Renting versus Owning a Captive

This article is provided by Strategic Risk Services. Contact details for the company can be found at the end of this article. Background - Traditionally prospective captive owners have had the option of capitalizing their own insurance companies or participating in an existing group facility. In the latter case rather than provide capital, participants pay a fee to "rent" the existing capital, licenses and services within the facility. Historically a major drawback to the rental facility has been the possibility that a participant may be exposed to the adverse claims experience of another participant. This was eased with the creation of protected cell legislation in many domiciles. This legislation, first passed in 1997 in Guernsey, provides for the legal separation of the different accounts within the captive ? essentially the creation of a "firewall" between account holders. Protected cell laws now exist in most domiciles although often under different names: Segregated Account Companies (Bermuda), Segregated Portfolio Companies (Cayman), Sponsored Captives (Vermont), Protected Cell Companies (Guernsey) ? collectively Protected Cell Companies (PCCs). With the legal separation of accounts in PCCs, individual accounts have many of the same characteristics of an owned captive without the need to capitalize the company. However, there remain differences in the structures that need to be fully assessed in evaluating the decision to rent or own. Costs - PCCs have lower management and initiation costs. ? Management costs should be slightly lower under a PCC due to the sharing of some costs, such as audit, actuarial, accounting, legal and regulatory compliance. However the difference is not significant as the majority of the accounting functions need to be performed for the individual account in the same way that they would for the owned captive. ? Initiation costs can be significantly lower with a PCC as the prospective participant is taking advantage of an existing facility rather than incurring the time and expense of creating a new facility. Some owners of PCCs may provide feasibility services free of charge. This is particularly true where the captive program is integrated into an insurer's product offerings. Capital - This is perhaps the most significant difference between the two approaches. Utilization of a "cell" in a PCC does not require the provision of statutory capital to the captive, as this is provided by the owners of the facility itself. An owned captive on the other hand will require the funding of a minimum amount of free and clear capital to satisfy regulatory requirements. This will typically be equivalent to the minimum levels of capitalization for the domicile. For a single parent captive this is $250,000 in most onshore domiciles and $120,000 in most offshore domiciles. Collateral - Collateral is required to protect against the credit risk associated with the captive's underwriting position. This is true for any self-insurance program where there is a counter-party involved, such as a fronting insurer. For PCCs, participants are responsible for losses within their cell accounts. This requirement is usually documented in the participation agreement between the captive owner and the cell participant. The captive owner faces a credit risk that participants will not be able to meet their obligations under the participation agreement. To protect against this risk, PCC participants are required to subscribe for capital or post collateral. Both PCC participants and owned captives may also have to post collateral to fronting insurers. While a single collateral provision will suffice both fronting insurers and PCC owners, the need to satisfy two masters may lead to more onerous collateral requirements under PCC programs. One strategy employed by captives to eliminate collateral requirements is to underwrite direct wherever possible. However writing direct business may not help a cell participant, who will still need to post collateral to the owner of the PCC. Risk sharing and stability - It is worth reiterating that as loss experience is legally separated into separate accounts, there is no greater stability in participating in a PCC than in an owned captive. PCCs are often positioned as being a suitable solution for smaller accounts. While there may be reduced formation costs associated with these programs, they do not benefit from any greater risk spreading than an owned captive. Owned or rented options should be neutral in terms of the stability of risk financing costs. Flexibility - A cell program is governed by the parameters of the PCC's license with the local domicile and the captive's by-laws. This may impose limitations on the lines of coverage that may be insured, the acceptance of any third party business and underwriting direct. A PCC owner typically seeks approval for all lines of business to provide flexibility for participants using the facility. An owned captive provides a great deal more flexibility in the design and structure of programs as the requirements of the PCC owner do not have to be met. Ease - The process to create and approve a cell program is significantly shorter than that of an owned captive. The creation of an owned captive involves regulatory application and approval. This usually requires a minimum of 30 days for approval from the regulators after the business plan and application has been developed. There can also be significant internal delays in securing the capital investment required to create an owned captive. On the other hand, once a cell program is approved by the owner of the PCC, the regulators in most domiciles must be advised and approval granted, but this is usually a 24-hour expedited process. Also, as no capital investment is required to create a new subsidiary, the internal approval process can be considerably faster. Control - A PCC program involves an off-the-shelf standard service package with service providers (captive managers, investment managers, bankers, auditors, lawyers) assigned to the captive as a whole. Individual cell participants usually do not have the freedom to choose their own service providers. Should service standards suffer on the program, the cell participant may find it difficult to change service providers. An owned captive is a custom solution with service providers selected purely for that captive. Service providers are directly accountable for the individual captive program. Accounting - FAS 113 requires that there be a "significant chance of a significant loss" in an insurance contract for it to be subject to insurance accounting. Otherwise deposit accounting will apply. The general consensus is that risk transfer is limited in each cell of a PCC due to the legal fire walls inherent in the PCC structure and the collateral requirements of the PCC owner. Typically in a PCC the full limit of each policy is funded through premium and collateral. Therefore, there is no potential for loss and no risk transfer has occurred. While owned captives must be structured appropriately to include the required risk transfer elements, most will meet FAS 113 as capital is being put at risk in the captive. Tax Issues - A related issue applies to the tax treatment of owned captives versus PCCs. There are a couple of issues to consider. Firstly will the captive be treated as an insurance company for tax purposes? This has the benefit of allowing for deductibility of premiums. There is a reasonable body of law that defines parameters for an owned captive to meet this test. However, there is minimal case law applying to PCCs. As mentioned previously, the tax position for a PCC participant is probably significantly weaker than for an owned captive due to the lack of risk transfer. A second tax issue is whether a captive can qualify under the 831(b) small insurance company tax regulation. This provides that insurers with less than $1.2 million in premium can elect not to be taxed on their underwriting income. Most small owned captives can qualify for this tax beneficial election. However, if a PCC participant can not qualify as a bona fide insurer due to a lack of risk distribution and shifting, then it can not be considered an 831(b) insurance company. This may result in the loss of significant tax benefits. Scrutiny - Owning an insurance subsidiary may draw undue attention internally. Participating in a PCC overcomes this as the participant is not the owner of the insurance company. Conclusion Like other decisions affecting the creation of a captive program, there are pros and cons with owning versus renting. There is no single answer to cover all situations. The options need to be evaluated against the characteristics of each insured's situation. Additionally the two options do not need to be considered purely as alternatives. A cell program can also be used as a stepping stone to the creation of an owned captive. In this situation, it will be important to negotiate the exit strategy up front as the holding of collateral by the PCC may limit the funds available to capitalize an owned captive. About SRS SRS provides underwriting, management and wholesale brokerage services in the alternative insurance market. They design, implement, manage and grow captive and ART programs on behalf of corporations, groups and insurance companies. SRS is an approved manager of captive insurance companies in Arizona, Bermuda, Cayman Islands, South Carolina & Vermont. Through a wholly owned subsidiary SRS is also licensed as an insurance broker in Bermuda. For more information on SRS, visit them at www.strategicrisks.com. Contact: info@strategicrisks.comAbout SRS SRS provides underwriting, management and wholesale brokerage services in the alternative insurance market. They design, implement, manage and grow captive and ART programs on behalf of corporations, groups and insurance companies. SRS is an approved manager of captive insurance companies in Arizona, Bermuda, Cayman Islands, South Carolina & Vermont. Through a wholly owned subsidiary SRS is also licensed as an insurance broker in Bermuda. For more information on SRS, visit them at www.strategicrisks.com. Contact: info@stategicrisks.com