Charles Winter and Peter Chesman – Captive considerations in a global programme

Therefore, once an organisation grows to a certain size and maturity, premium spend and an increased focus on cost containment results in them considering more sophisticated forms of risk financing. It is not logical for an organisation to insure on the basis that leaves the insurance market paying for losses that could otherwise be absorbed by the organisation. However, it would be remiss of an organisation not to insure those large losses which could damage its solvency or liquidity.

Therefore, most organisations seek insurance structures that achieve the balance suitable for their particular organisation and culture. They consider, for example:

– Local policy deductibles sufficient to energise subsidiaries in risk management matters but not large enough to threaten stability or de-motivate local management;

– Insurance cover above a self-retained layer commensurate with the consolidated organisation’s risk tolerance / appetite;

– A captive insurance company that bridges the gap between the risk tolerance of subsidiaries and the attachment point of insurance with third party insurers.

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Role of a captive

A captive insurance company can be defined as an insurance entity created by a company whose primary business is not that of insurance, to insure the risk of its parent. It is a method that plays a central part in managing the balance of retained versus transferred risk, and managing (re)insurance market relationships within corporate risk financing programmes.

In addition to the financial benefits of segregating an organisations ‘above average’ book of business away from the rest of the insurance market pool, (including capturing profitable business results, retaining cash flows and investment income), a captive can create value for its parent organisation in a number of ways.

Firstly, it bridges the gap between group risk tolerance/appetite and individual subsidiary risk tolerance/appetite; i.e. it allows a group to make strategic decisions about the level of risk retained whilst maintaining the support of its subsidiaries for its global insurance arrangements. This enhances the capacity of a group to generate an effective response in times of insurance difficulties, e.g. following a large claim or during a period of general insurance market capacity shrinkage. The importance of this feature within a group varies depending upon the degree of autonomy the subsidiaries have in their operational decisions, which reflects largely parent group culture.

Secondly, a captive can create value through the enhancement of the reputation of the parent in the eyes of the insurance market. A captive can be seen as a demonstration of the parent’s commitment to, and confidence in, its risk management as well as an alternative to traditional insurance; accordingly, the parent’s negotiating position with the (re)insurance market can be improved.

Thirdly, a captive can be a convenient provider of ‘administrative’ services to the parent group; for example, taking over the management of an ‘escrow’ type account and supporting local deductible payments made on behalf of the local subsidiaries by loss adjusters.

Furthermore, the financial ‘stick’ provided by the captive can be combined with a reward ‘carrot’ to influence operational behaviour. It also gives the risk manager more leverage in the organization than an annual cost allocation process does by itself.

What do we mean? Put simply, because the local subsidiary’s profit and loss account is directly impacted by the performance of the captive, this can act as a precursor to enhanced local responsibility for the creation of a risk management culture where all take responsibility for risk management, irrespective of whom is accountable at group level.

More recently, owners have been reviewing captive utilisation and identifying additional areas in which a captive can add value beyond those traditional areas above. This has culminated in the formation of the ‘Four Pillar’ captive utility approach.

The intention of the first pillar is to ensure that the captive is being most efficiently utilised on traditional classes of business.

Pillar Two is focused on utilising the captive in areas which can enable the parent company to enter new market places and develop new revenue streams, which perhaps otherwise they would not be able to. For example, the captive affording some form of guarantee protection which could prove the difference in successfully winning a contract the organisation is competing for.

Pillar Three identifies where the captive can generate financial leverage for its parent company. An example may be an organisation moving ahead in merger/acquisition activity in the knowledge that the captive could bridge the gap in risk profile between the two organisations.

Pillar Four suggests a captive can sometimes act as what is known as a ‘risk incubator’. Actually, this is a misnomer as the incubation applies to data about a risk, not the risk itself, the concept being that information about a risk currently unknown in the insurance market and, therefore, ‘uninsurable’ can be collated over time and used to cultivate interest on the part of, and ultimately risk transfer to, the insurance market. Examples of such emerging risk may include cyber liability or environmental impairment liability.

Considerations

Selecting an appropriate domicile requires a number of aspects to be reviewed. Considerations such as, the ability to provide cover on a direct or reinsurance basis, the relevant domicile’s minimum capital/solvency requirement, transport links (to minimise directors’ time commitment), corporate tax considerations (see below) and a domiciles’ regulatory framework are just some of the issues firmly at the forefront of a risk manager’s mind when it comes to choice of domicile.

Among the domicile considerations that a corporation would need to understand are the implications of Controlled Foreign Company (CFC) legislation. CFC applies typically to parents of subsidiaries controlled by a company or group and resident in a low tax jurisdiction. The effect of CFC rules is for the profit of a subsidiary (such as a captive) to be included in the parent company’s tax computation.

Challenges

Increasingly, captive owners are scrutinising captive programmes in respect of ‘admitted’ and ‘non-admitted’ regulations and premium tax compliance. The former considerations determine the basis upon which a captive can legally provide cover into certain territories. Some territories accept ‘non-admitted’ cover, whilst others only accept ‘admitted’ paper. Each captive domicile is affected differently and adherence to the regulations determines whether the captive writes direct or reinsurance business.

A related issue is premium tax compliance. Again, this is specific to the individual territories and affects each captive domicile to a different degree. A captive will need to consider whether they are compliant from a premium tax perspective, and any third party service providers they may need to engage in order to achieve compliance.

A further corporate tax consideration is Transfer Pricing legislation. Transfer Pricing regulations apply generally to transactions between members of a corporate group situated in different tax jurisdictions and are designed to avoid profits being transferred artificially to the lower tax jurisdiction through undercharging or underpayment for goods and/or services.

Transfer pricing regulations differ from jurisdiction to jurisdiction but generally require intergroup transactions to be priced ‘at arm’s length’. Premiums paid to a captive can usually be justified under Transfer Pricing rules by the provision of bona fide quotations from independent underwriters for equivalent or higher premium.

However, this in itself does not fully exhaust the reach of Transfer Pricing; increasingly tax authorities are considering the substance of transactions and have shown a willingness to challenge arrangements with captive insurance companies where there is a perceived diversion of revenue to other tax jurisdictions (particularly those seen as low tax jurisdictions).

Summary

The captive environment is more challenging, but there has been no retreat in the utilisation of captives by global firms, where they often remain the glue that holds the global insurance programme together.