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Alternative Risk Mechanisms: Captive Insurance Strategies

Daniel I. Simon, Attorney at Law, Solvang, California, USA

The article deals with the rationale, design, and implementation of captive insurance companies, and their potential benefi t to basic Russian commercial enterprises and to the Russian fi nancial services sector and its customers as well1. The article also provides a defi nition of captive insurance companies, describes their structure and types;, lists their advantages and analyses some statistics relating to the Russian insurance market.

The purpose of this article is to provide a primer or basic guide to the history, use and implementation of captive insurance companies for a Russian audience.  The basic content is drawn from US, European, Asian experience and sources.  It is pragmatic in its approach and general in its scope.  It is not intended to be a definitive statement on the use, design, formation or implementation of captive insurance companies.   It should be considered as a point of departure, for those readers new to the subject, which provides a glimpse of the captive environment, an explanation of the terminology associated with it, and a hint at the exceptional value of the concept.

Although this article concentrates on the mechanics of designing and implementing a captive insurance company, it is important to point out the ancillary benefits which may accrue to the financial services industry and its infrastructure in Russia.

It should also be noted that Russia does not seem to have any statutes which deal specifically with the concept of captive insurance companies.  Their creation neither seems to be allowed or prohibited within Russian borders.  There is also an absence of any legislation which allows or prohibits the “use” of captive insurance companies by domestic Russian companies, whether existent within Russia or “offshore.”  To create a proliferation of the captive insurance concept within Russia, appropriate legislation may be required.

The growth of the US captive market did not really accelerate until the normal insurance markets and infrastructure entities recognized its potential rewards.  Innovative Russian financial services companies and their principals may want to consider the following scenario and specific cast of characters:

Banks began to take an interest in captives when State regulators required certain specific security measures to collateralize reinsurance receivables and claims’ payments through the use of mutual trust funds and letters of credit.  They also became depositories for large amounts of capital and investment funds, as well as investment managers for those funds;

Insurers and reinsurers achieved major roles servicing clients, who had established captives for themselves, by offering fronting, reinsurance, and all manner of stop loss and excess of loss programmes designed to protect the financial integrity of the captive.

Investment managers realized that captives needed the same advice and service that traditional insurance companies needed to manage the captive’s funds and insure liquidity;

Accountants became more involved with captives in order to keep appropriate records and deal with taxation issues;

Actuaries became very important when loss forecasts and modeling was necessary to maintain the credibility of the captive;

Brokers found a niche for themselves when designing fronting and reinsurance programmes;

Claims managers took on loss adjustment and claims’ management for major captives;

Attorneys were slow to come to the table, but are now fully involved in all of the major aspects of captive design, implementation, regulation, dissolution and taxation issues.

Government Regulators became a mandatory necessity in most domiciles to safeguard public, private and governmental interests.

Considering all of the above players, who are then supported by hospitality and travel service workers, travel agents, food and beverage purveyors, conference organizers and the myriad of other unidentifiable members of the international workforce, it is quite apparent that the captive insurance industry has had a definite and positive effect on the world economic stage.

 

Definition of Captive Insurance

A captive insurance company is defined as: “an insurance company that primarily insures the risks of businesses which are related to it through common ownership.”

“The term "captive" comes from the "father of captive insurance", Frederic M Reiss, who coined the term while he was bringing his concept into practice for an industrial client in Ohio in the 1950’s.  The term "captive" came to Reiss when working with his first client, the Youngstown Sheet & Tube Company. The company had a series of mining operations and its management referred to the mines whose output was put solely to the corporation's use as captive mines. When Reiss helped the company incorporate its own insurance subsidiaries, they were referred to as captive insurance companies because they wrote insurance exclusively for the captive mines. Reiss continued to use the term for his concept, and both the captive and the term have adopted a far wider context. The term also made sense as the policyholder owns the insurance company i.e. the insurer is captive to the policyholder. If the captive only insures its parent and affiliates it is called a pure captive” [1].

There are five types of domestic and offshore captives:

  • (1) parent-only or pure captive;
  • (2) association or industry captive;
  • (3) agency captive;
  • (4) quasi profit center or open market captive;
  • (5) protected-cell/segregated account companies.

 

Why a Captive?

  In a traditional scenario when a company needs to cover its property and casualty risks, it seeks out traditional insurance coverages.  This normally requires it to use the services of an insurance broker or agent to act as its representative to the insurance market.

