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Captive Insurance Companies: a Lawyer’s Perspective

Ian Mathers, LLB (Lond), LLM (Cantab), BSc (Lond), ACII, Legal Consultant, London, Great Britain

The use of captive insurance companies has increased substantially in recent years, including by businesses in Russia, as their advantages as compared with self-insurance or insuring in the commercial market have come to be recognised. Th is article examines the principal features of captive operations, in particular those on which lawyers may be called upon to advise.

Introduction

A captive insurance company (or “captive”) is, in simple terms, a privately owned company that insures or reinsures its owner’s business. 

The principal rationale for captive insurance companies arises from the greater level of physical risk control exercised by the parent company, which permits the insurance programme to be priced at a lower level than the insurance market can offer, and also permits greater flexibility in policy covers and wording.  A captive insurance company may operate either as an insurance or reinsurance vehicle or both.  Captives are today often domiciled in jurisdictions that specialise in captive insurance and host a range of specialist skill sets, namely lawyers, accountants, banks with related products, actuaries and insurance managers.  In the past, there was no supervision of insurance and reinsurance in some jurisdictions, and a number had a low or no-tax regime.  However, the position has changed significantly in recent years, with some jurisdictions seeing economic advantage in developing a basis for this business which would receive international recognition.  In a number of cases, a specific regulatory framework has been established for captives that recognises their structure and operation.

Most captives only insure (or reinsure) the risks of their owners.  Many captives have an exposure to third parties by underwriting classes of business such as employers’ liability or workers’ compensation.  Some captives also have an exposure to unrelated parties.  Third party risks will normally have to be insured through insurers licensed in the country where the risk is located.  The parent company or its subsidiaries may not be permitted to insure certain classes of business directly with the captive, and the risk is accordingly often insured with a commercial insurer which in turn reinsures with the captive (“fronting”).  Typical risks that a captive could insure include property and business interruption, product liability, employer’s liability and workers compensation, marine, transit, personal accident and, in some cases, life.  Sometimes also directors and officers and professional indemnity insurance may be written.  Captives tend to avoid writing long tail business, which can inhibit winding up if there should be a change of circumstance.

 When a company is considering the establishment of a captive, it will need to weigh the resulting benefits against the costs of establishment, operation and tied up capital, as well as the risk of adverse results, particularly if the captive writes unrelated business.  Care should also be taken to ensure that the captive is not established in a jurisdiction which restricts the repatriation of dividends through exchange and other controls, potentially inhibiting cash flows or financial support to the captive.

As a rule of thumb, companies or groups with $500,000 or more in operating profits and risk which is currently uninsured or underinsured will be in the best position to derive substantial advantage from the exercise.  In all cases, a feasibility study with an end-calculation of potential net benefit will be required.

There are now around 6000 captive insurance companies worldwide.

 

Kinds of Captives

Captives may be roughly divided into the following kinds:

Pure captives – single parent companies writing only the risks of their owner and/or affiliates

Group and/or association captives – multi-owned insurance companies writing only the risks of their owners and/or affiliates, usually within a specific trade or activity.

Rental captives – insurers specifically formed to provide captive facilities to unrelated bodies for a fee.  They are used by entities that prefer not to form their own dedicated captive

Diversified captives – insurers writing a limited proportion of unrelated business in addition to the risks of their owner and/or affiliates.   In some territories, notably in North America, captives are required to write some unrelated business in order to obtain tax deductibility for the insurance premiums of the parent.   Supervisors usually have the flexibility to determine what level of supervision to apply to such entities.

Insurer held captives – captives employed by insurers to reduce the level of capital that the insurer is required to hold (so-called “shadow insurance”).

Special purpose captives – captives formed to facilitate securitization transactions and other risk financing structures.

 

PCCs

PCCs provide a vehicle for captives to write insurance or reinsurance business while benefiting from economies of scope and scale through the sharing of capital and management costs (both set-up and on-going), both to the owner of the PCC and all cell owners.

