability; or (2) a solely state-owned enterprise,” which was cancelled in revision 2009. Further stipulations include: “The minimum amount of registered capital required for the establishment of an insurance company is RMB200m.” Only selected companies can fulfil the statutory ownership and capital needs (Mei, 2010). The Chinese businesses limited capacity is also a hurdle being small in size. Captives are structured by large companies which are just 0.1% of the total strength. This limited strength of Chinese companies also reduces the capital strength of Chinese businesses. Limited strength results in not only the deficiency of capital needed for the setting up of a captive, but also the deficiency in minimum risk exposures needed by the Law of Large Number (Mei, 2010). Lack of experience in risk management is another cause of the absence of captives in China. The cost of it is so huge that businesses prefer to purchase insurance from the commercial market than from the captives (Mei, 2010). Feasibility Study Evaluation of a captive can be done by conducting a feasibility study on it by testing its advantages to a specific insured group and considering the kinds of risks to be shifted to a captive and the costs, loss and claims record related with such risks. Such a study offers a sitemap on how a captive can be particularly used to fulfil the insurance needs of its owners and related party insured’s (England et al., 2007). Investment Limitations and Capitalisation Needs In all states, there are limitations on allowed investments by a captive. Investments vary from one state to another, therefore necessitating the need to know the rules. All the same, capital needs for a newly established captive ca differ widely from one region to another from less than $150,000 to well above $1 million. The difference depends on a number of elements, including the asked coverage offered by a captive and whether the insureds are linked to the captive or third party (England et al., 2007). Limitations on the Use of Surplus Surplus is the amount of premiums or income that is kept by an insurance company but that is not required for the given time for disbursal of claims. By increasing surplus, captives can increase their capability to keep risk (e.g., to write additional coverage). Captives have some important areas to invest surplus until they are fulfilling essential fundamental condition and their capital base is intact. Intra-group loans are allowed in selected regions significantly for certain purposes. There is a binding limit to maintain minimum solvency needs (ratio of surplus to written premium, loss reserves, etc.), which are to be regulated by each state and country and it is mandatory for all insurance companies, including captives to keep that reserve aside (England et al., 2007). Premiums paid to the Captive One of the advantages to the parent or group having a captive is the tax deductibility of premiums paid to the captive. This is dissimilar from the normal direct self-insured setting, where an insured identifies a tax deduction as losses are paid out over time although losses are actually kept. Taking the example of workers’ compensation losses that occur through an event in one underwriting time, which are given out across many years. The tax deduction is identified till such losses are given out only in the financial period they are paid. Under a captive scenario, premiums are computed by adhering to insurance accounting principles by considering also the future loss exposures in account since the captive is a genuine insurance company. Such planned premiums are presently deductible if the U.S. Internal Revenue Service (IRS) identifies the captive coverage as a genuine insurance setting as against just being in actuality a self-insurance reserve. It is also crucially significant from a group cash flow outlook. It needs to be considered that a captive established as and actually functioning as a genuine insurer can fix deductible insurance loss reserves in the ongoing period for slabs of taken-for-granted risk, earlier kept for by the insured, besides risks currently covered by the captive and linked to later events. The end results of the proceeding are increased cash flow and suspended and possible cut in total taxable income for the integrated corporate group (England et al., 2007). It can be explained through an example as given below in the Tax Deductions and Cash Flow chart, which shows that (i) cash in the amount of the cumulative loss reserve taken to the books of the parent company ($50 million) will be shifted by it to the captive, and taken as a premium payment, in the year the captive starts functioning and (ii) an annual premium ($10 million) will also be paid to the captive in that year, as well as in each of four coming years. Thus, across a five years period, as stated in the example chart, the supposed 80% loss reserve fixed by the captive (against $100 million aggregate premium income) creates integrated tax deductions of $80 million, providing tax savings (at an effective tax rate of 40%) of most probably as high as $32 million during the period (impacting negligible tax on the captive’s net income) (England et al., 2007). TAX DEDUCTIONS AND CASH FLOW (Amounts in Millions) ____________________________________________________________________ Use of Captive Insured Captive Group Transfer of Accumulated Loss Portfolio Reserve by Insured as Premium paid to Captive (Year 1) ($50) ($50) Annual Premium Deduction by Insured (Five years) ($50) ($50) Total Premium Income of Captive $100 Loss Reserve Deduction by Captive (80 percent of Premium) ($80) Net Income (Captive) $20 $20 Net Consolidated Deduction ($80) Tax Deferral @ 40 percent $32 Taxes Evaluating the tax problems in the context of a captive insurance company, it requires, naturally, studying the rules in the domicile in which the captive is to be situated besides the U.S. tax provisions. Thus, for instance, a captive positioned in Bermuda is a foreign insurer for purposes of U.S. tax and the U.S. levies a U.S. federal excise tax of 1% on total yielded reinsurance premiums and 4% straight on property and casualty premiums kept with such captive. If the premiums made by the insured to its