  The client (“Buyer”) and its Broker review the coverage requirements.  Does the client need to cover potential real property/improvements, or does it just need casualty coverage for its business operations or a combination.  What levels of protection are needed?  This is the classic discussion of first party versus third party risk evaluation.

  The Broker then takes a Proposal or Application to an underwriter at various insurance companies (“markets”), after an evaluation of which, the underwriter may issue a coverage proposal/policy, priced to cover the needs of the BOTH the insured and insurer.  The calculated premium will contain factors for the pure insurance, the marketing costs (commissions to Broker), reinsurance costs and taxes.  These cost elements (excluding pure insurance and reinsurance) may often amount to 25% to 45% (or more) of the total premium charged to Buyer.

  Buyer and Broker review the Proposal and Policy and accept it.  Buyer pays the premium; Broker gets it commission from the Insurer, and the balance of the premium remains with the insurer.  From that point on, the only contact the Buyer may have with the insurer is in the event of a claim or loss.  At which time, the claim is presented to the Insurer, which may or may not honor the claim.  In most instances, with or without claims or losses, the Buyer never sees any portion of the paid premium again.

An alternative to the above scenario (which is why this paper is entitled “Alternative Risk Mechanism”) is the formation of a captive insurance company.  A captive will allow the Buyer (“Parent) to keep much of its premium under its control, eliminate most of the commission and taxes as a cost element, control losses, and develop an insurance entity which builds its net worth over a period of time.  All of this at a cost equal to or less than traditional insurance programmes.Why then don’t more Buyers have captives of their own?  The following discussion looks at the ramifications of forming and owning a captive.  It is not always an exercise for the faint of heart, and it carries with it a learning curve of some magnitude for the Buyer’s management team. However, once the learning curve has passed, it is more often than not determined that a captive was a good idea!

 

Traditional Insurance Concepts Comparisons

The most recent prestigious Swiss Re sigma study on world insurance in 2012 shows premium growth resumed, reaching 2.4% despite a very challenging economic environment (26 June 2013, Zurich):

  • Non-life premium growth picked up to 2.6% in 2012, while life premiums resumed growth, rising by 2.3%. Overall premium volume expanded, but developments in Western Europe, China and India weighed on the result.
  • Premium growth will likely improve further in the near term. The gradual hardening of prices in non-life insurance is likely to broaden and deepen. In life insurance, China and India are expected to rebound in 2013. However, the weak economy in the Eurozone will remain a drag on insurance demand in the region.
  • Asian insurance markets will continue to rise in importance over the next 10 years. In the very long-run, projected population patterns suggest that Africa could become the next star of the industry.

Swiss Re’s latest sigma study reveals that total global premiums written increased by 2.4%1 in real terms in 2012 to USD 4 613 billion. Life premiums expanded by 2.3% unwinding some of the contraction in 2011, thanks to improvements in emerging markets and solid demand in the US and advanced Asian markets. In non-life, premiums rose by 2.6% on the back of continued economic expansion in emerging markets and selective price increases in some advanced markets. Profitability of life insurers remains subdued but non-life underwriting results improved modestly. Low interest rates continue to depress investment income, but are boosting reported accounting capital and solvency levels under Generally Accepted Accounting Principles (GAAP).

In the last 30 years the growth in the number of captive insurance companies has reached well over 6,000 captives.  On a worldwide basis, the premium writings exceed more than US$20bn. These companies have capital and surplus estimated at over US$50bn.  

 

Russian Market Statistics

”The size of the Russian insurance market (other than compulsory medical insurance) in 2013 will approach 930 billion RUB (30 billion USD), strengthening Russia's position in the global insurance market. The key growth driver will remain the continuing (albeit not as strong as in the previous year) growth in the lending market.

Despite this ongoing growth, profitability remains a challenge; insurers believe that the main focus will shift from achieving high premium growth figures to increasing profitability through cost optimisation and deeper risk analysis. In the present conditions, insurers cannot achieve high figures in all market segments at once and are concentrating on the areas where they have the most significant competitive advantages. The latter include focus on the client, improving business process efficiency and further cost optimisation. 