Legislation governing the creation and operation of PCCS has been introduced in a number of captive jurisdictions.  Generally, the effect of this legislation is that, from a legal perspective, a PCC is  a single entity comprising within itself separate cells that constitute distinct and segregated units, which are ring-fenced from each other.  The PCC enables the writing of business (or the provision of insurance brokerage or management services) through an individually allocated cell, which constitutes a pool of assets and liabilities that is distinct from the assets and liabilities of any other cell and from the non-cellular assets and liabilities (core) of the company.

Consequently, creditors of one cell (or of the core) do not have a right of recourse to the assets of another cell.  This concept ensures that assets belonging to a particular cell are protected from the claims or liabilities of any other cell or of the core of the PCC.  Besides having a right of primary recourse to the assets of the cell with which the creditors transacted, such creditors also have a right of secondary recourse to the assets of the “core”, but only once all the assets of that particular cell have been exhausted.  A similar position is maintained on the insolvency of the PCC, although there may be differences in the extent to which the resulting segregation of assets and liabilities will be recognised n jurisdictions other than the domicile of the PCC.

Even though a cell does not have separate legal personality, each cell is treated as a separate entity for fiscal purposes as though each cell were an individual company.  Furthermore, dividends can be declared and distributed by a particular cell notwithstanding that the core or any other cells were not profitable in that same financial year.

In terms of solvency regulations, while the PCC  as a wholewill usually be required to hold a minimum amount of capital, each cell within a PCC is usually not required to do so. 

 

Advantages of captives

The use of a captive insurance company can bring to the parent the following benefits.

Risk management

The implementation of a risk management programme, particularly in the case of large groups, can be more effectively controlled if delegated to a central separate entity rather than being dissipated over a number of units.  A captive insurance subsidiary is well placed to perform this function, particularly through the application of standard insurance procedures which are subject to external supervision.  Credit rating agencies are likely to recognise the resulting reduction of risk.

Reduced insurance costs

The insurance market is cyclical and fluctuating costs have an undesirable impact on budgeting and profit forecasting by captive owners.  A captive can operate at reduced expense compared with traditional commercial insurers because it will not have marketing expenses.  It will benefit from lower personnel costs, lower overhead expenses and be willing to accept a minimal underwriting profit.  Consequently a captive can accept risk at a higher loss ratio than the commercial market is willing to accept.  The premium payable to a captive should more accurately reflect the parent loss history, which can be mitigated by a risk prevention programme determined in conjunction with the captive.   In addition, insurers are sometimes reluctant to provide customised policy wordings or tailored coverage.   Captives are well placed to offer customised wordings, and will typically be established in jurisdictions where there are few legal controls on the wordings which may be employed.  Lawyers will advise on those wordings.  In addition, a captive can be used by a multinational to set global deductible levels that allow the local manager to insure with the captive at a level suitable to the size of his business unit, while the captive purchases reinsurance appropriate to the group as a whole.

Reinsurance access

By accepting cessions from captives, reinsurers benefit from improved risk management and loss control by the parent company of the captive as well as gaining a more complete understanding of the nature of the risk.  Consequently reinsurers may sometimes offer more competitive terms.  Also, most captives are managed by specialists who themselves have ready access to both the traditional market and to specialist captive reinsurers.  And a captive may earn commission on its reinsurance premium. To reduce their credit exposure to a captive, reinsurers have traditionally favoured the use of letters of credit.  The letter of credit will normally be provided by a bank, based on the customer’s credit rating.  However, alternative arrangements have more recently been put in place, such as Zurich’s eZ trust, which is a tri-partite agreement between Zurich, the captive and the investment manager, giving a charge over a proportion of the captive’s existing investment portfolio.  Lawyers will often be asked to review both the reinsurance treaties entered into by a captive and the accompanying arrangements for collateral.

Cash flow

The premiums paid by a company to a commercial insurer are usually paid at the commencement of the year and attract, for the commercial insurer, an amount of investment income.  If premiums are paid to a captive, this can achieve improved cash retention and control by structuring premium payments over a financial year, paying insured losses appropriately as they arise and retaining premiums within the group until claims become payable and hence deriving investment income from those accumulated premiums. 

