Captive Insurance Company-Nutshell - Term Paper Example

CORPORATE RISK MANAGEMENT Captive Insurance Company-Nutshell A Captive Insurance Company is, in a nutshell, an insurance company formed by a businessowner to insure the risks of the operating business, i.e. a wholly owned insurance subsidiary of a non-insurance parent, which is used to self-insure the risks of the parent and associated companies. The operating business pays premiums to the captive, and the captive insures the risks of the operating business. A captive is much more than an exotic form of self-insurance: It is the creation of a new insurance company that has the potential to grow from being a mere captive into a full-blown insurance company seeking to profit from underwriting the risks of others. The concept of the captive insurance company is not new at all. Many of the insurance companies formed during 18th and 19th centuries in UK, and later in the United States, would be regarded as captives if they were formed today. The growth in domestic captives was a feature of the insurance market in the early part of this century but it was not until the 1960s that the benefits to be gained by incorporating offshore captives were widely recognized. Most developed countries enacted legislation to regulate insurance business but successive amendments often resulted in simple laws becoming complex statutes which were difficult to understand. With legislation being largely designed to protect the consumer, corporations sought alternative methods of securing insurance for their own risks. It was soon recognised that by forming offshore subsidiaries, companies could arrange insurance cover appropriate to their needs and very often at a reduced cost. There was also the added benefit to the subsidiary of being able to maintain reserves and accumulate earnings in a low or no tax area which was also relatively free of over-restrictive regulation. The offshore captive was born. The offshore insurance market developed in a number of small territories which were perceived to be politically stable and whose laws were conducive to the conduct of insurance business. These territories also boasted relatively good communications, financial and legal services, low taxation and were free of monetary controls. The continuing increase in the number of captives being formed is a reflection of their general acceptance globally and an appreciation of their being a long term financial tool with significant advantages for many organisations. In the last 20 to 30 years there has been phenomenal growth in the number of captive insurance companies, especially the last decade. Today there are well over 5,000 captives worldwide writing more than $20bn in premium. These companies have capital and surplus estimated at over $50bn. The greatest stimulus to the development of captives has been the expense or lack of availability of certain types of insurance cover in the commercial market. Other considerations apply, however, and these have become so important in the minds of risk managers and finance directors that, even when commercial premium rates have been extraordinarily low, the interest in captives has been greater than ever. The U.S. dominates the captives market. Fully 30% of all captives are domiciled in the U.S., and even most of the offshore captives have U.S. parents. Doubtless, this is due to the peculiarities of the U.S. tax code which disallows an ordinary company from accruing reserves against future claims, but allows another company within the same economic family (the captive) to do precisely that. The point is that captives are a recognized and established planning tool for U.S. businesses. Captives are great planning tools and there is now a whole industry that supports them. Yet, captives are poorly understood by both business owners and business planners. Where should the Captive Insurance Company be located? Ideally, A Captive Insurance Company should be located offshore based on three factors, i.e. Legislative restrictions, Taxation and Exchange control and investment flexibility. Legislative Restrictions: Regulations governing the operations of insurance companies in most major countries are designed for insurance companies soliciting business from the general public. This means the captive would be subject to the strict legislative requirements to maintain the same standards as a major commercial insurance company, especially related to “Minimum capital levels, Solvency tests and minimum reserve levels, Stringent reporting procedure, Public disclosure of financial statements, Investment of reserve funds” etc.. Taxation: One of the advantages of a captive insurance company is the generation of cash flow benefits to the corporate group through the deferment or reduction of tax liabilities. Payment of insurance premiums to a captive insurance company will generally be tax deductible to the insured group members. If the captive insurance company is in a taxable jurisdiction, the gross premium received will be taxable although deductions can be made for reinsurance premiums and overhead expenditure. Exchange Control and Investment Flexibility: Accumulated net premium funds held by the captive insurance