In recent years, the Russian insurance market has seen significant legislative changes, in the shape of tighter capital requirements, the transition to mandatory IFRS reporting, the introduction of new mandatory classes of insurance, and the start of the process of creating a single financial regulator. Even so, most insurance company bosses believe that insurance law in Russia needs further refinement, particularly with regard to control over the activities of brokers and financial reporting.

The attractive growth in the market, together with the recent increase in the limit on foreign capital is providing foreign players with a good opportunity to enter the market. However, while the market participants expect the number of mergers and acquisitions in the Russian market to increase in 2013 and 2014, they believe that these deals will mainly involve domestic insurers"[2].

 

Origins of Captive Insurance Industry

The captive insurance industry can be said to have its origins in the formation of mutuals and co-insurance companies in the 1920s and 1930s. However, the start of the real growth of the captive industry can be traced to the early 1950s and the move by parent companies to establish their captives in offshore domiciles such as Bermuda. It has only been in the last ten to fifteen years that individual US States have established “captive” legislation and allowed the formation of such entities domestically.  The leaders in this movement have been Colorado, Arizona, Vermont, New Hampshire and Hawaii.

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.

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 since been joined by the likes of Vermont, the British Virgin Islands, Gibraltar and Ireland. In a move that demonstrates forcibly the emergence of captives into the mainstream of the insurance and risk management arena, the Council of Lloyd’s passed a by-law in November 1998 permitting the establishment of captive operations at Lloyd’s.

 

Advantages

Recently, private citizens have also recognized the utility in creating and using a captive insurance company as a means of protecting their own assets while realizing tax benefits. The significant difference between captive insurance companies and traditional insurance companies is that captive insurance companies deal with a restricted risk that the company underwrites or reinsures. Many companies are incorporated in offshore financial centers which offer several advantages.

Some of the advantages in offshore financial centers include:

  • (1) less restrictive insurance regulation;
  • (2) freedom from exchange control;
  • (3) absent or low rates of taxation;
  • (4) faster implementation
  • (5) lower capital/surplus requirements
  • (6) freedom in choice of written risks
  • (7) lower associated infrastructure costs

 

Structure

         There are five basic types of domestic and offshore captives:

  • (1) parent-only or pure captive;
  • (2) association or industry captive;
  • (3) agency captive;
  • (4) quasi profit center or open market captive;
  • (5) protected cell/segregated account companies.

The parent-only or pure captive is a wholly owned or controlled company that only insures or reinsures the risks of its non-insurance parent or affiliated companies. An association, or industry captive, is owned by a group (i.e. doctors) for the sole purpose of insuring or reinsuring their risk. An agency captive is a company that is owned by insurance brokers or agents who sell insurance and then reinsure a portion of that insurance with their own captive company. A quasi profit center, or open market captive, is one that insures or reinsures the risks of its parent or affiliated companies and, at the same time, insures the risks of unrelated parties.  The protected cell/segregated account company allows for joint participation and cost sharing by multiple entities without cross liability between cells or accounts.

The typical captive is a parent-only captive covering “mandated risks,” and which may also entertain certain “open market” types of coverage from related third parties, such as normal property/liability insurance.  There are specific regulations for each type of company and these differ in every country. The requirements for reinsurance companies are generally not as restrictive; therefore most offshore captives are established basically as reinsurance companies. This means that the policy is first purchased from a domestic insurer which writes the primary policy and then it transfers all or part of the risk back to the captive. Each type of captive caters to specific business goals. There are also specific rules pertaining to insurance companies, and they change frequently.

 

Rationale

Marsh, 2009 Captive Benchmarking Report

There are many different reasons for establishing a captive insurance company, but it is a general rule that more than one of the following reasons must be present in order to make establishing a captive insurance company worthwhile:  

(1)       There are cost reductions. Insurance companies have many costs that can be reduced or eliminated by using a captive insurance company. Two of those costs include overhead and profit which can be as much as 40% of the premium. A captive insurance company will not eliminate all costs, but they will be significantly reduced. Other costs which may be significantly reduced by using a captive insurance company include: administration and settlement of claims, loss control expenses, various state and federal taxes, brokerage commissions as well as other acquisition costs, and consulting fees.

(2)       There are additional benefits, such as insuring the uninsurable. Due to changes in the market and competition, at times, insurance companies drop coverage for certain types of insurance. These risks are considered uninsurable. A captive insurance company will insure the uninsurable.