Placement of specialised risks

Certain types of risk such as sensitive product liability risks, environmental impairment, pharmaceutical liability and selected professional indemnity, regardless of the claims history, are either frequently extremely difficult or even impossible to place in traditional markets.  Alternatively they demand either high premiums or unacceptable terms and conditions even though the insured may have an acceptable claims history.

A properly structured captive may not only cover the required risks but with more favourable access to the reinsurance market can ensure that a sound programme is in place.  Additionally captives facilitate the provision of cover to satisfy legal and contractual obligations, which could not be offered by a self-insurance fund or are too small to warrant obtaining cover for in the commercial market.  The captive can provide a greater variety of options for the insured in unusual situations.  Lawyers will advise on the drafting of appropriate wordings.

Control of cover and cost of multi-national programmes

A captive enables a multinational company to apply group net insurance retention at a higher monetary level than can be justified at local subsidiary level.  There is greater diversity of risk at the group level and there will be no need for the subsidiaries to purchase potentially full coverage with low deductibles in their local insurance market.  There is additionally more control on claims through a single group captive.  However small the captive participation, and whether or not this passes through a fronting company, the parent becomes aware of all the claims.  It can track these and their development, obtaining all necessary information on the reason for their occurrence which in turn feeds back into the group’s risk management policies and practices.  This is a further tool to risk management.  Geographically remote subsidiaries may otherwise have an adverse claims or loss experience which is never apparent to the parent but is information held between the subsidiary and the local insurer.  Where a group has operating units in a variety of countries, simplified global policies can be issued.

 

Formation

Captive insurance companies can take various legal forms such as limited companies, limited partnerships or limited liability companies.  Captives are also increasingly being established as cells within protected cell (or segregated cell) companies (PCCs).   Lawyers will normally be given responsibility for the captive’s incorporation, including drafting its constitution, directors and shareholders’  agreements and agreements with brokers and managers;  as well as the captive’s insurance and reinsurance policies.

 

Regulation

The purpose of insurance regulation is to protect policyholders (who are in most captives also the shareholder), investors and other stakeholders through the provisions of supervisory tools to ensure that companies operate in accordance with acceptable standards of corporate governance, financial strength and market conduct.  This in turn promotes efficient, safe, fair and stable markets, which encourage growth and competition in the sector.

In applying insurance regulations to captives, regulators may adopt a risk-based approach, which take account of both the nature of the captive insurance market and the form of the individual captive.  For example, the risk posed by a captive that only underwrites the property risks of a single parent without recourse to reinsurance is little different from the risks imposed by retaining risks on the parent’s balance sheet protection.  On the other hand, a captive that is significantly exposed to risk from unrelated business, is no different from a normal commercial insurer.  Whilst the owner/captive relationship permits the owner to exercise significant influence over its captive, it is important that the captive practises good corporate governance to ensure that it continues to meet its solvency requirements and maintains adequate technical provisions. 

It is normally felt that all captive insurers should be subject to insurance regulation, even “pure” captives which underwrite only the risks of their parent company.  Even if no third party risks are involved, pure captives often undertake transactions with fronting companies and reinsurers who benefit from and often require the security provided by proper licensing and regulation.  The application of appropriate regulation also reduces the risk that a captive may become involved in fraudulent activities or be used as a vehicle for money laundering.  On the other side, a captive which is managed to a standard similar to a commercial insurer with similar operating procedures will the more readily be transferred out of the owner’s group should a more effective insurance programme present itself.  A recent example is provided by transfer of LUKOIL’s captive insurance company to Kapital.

Captive insurance is, in addition, an alternative form of capacity available to finance commercially uninsurable risks or risks that are otherwise retained.  The establishment of the captive requires investment of capital to support the taking of risk.  When underwriting profits are retained in the captive, rather than distributed, then additional capacity is created. If captives fail, capacity is likely to be reduced, because future captive owners and users will be less likely to invest capital in order to finance their risk in a captive.  Confidence in the integrity of the captive mechanism needs to be maintained in order to ensure availability of this alternative source of capacity.

