Setting up a captive: what could possibly go wrong?

In the excitement of creating a new company it is often difficult to step back and make sure all the details have been addressed. In fact, I often try to convince people to think about how you can close your captive down or terminate any relationships before drafting any formation documents or contracts.

Here are some of the more common areas of concern you need to revisit before proceeding with forming and capitalising your new captive.

Understanding capital and collateral

Capital and collateral can be confusing because depending on the domicile and or structure of the captive programme collateral can be a replacement or an offset to required capital.

The first thing to understand and one of the most basic concepts of insurance is that an insurance company must be able to lose money. The concept of risk transfer means that potential losses should exceed the premium received for the coverage provided. For example, a $1 million premium for a $1 million policy does not pass risk transfer and cannot be considered insurance. While most audit firms are reluctant to give a definitive answer on what constitutes risk transfer I have yet to get push-back from using 20 percent contribution over gross premium written as a defensible level.

Accordingly, a captive with a $2 million expected premium level should expect that most domiciles will want premium support of at least $400,000 in a captive, and this is higher than almost every domicile minimum capital of $200,000 to $250,000.

So, the required minimum capital isn’t always what you will need.

The next consideration is that if the programme is fronted or has high deductible type coverage, there is a high likelihood that the issuing carrier will require the insured or reinsurer (normally the captive or captive owner) to post funds (collateral) to ensure that the issuing carrier is protected for the exposure it has in the event the insured/reinsurer can’t pay its level of assumed losses.

If the coverage is long tail, such as workers’ compensation, general liability or auto liability, the likelihood is that you will be required to post collateral for several years as the issuing carrier will take the position that it takes quite some time for losses to fully develop and for it to be sure the funding you were required to post will cover the programme’s losses.

It can come as quite a shock to some captive owners that having posted $400,000 in year one, they are then asked to post an additional $400,000 in year two and quite probably another $400,000 in year three. This stacking of collateral can tail off after three years unless the programme is growing in which case there will still be a need of further collateral inputs in years after the first three.

It should be noted that many domiciles do not recognise collateral as capital and this can result in a substantial additional early funding commitment. Offshore domiciles and cell captives seem to be more willing to look at capital as not at risk when there is also collateral posted and thus give credit for the level of collateral and require only minimum capital at inception.

Risk transfer and risk distribution—are you sure you pass?

Risk transfer has usually been addressed by having capital and/or collateral equal to or greater than 20 percent of gross or net premium written. However, risk distribution is a more challenging test to meet for many prospective captive owners.

There are three possible routes to meet risk distribution:

• Third party risk. If your captive writes more than 30 percent third party risk, based on the Amerco court case, you have sufficient risk distribution to achieve insurance treatment. The safe harbour from the 2002 Internal Revenue Service (IRS) Revenue ruling wants 50 percent third party risk. This path has been tried by many captives through utilising pooling mechanisms, but several such arrangements have been held by courts to be shams as the loss ratios were very low for a risk pool. The basic premise is that it is conceptually possible for a single captive to have very low or zero losses but it is statistically improbable for 300 such companies pooling to have low or zero losses if they are truly distributing insurable risk.
• Brother/sister arrangements. If you receive premium from seven or more legally separate entities you meet the definition of risk distribution from Revenue Ruling 2002-91. This developed out of the Humana court case from 1994. It should be noted that the IRS issued a Revenue Ruling 2002-90 that said you needed 12 legally separate entities if they are affiliated. Many captive insurance observers feel there is no logical reason for the difference in number of required entities between these two revenue rulings and have stated they feel it’s strongly defensible that seven legally separate entities should be sufficient for risk distribution.
• Exposure units. The Securitas and Rent-a Center court cases passed risk distribution based on the number of exposure units written in their programmes. The court basically said that if captive policies were covering thousands of employees and thousands of vehicles it clearly had risk distributed and the law of large numbers should apply.

It is important for prospective captive owners to understand whether they meet these tests, and what their accounting options are if they do, or do not, meet them. A captive can fail these tests and still make sense for many reasons but the owners should understand they will be using the deposit method of accounting and not insurance accounting.

Contractual obligations—have you checked them all?

A good captive manager will ask a lot of questions up front in the early stages of building a successful captive. An important one is: “Do you have contractual insurance requirements?”

This is important because a captive is not usually admitted or rated and many contracts with business partners, investors, banks, and government entities will have wording requiring insurance protection and there may be specific restrictions on what is acceptable insurance in these contracts.

If the wording says the insurance policy must be from an admitted insurance company this could still allow for direct writing by a captive if it can be formed in its “home” state because a captive is normally considered an admitted company in its state of domicile. If, however, the contract wording requires a financial size or independent rating the captive may have to partner with a carrier meeting these requirements or put in substantially more capital to potentially obtain its own independent rating.

The capital need of probably $25 million-plus eliminates self-rating for most captive programmes and the captive manager has to build in additional costs for partnering with a rated insurance company to ensure that the programme can still meet the contract obligations of the captive owner.

Taxes—be careful what you believe

Tax benefits should rarely be the primary reason for forming a captive because the tax rules can change at any moment and the perceived benefit can be eliminated. If the programme has been designed to pass most of the previous issues, then it is likely that the captive will qualify as insurance for tax purposes.

The benefit of insurance tax treatment is generally the ability to deduct premiums paid to the captive as a business expense and then the captive can also establish and deduct loss reserves.

If you are being promised additional tax benefits such as no tax by using a foreign domicile or no tax on underwriting profits by forming an 831(b) captive (the small insurance company election), you need to run these past your tax advisors and understand that while these types of tax benefits are possible the IRS will potentially scrutinise your captive.

There are severe penalties if your captive does not have risk transfer or risk distribution for the 831(b) election and/or the complicated multi-owner structure required to be considered a non-controlled foreign corporation.

The IRS has never been a fan of captives and owners need to be clear on the audit risks and have a clear understanding of why they need a captive, that they need to run their captive like an arm’s length insurance company and that it must be properly capitalised and regulated.

Do you know your vendors?

Your captive will need to hire (i) a captive manager; (ii) auditors; (iii) actuaries; (iv) legal advisors; and (v) investment managers. It is essential you check out the qualifications of the parties you are working with. Items to consider:

• Do they have multi-domicile experience?
• Do they provide services for multiple captives and even more specifically multiple types of captives?
• Have they been published in the captive insurance press?
• Have they spoken at captive insurance conferences?
• Can they provide references?
• Do they carry adequate professional insurance?

There have been many entrants into “captive management” by companies selling wealth management and tax strategies as opposed to risk financing. It will serve you well to do some background research on the companies you are looking to engage and you should be asking them pertinent questions. You might ask if any of their clients are under IRS audit, if you can speak to some current clients and also speak to clients they have lost.

A captive is a wonderful tool to assist companies with risk and risk financing. It is important to remember why insurance exists and to keep in mind that for a captive to be successful it should think and behave like an insurance company.

Address these issues outlined above and you will be well on your way to creating a successful captive insurance company.