company, under the control of the corporate group, offer a flexible investment policy for prudent investment. This is often not possible for domestic captive insurance companies because of legislative requirements controlling the investment of accumulated funds. Many countries also restrict investments through local exchange control regulations, thus reducing the potential of an international investment portfolio. Summary: Evidence of this interest is provided not only by the number of captives being formed but also by the increasing number of domiciles available for their incorporation. Long-standing domiciles, such as Bermuda, the Cayman Islands, Guernsey, the Isle of Man and Luxembourg have been joined by the likes of Vermont, the British Virgin Islands, Gibraltar and Dublin. Worldwide, 2004 was a red-letter year for captive growth. Onshore and offshore captive domiciles reported record growth in captive formations. Despite the widespread growth in captives, some domiciles fared better than others. One domicile that continued its fast pace is Vermont. Already the largest U.S. domicile, and third largest worldwide, Vermont continued to add to its totals. But what is the reason that this small, Northeastern state continues to come up big in captive formations, year after year? Over the years, captive insurance companies and Vermont have become synonymous. Today, we take these kinds of things for granted but 24 years ago, they were quite innovative. Vermont has maintained this leading edge approach and continues to refine its captive laws as needed. Types of captive In its simplest form a captive can be defined as a wholly owned insurance subsidiary of an organisation not in the insurance business whose primary function is to insure some or all of the risks of its parent. There are now many types of captive, including: Single-parent captives, Association captives, Agency captives, Rent-a-captives Special purpose vehicles (‘SPV’s) etc. Reasons for forming a captive insurance company Risk Management: Risks are encountered at various stages in the life of a corporate venture. Some of these risks are not only inevitable, but also inherent in the game of business itself. Risks can take the form of opportunities or dangers. When it is considered as an opportunity, the greater the risk of the activity, but greater will be the chances of return from the project. Risks are measurable and can be managed. Recognizing risks, which are key decision points or events lies at the heart of active management of a venture. As a concept, Risk Management can be defined as the process of measuring, or assessing risk and then developing strategies to manage the risk. In general, the strategies employed include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the consequences of a particular risk. Captive method: It is popularly thought that a captive is primarily a tax minimisation device. In fact, captives are usually formed for other economic reasons with the main drivers being risk management and risk financing. Some of these reasons are summarised below. Risk management. A captive can act as a focus for the risk management and risk financing activities of its parent organization. An effective risk management programme will result in recognizable profits for the captive. Risk management can be viewed by a captive owner not as a cost centre but as a potentially profitable part of the company’s activities. A captive can also be used by a multinational to set global deductible levels by enabling a local manager to insure with the captive at a level suitable to the size of his own business unit while the captive only buys reinsurance in excess of the level appropriate to the group as a whole. Lower insurance costs. Commercial market insurance premiums must be adequate to meet the cost of claims but, in common with other commercial enterprises, insurers are in business to make money and will therefore include in the premium an element to provide for their acquisition costs, overheads and profit. Cash flow. Apart from pure underwriting profit, insurers rely heavily on investment income. Until claims become payable the premium is available for investment. Risk retention. A company’s willingness to retain more of its own risk, may be frustrated by the inadequate discount offered by insurers to take account of the increased deductible and by the fact that the company is unable to establish reserves to pay future claims. Establishment of a captive can help address both these problems. Unavailability of coverage. Where the commercial market is unable or unwilling to provide coverage for certain risks or where the price quoted is seen to be unreasonable, a captive may provide the cover required. Access to the reinsurance market. Reinsurers are the international wholesalers of the insurance world. Operating on a lower cost structure than direct insurers they are able to provide coverage at advantageous rates. Writing unrelated risks for profit. Apart from writing its parent’s risks, a captive may operate as a separate profit centre by writing the risks of third parties. In particular, an organisation may wish to sell insurance to existing customers of its core business. Tax