Aspects of the supervision of insurance and reinsurance companies include licensing (authorisation); the suitability of controllers and key directors, officers and service providers; procedures for changes in control and portfolio transfers; corporate governance; internal control mechanisms; reporting, monitoring and inspection, group supervision; risk assessment and management; capital adequacy, solvency and reserving; investment restrictions; and conduct of business.  Many of these functions will apply equally to the supervision of captives, but can be reduced or tailored in light of the more limited activity and exposure of the captive.  This can be illustrated by the following examples.

Licensing

Since a captive is often just one part of its owner’s risk management programme, it is important that the supervisory authority has a clear understanding of how the captive fits into the programme and its particular goals and objectives.  The captive’s owners may not be familiar with the operational requirements of an insurance subsidiary.  It is therefore important that the supervisory authority satisfies itself that the captive will be carried out by a captive management company licensed in the domicile and known to the supervisory authority.

Any licensing application will be accompanied by relevant licensing details, which will include information on proposed beneficial owners, directors, controllers and managers, and also a business plan.  Key persons will need to be shown to be fit and proper and have the commensurate experience, skills and capacity to fulfil the responsibilities of their roles.  If the captive is to write life insurance, consideration will be given as to the details of the proposed actuary or actuarial support and to the requirement of an actuarial report to accompany the business plan.

Prior to granting authorisation to write business, the supervisor will want to be satisfied that the captive has been properly established, that it is conceptually sound and has adequate resources to conduct its insurance and/or reinsurance business appropriately from the outset, as well as to the availability of additional financial resources at a later date should this prove necessary.  A declaration and statement of source of capital funds will normally be required and confirmation of capital received and shares issued, including any legal opinions which are deemed necessary.Captive owners may be required to show that they have contributed adequate capital to allow the owner to take and retain risk and also treat any third party claimants or unrelated party insureds in accordance with acceptable rules of conduct.  A business plan will normally be required  in a prescribed format, and will include a projected balance sheet, profit forecast, cash flows, intended classes of business and cover, limits of liability, details of reliance placed on reinsurers and an outline of investment and dividend strategies.  The business plan will need to be reviewed by the proposed auditors who themselves will be expected to have the necessary skills and capacity to act as auditors of a captive.

Supervisors may place specific conditions or restrictions on a captive to ensure that it conducts business in accordance with its business plan and to require notification of business plan changes.  Common restrictions include limiting business strictly to related-party risks, permission to conduct business only through a fronting insurer, or limiting the captive to certain lines of business.

The owner’s location may have an impact on the licensing decision because transparency and reliability of financial information can vary between countries and differences in accounting practices can complicate assessment of ongoing financial strength.    This will be taken into account in performing due diligence on the owners which may involve the exchange of information between regulators of different jurisdictions. 

Corporate governance

For most commercial insurers, the maintenance of adequate systems of control and accountability will be key to the financial health of the company and the supervisory authority will need to be assured that such systems are in place.  In relation to captives, this remains true, but there are some important differences.  Many captives are small and have a relatively simple risk profile, so the need for elaborate controls is reduced.  On the other hand, the parent company and its directors may have limited experience in insurance and it is common for the management and operations of the captive to be carried out to a firm of professional insurance managers, whose own management systems will be critical.

