Captive
Insurance Companies
A captive insurance company is, in its simplest and purest form, an insurance company
that only insures all or part of the risks of its parent.
In the last 20 to 30 years there has been phenomenal growth in the number of captive
insurance companies so that today there are well over 4,000 captives worldwide writing
more than $20bn in premium. These companies have capital and surplus estimated at over
$50bn.
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 offshore.
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, Vanuatu, the Cayman Islands, Guernsey, the Isle
of Man and Luxembourg have been joined by the likes of Vermont USA, the British Virgin
Islands, Gibraltar and Dublin.
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 byelaw in
November 1998 permitting the establishment of captive operations at Lloyd's.
Tool for Value Shifting
From an asset protection perspective, the primary benefit to a captive insurance
company is that it gives a mechanism to transfer value out of the operating business in a
legitimate and a tax-efficient manner. Wealth that would have been accumulated in the
business, distributed to the owners is removed from the reach of creditors. For example,
assume that an operating business is able to justify the payment of $500,000 per year in
insurance premiums to its captive, which holds those premiums as actuarially calculated
reserves to pay future claims, or as surplus once it is no longer needed as reserves. Over
ten years, that $5 million has been quietly moved out of the operating company. Of course,
those funds don't sit in a safe as a pile of cash. The funds are invested to earn income
and gains. If the business makes no claims over that ten year period, the captive may have
considerably more than $5 million in assets. Although there are some restrictions placed
by insurance commissioners on the investment of some or all of a captive insurer's
reserves, capital and surplus, investment rules for captives are more relaxed than those
for commercial insurers. The captive may be able to invest in the owners' related
businesses and in new business ventures. From an asset protection perspective, the captive
may also be able to function as a secured lender to strip equity from other valuable
property of the owners.
Assuming that the premiums are reasonable and justified from an actuarial perspective,
it will be very difficult for a subsequent creditor to prove that the transfers were not
"for value" transfers for purposes of the Uniform Fraudulent Transfer Act.
Moreover, the issue is unlikely to arise at all, because insurance premium payments made
in the ordinary course of business are rarely a red flag to attract the attention of a
court or a creditor.
Of course, the captive itself must be protected from the creditors of the captive's
owners. At the very least, the captive should be owned through a limited partnership or
limited liability company so as to give charging order protection to the stock in the
captive.
Some of the other primary reasons are summarized below.
- 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. This portion of
the premium can represent as much as 35%
or 40% of the whole. In establishing a
captive, the parent seeks to retain the
profit within the group rather than see
it go to an outside party. A captive may
also help reduce insurance costs by charging
a premium that more accurately reflects
the parent's loss experience.
- Cash flow. Apart from pure underwriting
profit, insurers rely heavily on investment
income. Premiums are typically paid in
advance while claims are paid out over
a longer period. Until claims become payable
the premium is available for investment.
By utilizing a captive, premiums and investment
income are retained within the group and,
where the captive is domiciled offshore,
that investment income may be untaxed.
Additionally the captive may be able to
offer a more flexible premium payment
plan thereby offering a direct cash flow
advantage to the parent.
- Risk retention. A company's willingness
to retain more of its own risk, particularly
by increasing deductible levels, 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.
- 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.
- 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. By using a captive to access the
reinsurance market the buyer can more
easily determine his own retention levels
and structure his programme with greater
flexibility.
- 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 organization may wish
to sell insurance to existing customers
of its core business. For example, retailers
may sell extended warranty cover to customers
with the risk being carried by the retailer's
captive. The claims pattern of this type
of business is usually very predictable
with a large number of small exposures
and can provide the retailer with a valuable
additional source of revenue.
Since captives were first formed the industry has looked at new ways of developing the
captive model to provide appropriate vehicles for a wide range of different owners and
users.
There are now many types of captives, including some unique to the Vanuatu jurisdiction
such as a Discretionary Mutual Insurance Portfolio (DMIP's) - see next section.
Some of the most common types of captives are;
- Single-parent captives, underwriting only the risks of related group companies.
- Diversified captives underwriting unrelated risks in addition to group business.
- Association captives which underwrite the risks of members of an industry or trade
association. Liability risks such as medical malpractice are frequently insured in this
way.
- Agency captives formed by insurance brokers or agents to allow them to participate in
the high-quality risks, which they control.
- Rent-a-captives are insurance companies that provide access to captive facilities
without the user needing to capitalize his own captive. The user pays a fee for the use of
the captive facilities and will be required to provide some form of collateral so that the
rent-a-captive is not at risk from any underwriting losses suffered by the user.
- Special purpose vehicles ('SPV's) are used in risk securitization. They are reinsurance
companies that issue reinsurance contracts to their parent and cede the risk to the
capital markets by way of a bond issue.
Captives may be established as direct-writing companies issuing policies to, and
receiving premiums from, their insureds but the insurance industry is generally highly
regulated and, in many jurisdictions, certain risks may only be written by an admitted
insurer.
Usually, and 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.
DMIP's are a unique insurance concept introduced by Commercial Pacific Insurance Ltd'.
While currently limited to Aviation and Marine risks only DMIP's were created for smaller
risks where it was uneconomical to set up a structured captive in its own right.
An insurance policy issued as part of the DMIP forms part of Commercial Pacific's
Discretionary Mutual (aviation or marine) Insurance Portfolio where each insurance policy
issued is managed in a collection of similar insurance policies from various policyholders
combined (or co-mingled) together as one single mutual portfolio but, with performance
apportioned to individual insurance policies at CPI's discretion.
In a similar fashion to protected cell captives the principal attraction of the DMIP is
that any given insurance policy is legally insulated from the liabilities of other
policies, thereby preventing credit risk between them.
While significant tax benefits are usually available as a consequence such tax benefits
should not be seen the prime motivation for taking out an insurance policy in the DMIP.
For more information about DMIP's please click on the following link. DMIP
- Lower capital requirements
- Stable insurance regulatory environment
- Vanuatu has no tax treaties with any
other jurisdiction
- Proactive commerce environment - both
infrastructure and legislative.
- An attractive tax regime; there is no:
o Company tax
o Personal income tax
o Capital Gains tax
o Withholding tax
o Exchange controls
Commercial Pacific's aim is to provide management services that are carefully tailored
in each case to the individual requirements of the captive and its parent.
In order to achieve this we are always ready to work harmoniously with other professional
advisers and service providers such as risk managers, brokers, fronting insurers,
reinsurers, accountants, actuaries and lawyers.
We manage a comprehensive range of captives drawn from every sector of industry and
commerce and can conduct the following tasks on your behalf;
- detailed feasibility studies - including risk and exposure analysis, risk financing cost
analysis, captive cash flow modeling and comparative financial analysis using discounted
cash flow techniques;
- establishing captive and reinsurance programmes, including assistance with placing
covers into international markets and setting up fronting arrangements;
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;
- risk management consultancy.
The Manager "Captive Bureau"
Commercial Pacific Insurance Ltd'
Level 1 Anchor House
Lini Highway Port Vial Vanuatu
Ph: Int: 678 - 28062
Fax: Int: 678 - 28069
Email: cpi@vanuatu.com.vu
The content of this page is intended to provide a general guide to the subject matter.
Specialist advice should seek about your specific circumstances.
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