(3)       Consider the stability of the market. Regardless of the changes in the insurance market, the person looking for coverage can be confident that there will be coverage at a reasonable price.

(4)       Risk retention, risk management and loss control should be taken into consideration. For the types of risk where self-insurance is not permitted and tax deductibility is not available, an offshore captive reinsurer may enable a company to achieve these objectives, subject to reasonable fronting costs.

(5)       There exist cash flow benefits. So long as a captive insurance company is adequately capitalized, it does not need to rely on future payments as much as other insurance companies. Therefore, the captive insurance company, rather than the conventional insurer, reaps the benefits of the premiums.

(6)       A captive insurance company can reinsure through an international insurance company which is generally less expensive than conventional direct excess and umbrella coverage.

(7)       A captive can diversify into open market insurance services and operate as a separate commercial profit center. 

(8)       A reduction of government regulations and restrictions which results in there being more investment opportunities for captive insurance companies.  

(9)       The insured was not satisfied with the services provide with the conventional insurance company.

(10)     Tax minimization and deferral. Although tax reasons should not be a primary consideration in forming or using a captive insurance company, the inevitable result is that there are a number of tax advantages. There are two main tax benefits to using or establishing a captive insurance company. The first is that there is an accumulation of tax-free underwriting and investment earnings. The second is that by using an offshore or foreign captive, a company may be able to utilize foreign tax credits that would otherwise expire.

Also, many complex rules regarding insurance structures exist. There is also considerable anti-avoidance tax legislation in countries such as the US, UK, Japan, and Germany, so expert advice must be sought before incorporating a captive. Expert advice should also be sought because there may be other alternatives to using a captive insurance company which better suit the needs of the client.

One of the alternatives is a self-insurance programme, which will offer some of the same benefits of a captive insurance plan. However, this may not be allowed by domestic tax legislation and it may not be tax effective.

Another alternative is using a retrospective rating plan policy where an initial or deposit premium is paid and then retrospectively adjusted based on the actual loss experience of the insured. Also the optimum use of deductibles, which may be available from a direct insurer in exchange for a discount from the basic premium rate, could be a consideration. A feasibility study should be done to research the above alternatives and determine what is in the best interest of the parent company. 

 

Captive Management

Captives require management just like any other company.  Normally, the parent company does not have the expertise to manage the captive and therefore it looks to outside experts for the necessary support services.  Also, most foreign jurisdictions require that the captive be managed by an on-island, qualified manager in order to meet statutory standards.  In many jurisdictions, the on-island manager has strict fiduciary duties to the client, and disclosure responsibilities to the regulators.  The following list is representative of services normally furnished by most captive managers.

1. Accounting

Includes:

  • Keeping books and records
  • Paying company expenses, including both administrative expenses and losses
  • Collecting receivables, including premiums, investment income and reinsurance recoveries

2. Financial Reporting

Includes:

  • Providing periodic financial statements to directors and shareholders
  • Providing periodic benchmarking analyses for directors and shareholders
  • Providing annual financial statements for audit review; assistance to auditors for a smooth audit; and assistance to tax advisers in preparing tax returns
  • Filing premium tax returns
  • Preparing annual budgets
  • Filing goods and services tax returns

3. Investment

Includes:

  • Assisting the Board of Directors in establishing investment policies
  • Monitoring cash flows and projecting cash-flow requirements, to identify excess cash for investment
  • Investing excess cash in accordance with investment policies established by a Board of Directors
  • Monitoring investments

4. Legal Assistance

Includes:

  • Ensuring the captive is in compliance with all applicable insurance regulations
  • Ensuring the captive is in compliance with the local “Companies Act” -- Holding annual meetings of shareholders and directors, filing annual returns
  • Ensuring that the principals are in compliance with such legislation comparable to the US Foreign Corrupt Practices Act
  • Ensuring that the company management has installed all procedures in compliance with local and international Anti Money-Laundering requirements

5. Insurance

Includes:

  • Coordinating the preparation of insurance and reinsurance agreements
  • Liaising with the captive's actuarial consultants; includes annual loss-reserve analyses, where required
  • Monitoring underwriting results to ensure actual results approximate the business plan; if not, the design of the programme may have to be changed, by changing either retention levels or the reinsurance programme
  • Claims-handling procedures, which vary considerably from captive to captive, but generally the captive will be authorized to settle claims up to a certain level, with ultimate settlement authority resting with the parent company; a specific claims procedure should be developed, agreed upon by the Board and implemented