Risk management

Supervisory systems typically analyse the risks facing insurers and reinsurers so as to include for example underwriting risk (processes, market conditions, concentration) , claims risk (reserving methodology, claims handling systems and information),  reinsurance risk (retentions, security rating),  management risk (knowledge, experience),  operational risk (management error, expenses); investment risk (risk appetite, volatility, spread, counter-party risk); and environmental risk (inflation, market changes, social and technological changes). Many risks normally associated with a commercial insurer are mitigated or are of less impact in a captive insurer.  Legal risk is generally quite low since the captive frequently insurers just its owner, though it is important that the terms of reinsurance contracts are properly expressed and aligned with the primary cover.  In some instances, such as a fronting arrangement where the risks to the fronting insurer are fully collateralised, credit risk and market risk in the captive are reduced.  Operational risk may be low if the captive has few transactions or a limited number of policies.  On the other hand it is common for captives to out-source many of their management functions so that the control of risk within the captive may be higher or of a different nature from that of a commercial insurer.  Altogether the risk management system in place in a captive may be significantly different from that of a commercial insurer.  However, the lower risk to insurance consumers and financial markets posed by captives does not exclude the need for them to have an adequate, well thought out business plan, proper expertise in place to manage its insurance risk and adequate information on its insurance and reinsurance arrangements.

Capital adequacy and solvency

Key components of any solvency regime are the rules on the valuation of assets and liabilities, asset/ liability management and the suitability of different forms of capital.  Regulators will establish a minimum solvency margin requirement which adequately reflects the risks that aretypically inherent in captive insurance companies.  The risk portfolio may be unbalanced, consequently a formulaic approach may be inappropriate.  Although the policyholder is generally the parent, there may be third party interests to protect, especially if liability risks are written.  The level of solvency margin required in the case of captive insurance companies will be especially influenced by the extent, appropriateness and security of its reinsurance arrangements as well as the adequacy of its technical provisions.  Where there is a contractual requirement by a fronting insurer for the captive to deposit collateral and because this is usually in the form of cash or an irrevocable letter of credit, this arrangement reduces the financial risk to the captive and therefore the level of solvency required.  Current proposals for the EU’s Solvency II directive have resulted in concerns being expressed by the captive insurance market that the new requirements envisaged, in particular the 99.5% confidence level for the estimation of future liabilities, may make the establishment of captive insurance companies within the EU unviable.  However, Commission representatives have indicated that a more proportionate treatment for captives will be considered.

Investment policy

Most supervisors require that captive boards, as part of the business plan, set down an appropriate investment policy (strategy and objectives) to be followed prior to captive formation and will expect that policy to be appropriate to the needs of the captive.  Requirements for security, liquidity, low volatility and the expected shape of the liabilities side of the captive’s balance sheet including the matching of liability maturities must be borne in mind.  In particular cash flow is likely to be a focus of attention since many captives will receive a single premium payment at the beginning of the policy year.  The investment policy would also be expected to define what entity will manage and act as custodian for the investments and contain guidelines for proportions of assets to be invested into various categories.

Such investment policies will frequently be simple and straightforward, not requiring significant analysis or depth of strategic thinking, especially in the case of smaller captives writing short-tail, e.g. property, business.  A captive will usually not establish its own investment department and smaller captives will contract out the administration of this role to the insurance manager who in turn may provide some straightforward investment advice but, more likely, will rely on professional advisors or their own or their captive’s bankers to supply the necessary skills to develop appropriate policy.  In such cases, the employment of lawyers may be limited.  However, in some cases captives may be employed in association with the operation of a more sophisticated multinational programme involving the use ofART products of various kinds, such as finite insurance and derivative instruments.  In such cases lawyers are likely to be asked to draft or review the relevant documentation;  and so far as the captive is concerned to ensure that any contracts it enters into fall within the scope of its licence and approved investment mandate.

Conduct of business

Most regulatory regimes will contain rules concerning the conduct of business by insurers.  The rules may include the provision of timely, complete and relevant information to customers both before a contract is entered into and until its expiry.   These rules are intended both to protect the reputation of markets and to prevent complaints about mis-selling from adversely affecting the reputation of a insurers or even, directly, its balance sheet.  Rules are usually slanted towards the protection of consumers rather than commercial buyers of insurance on the basis that commercial buyers will normally be more sophisticated and better resourced to negotiate satisfactory arrangements.  In the case of captive insurance companies, their relationship will normally be with the owners or with a commercial insurer or reinsurer with which the captive enters into arrangements; and accordingly conduct of business rules become less relevant.  However, if the captive underwrites liability risk, or writes third party business, those rules may become relevant.