captive are not taken as insurance premiums for IRS purposes, they are relieved from this U.S. federal excise tax, but it would result in a loss of U.S. tax deductions linked with the payment since they would not tantamount to be treated as payment for “an insurance premium” (England et al., 2007). A route to avoid federal excise tax is for the offshore captive to take the Section 953(d) choice offered in the U.S. Internal Revenue Code. This choice permits foreign insurers to be treated equal to the U.S. taxpayers. Nevertheless, if such choice is made: The captive would be liable to U.S. tax at the captive level; its losses could not counterbalance profits from other functions under the parent’s group, although losses could be taken forward and used to counterbalance future captive income; This choice is unchallenged unless IRS agrees; Either a security bond or U.S. assets of the captive must be offered; and The aspirant must forego any otherwise relevant tax treaty advantages. There are possibly huge and crucial advantages in taking the Section 953(d) choice. To be sure on one thing, the captive would be taken as a U.S. taxpayer. Therefore, the interest on intercompany loans between the offshore captive and a U.S. parent would not be termed as recouping tax of 30 %. Also, the choice can remove the application of “Subpart F” concerning anti-deferral rules applicable on U.S. shareholders of an off-shore insurance company, known as the “controlled foreign corporation” (England et al., 2007). Direct Placement Tax It is the obligation of the insured parent or associate to give direct placement tax as per that state’s law if insurance is sought from a non-admitted insurer. A captive domiciled in one state is taken as non-admitted insurer in another state. Therefore, the direct placement tax has to be paid by the insured on the basis of net written premium paid to the captive. Besides, there are economic conditions stipulated between the captive and its parental group, which need to be adhered to by both (England et al., 2007). Risk Distribution Traits • In a brother-sister insurance scenario, there need to be at the minimum 12 affiliated corporate policyholders that share their risk. In an association captive setting, minimum number of policyholders is seven. • In case there is no brother-sister relationship and the parent of captive is an insured, the writing of huge business with third party insureds becomes very crucial for deducting premium. Primarily, there must be “substantial” third party business by the captive in the given circumstances (30 % of premium income of captive needs to accrue from third party insureds entities, which are normally taken as enough for premium payment deductibility). • No individual policyholder’s risk should be more than 15 % of the captive’s total maximum exposure to loss. • The bulk of possible loss events are important, which means that it is critical statistically, in the way that data are enough to enable an actuary to provide possibilities to the insurer’s possible underwriting losses. • Shared risks are similar in nature and there is actually a bulk of such risks. • It is most probable that a policyholder bears a covered loss beyond the premium it pays. • A policyholder is not required to pay extra premiums if actual losses cross over the premium during a period of insurance, nor can a policyholder ask for a refund if the premium surpasses its actual losses during the time of insurance (England et al., 2007). Conclusion A captive is structured by a parent company or group to resolve certain issues but it should be noted that the primary job of captive is to provide insurance in a controlled way. Secondly, it is established to finance risks at lesser cost. It is not the motive to save tax but a captive provides the incidental advantage in saving tax. Both the adherence to regulations of a specific jurisdiction, and IRS perspective on captives are dynamic areas. Therefore, before implementing a captive programme, communication with the governing bodies of the would-be domiciled state needs to be made. Finally, it is very important to conduct a feasibility study to create a customised business plan fit for to the specific captive setting so that a captive ideal makes essential business sense for a corporate group. References: Capstone Associated Services. 2011. How widespread is captive insurance planning? Available from: http://www.capstoneassociated.com/faqs.html [Accessed 5 January 2012]. England, Phillip., Druker, Isaac E. and Keenan, R. Mark., 2007. Captive insurance companies: a growing alternative method of risk financing. Journal of Payment Systems Law. Available from: http://www.andersonkill.com/webpdfext/cic-riskfinancing.pdf [Accessed 5 January 2012]. Hodgins, Peter., 2012. Captive insurance in Dubai. Clyde & Co. Available from: http://www.clydeco.com/knowledge/articles/captive-insurance-in-dubai 2012 [Accessed 5 January 2012]. Mei. Xue., 2010. Do captive insurers have future in Chinese market? Central University of Finance and Economics, Beijing, China. Available from: http://www.apeaweb.org/confer/hk10/papers/xue_mei2.pdf [Accessed 5 January 2012]. O’Donnell, George JD., 2008. Employee benefit captives: their role in managing enterprise risk. AON Consulting. Available from: http://www.aon.com/about-aon/intellectual-capital/attachments/human-capital consulting/Benefits_Captives_041608.pdf [Accessed 5 January 2012]. Rogers, Michael T., 1993. A hybrid risk financing option: combining large deductible plan with captive insurer for comp cover. Crain Communications Inc. Available from: http://www.captive.com/service/RiskServices/A%20hybrid%20risk%20financing%20option.pdf [Accessed 7 January 2012]. Skipper, Harold D., Kwon, w. Jean., 2008. Risk management and insurance: perspectives in a global economy. John Wiley & Sons. Available from: http://books.google.co.in/books?id=WePA0D3D1A8C&pg=PA330&lpg=PA330&dq=role+of+captive+insurers+in+insurance+and+risk+financing+market&source=bl&ots=f2htuLmHmq&sig=LzEtcJvVcmWAF6UUarovVX27tBE&hl=en&sa=X&ei=YbgCT4CxFYTYrQfc3LyhDQ&sqi=2&ved=0CGEQ6AEwCA#v=onepage&q=role%20of%20captive%20insurers%20in%20insurance%20and%20risk%20financing%20market&f=false [Accessed 7 January 2012]. Read More