minimisation and deferral. The tax considerations in forming a captive will depend on the domicile of both the parent and the captive. Integration of a captive as part of an overall tax planning strategy is a complex subject so that professional legal and tax advice is essential. A captive may be either a direct writing company or a reinsurer. Particularly in the case of smaller captives, it is simpler for the captive to operate as a reinsurer accepting the risks of its parent, which have been insured by a licensed direct-writing company (a fronting company) and then ceded to the captive. The fronting company will charge a fee for its services and may require a letter of credit to guarantee the captive’s ability to pay claims. Where the risks to be covered can be written by a non-admitted insurer or where the captive is admitted in the territory where the risk is situated, direct writing is possible Captives come in all shapes and sizes and are owned by individuals as well as corporations. Although, the formation of a captive is not for everyone, the scope of captives is much broader than is generally imagined and in appropriate circumstances a viable captive can be formed with a relatively small premium income. Establishing a Captive The first step in establishing a captive is to commission a feasibility study from professional advisers. The feasibility study should examine risk exposures, loss experience, the existing insurance programme, expected future growth trends at the parent company and all matters which impact upon the decision as to how best to design a vehicle for medium-term risk financing. Once the feasibility study is carried out, the other important steps to be focused in establishing a Captive are: Establishing captive and reinsurance programmes, Company formation and licensing, Bookkeeping and accounting, including annual statutory financial statements and periodic management reports, Daily administrative services and coordination of other service providers, Establishing underwriting procedures and sitting on underwriting committees, Advice on policy drafting and coverage and drafting of reinsurance contracts;, Claims administration and loss control etc.. Most common types of Insurance cover offered: The captive insurance company may insure almost any form of insurable risk, however the most common types of insurance cover affected through captives are: Product liability coverage, General property and casualty coverage, Medical malpractice liability, Workers compensation, General property (usually minor claims), Loss of profits, Marine-cargo and hulls, Employee benefits, Group pension plans, Casualty, Products recall, Product liability, Pollution liability, Expropriation of assets, Nuclear explosion, Currency devaluation etc.. Pitfall of the Captive concept The objective of financial risk management is to protect to planned profit development from adverse movements in financial markets. Captive insurance company, as it exists today does not address risks related to, foreign currency risk, Transaction risk, Translation risk, Interest rate risks, Liquidity risk, Credit Risk etc… Most companies still rely on planning, budgeting, and reporting techniques that have not changed since 30s and 40s. Requirement of today is a more dynamic planning system that considers both operational and financial drivers of performance while explicitly addressing risk and variability. What is missing is a systematic, objective, and comprehensive framework that assesses all of the non-financial variables contributing to an organizations risk profile. Conclusion Most industry experts agree that despite the current softening insurance market, the captive movement will continue. The increased sophistication of insurance buyers coupled with the vagaries of the traditional insurance industry will continue to generate captive formations. In addition, there continue to be affordability and availability issues in some lines of coverage. Thus we can come to the conclusion that the statement There is no doubt that a captive insurance company as an integral part of risk financing policy is here to stay of Paul Bawcutt, in 1997, has proven as an established reality. Works Cited Axson, David. (2003). Business Performance Management. Operational Risk Management: A New Performance Management Imperative. OutlookSoft Retrieved April 30, 2007 from http://www.bpmmag.net/magazine/article.html?articleID=13971 Financial Risk Management. (2007). Nokian Tyres. Retrieved April 30, 2007 from http://www.nokiantyres.com/financialrisks_en Captive Basic. Description. Captive Resources. Retrieved April 30, 2007 from http://www.captive.com/CaptiveResources/captive_basics.html Eveleigh, Martin. (2005). Captive Insurance Companies – What Are They? Definitions. Captive.com. Retrieved April 30, 2007 from http://www.captive.com/service/kpmg/kpmg_article2.html Schiraldi Frank. P. (2004). Report on Examination of CM Insurance Company, INC. As Of December 31, 2002. Retrieved April 30, 2007 from http://www.ins.state.ny.us/exam_rpt/21640f02.pdf Finkel, Adam M. Comparing Risks Thoughtfully. Risk Articles Index. Retrieved April 30, 2007 from http://www.piercelaw.edu/risk/vol7/fall/finkel.htm Read More