 6. Regulatory Issues

Includes:

  • Assisting with preparation of the initial application for licensing as a captive insurance company:
  • Ongoing liaising with the regulators, informing them of changes to the captive programme and obtaining prior approval from the relevant regulatory authority for certain actions requiring such
  • Submitting annual applications for captive-insurance license renewal
  • Not all captives require each of the above services, and some may require additional services or variations of those listed. It is recognized that many companies change their structure and business plan after a period of operation; a management company that offers all of the above services can ensure the captive is always fully utilized under any circumstances.”

 

Feasibility Study

A feasibility study is very important before committing to a captive insurance company. It is also important that the feasibility study be complete and accurate. A complete feasibility study should satisfy a number of criteria.

First, there should be a level of capitalization and premium volume that will make the captive financially viable.

The second is that there is efficient risk management and loss control.

The third is that there is a reliable fronting arrangement and good quality reinsurance.

The fourth is a commitment from the parent's management to support the captive with adequate finance and expertise.

The fifth is the availability of competent management services to operate the captive.

A person or entity should only commit to a captive insurance company after all of these criteria have been researched, evaluated, and benefits found for the client. After a company determines a captive insurance company is in its best interest, it must then decide on the location of the company.

The basic elements of a feasibility study are:

(1)   Data analysis should include studies based on estimates of expected frequency and severity of loss using available data. These estimates may be derived from: trended and developed historical loss data; outside sources of data (ISO, RAA, etc...); expertise within the firm; and judgment. It should be noted, however, that judgmental estimates should be disclosed as such and the source clearly stated. Judgmental estimates may be accepted as long as they are clearly disclosed.

(2)       Loss projections and risk margins of expected and higher-than-expected levels of loss should be included. These projections and margins are either actuarially determined or stated as such, or the methodology used is clearly documented. In all loss projection sections, each step should be explained in terms of how and why the procedure was used.

For example, how is trend and loss development handled? Are losses discounted for the time value of money?

(3)       Expense budgetfor the captive insurance company should be clearly discussed. In addition, the feasibility study must make reference to tax issues. The tax issues should address, either the state that the captive insurance company is subject to within the models, or that the captive insurance company is not subject to tax consequences. Should the feasibility study state that the captive insurance company is not subject to taxes of certain jurisdictions, the reasons for this must be clearly documented.  Tax consequences may be an extremely important consideration of captive insurance company formation. Types of tax issues may include but are not limited to the following:

. Income tax - to the captive, to the owners

. Excise taxes

. Excess and surplus lines taxes

. Domicile premiums taxes

. Local premium taxes

. Other assessments or applicable taxes (i.e., residual market mechanisms)

(4)       Premiums/Funding items (2) and (3) should be brought together in order to develop the total recommended premium for the captive.

(5)  Capitalization is needed to cover the variability and uncertainty of expected loss levels. Therefore, a relatively extensive discussion of capitalization should be included in the feasibility study. Included in the discussion should be a review of minimum participation requirements and any heuristic logic used in determining capitalization.

 

Criteria for Domiciles

         There are numerous criteria to consider when determining the location of a captive insurance company.

(1) The country should be politically and economically stable.

(2) The country should have flexible and acceptable legal and regulatory framework.

(3) Research the tax-free status or reciprocal tax treaties, depending upon the particular tax planning objectives.

(4) There should be competent local management, professional, and business services.

(5) The country should have few exchange controls and there should be an ability to transact business in principal international trading currencies.

(6) Finally, the country should have convenient travel and communication services.

 

Conclusion

There are many benefits to utilizing a captive insurance company. However, extensive research is a critical antecedent action before deciding to utilize those benefits. Furthermore, because the rules are complex, and often deal with at least two countries at the same time, and on multiple levels and disciplines, it is important to have expert assistance in the evaluation and decision-making process. It will be crucial to research and verify the results of a captive insurance company in an application associated with specific parameters. Creating a captive insurance company is a business decision and may not be the best choice for every company, but it is certainly worth investigating.



[1] Available at: http://en.wikipedia.org/wiki/Captive_insurance.

[2] Reward for risk: the insurance market in Russia in 2013, KPMG, Russian Market Survey, 2013.