 

Fraud, money laundering

The large sums of money received by insurance and reinsurance companies, together with their retention and investment pending claims, makes such companies a potential vehicle for fraud and money-laundering activities.  In relation to captives, the scope for such activities is relatively small, at any rate where third party business is excluded.   Nevertheless the operational systems and guidance incorporated in the establishment of the company ought to reflect standard procedures to satisfy the regulator the regulator that the risk of illegal activity has been minimised.  Legal advice on the content f those procedures will be advisable.   They should include appropriate audit trails which can if required be called up to identify the source and application of external funds.  If there should be an investigation or prosecution impacting upon the captive, a reference to lawyers will almost certainly be required.

 

Data protection

Similarly, data protection legislation introduced in many jurisdictions will need to be reviewed to ensure that the operations in a captive observe best practice.  Captive owners will obviously have an interest in maintaining the security of their own data, but any third party business will introduce a requirement to segregate sensitive information received from others.  From a practical point of view, the security of operating systems will need to be verified.

 

Tax

One of the important benefits of a captive is that, in most jurisdictions, the owner will be able to deduct premiums paid to the captive in calculating profits liable to taxation (as compared with reserves established for the purposes of self-insurance).   Such treatment will normally be allowed only if captive’s insurance policies with the owner cover the transfer of genuine risks for premiums determined at arm’s length and if the captive has sufficient resources to meet potential claims.  In particular, deductions may be challenged pursuant to applicable transfer pricing rules if premiums exceed the market rate, taking into account, for example, limited diversification and resources, limited experience, and limited diversification of risk.  Methods of determining an appropriate premium are likely to involve reference to accountancy experts, but aspects of the process may be referred to specialist tax lawyers.  Marsh & McLennan offer proprietary modelling software which integrates the input of relevant disciplines.

The overall advantage accruing to the owner is likely to depend also upon the tax treatment of the captive itself, and will be considerably enhanced by establishing the captive in a low tax jurisdiction.  Tax may be relieved on either reserves or dividends or both, and in some cases also taxes on VAT and insurance premiums.  Lawyers may also be called upon to advise as to whether the extent of the work performed by the captive in the owner’s domicile is sufficient to cause the captive itself to be treated as resident for tax purposes, as a controlled foreign company; and whether, in that event, the owner may take advantage of any double taxation treaty with the country where the captive is domiciled.

 

Establishment

The qualifications required for a captive domiciled in a country other than that of the owner or other member’s group to insure or reinsure the owner’s or the group’s risks differ.  In some cases, no such qualification is required; but in other cases the captive will need to be authorised in the country where the risks are written.  In the case of group coverage in the European Union there may be advantage in leveraging the common insurance passport, i.e. by establishing the captive in one EU country and making use of the facility under the European insurance Directives, to write insurance in other EU countries through a simplified procedure.   Lawyers can assist in setting up the requisite authorisations.  Luxembourg, Ireland, Gibraltar and Malta are captive jurisdictions which have profited from this facility.

 

Exit strategies: insolvency

It has been rare for captive insurance companies to run into financial difficulties.  On the other hand, this may potentially occur, and in any event changes in the owner’s risk profile together with developments in the insurance environment (e.g. tax changes) can lessen the value of a captive within a company’s insurance programme.  In such cases the main options will be either to cease underwriting and run off the existing liabilities or (less likely) to arrange for the captive to be acquired by a commercial insurer.  At least in the latter case, lawyers will typically be entrusted with the task of documenting the transfer.  It may also be possible to place the captive into a scheme of arrangement so as to accelerate the run-off, or into solvent (or in rare cases insolvent) liquidation.  In these cases the administration is normally placed in the hands of insolvency experts, but lawyers may be asked to advise on specific issues of valuation or particular aspects of the applicable legislation.  This is most likely to occur when the captive has written direct third party business.  Generally applicable insolvency rules are typically adapted to insurance insolvencies so as to create a priority for direct insurance claims, but the interpretation of relevant rules may leave room for interpretation.