Captives for Workers Compensation
In today's volatile workers' compensation insurance market, many companies find themselves in untenable situations. Increasing premiums and claims abuse can drive costs to levels unheard of just a few years ago.
The good news is that many legislatures passed laws for relief. But, while the playing field may be leveling, insurance companies are typically slow to react. Insurance companies by nature only have rearview mirrors, as they must look back to look forward.
Actuarial data must be collected for an extended period of time in order for carriers to make predictions on the losses they can expect. Even though insurers are in the business of covering risks, they are very averse to taking any risk at all. As a result, we have yet to see much downward movement in workers' compensation premiums.
Even when we have seen reductions, there have been increases in other areas, such as classification rates, that result in no improvement at all. With this environment of increasing premiums and costs, many firms are turning to the alternative funding arena for workers' compensation.
Large deductible plans have become increasingly popular. These plans allow a company to elect to pay all claims up to an agreed amount. At the per claim cap, the insurance carrier takes over. Large deductible plans usually have an aggregate stop point to save a firm from catastrophic losses.
For many firms, the use of a captive insurance company to pay the claims can be the tax break cherry on top of these plans. This discussion, while specific to California, will apply to most programs across the US. Please check for any variations your state may have on the information presented here.
Components of a workers' compensation plan
There are several components to every workers' compensation policy that must be in place no matter what type of plan a firm elects to employ: ? Security- All workers' compensation policies must be fronted by an admitted carrier. This satisfies the Director of Industrial Relations as to the validity of the program. The admitted carrier in essence just lends its name to the program. ? Claims Administration- Usually supplied by the carrier or a third party administrator. Each will charge a per claim fee for the service. This provides labor code compliant claims management. ? Aggregate Stop Loss Re-Insurance- Low cost policies obtained from a large re-insurance company to limit the annual cost of the program. The attachment point for these policies is usually at $1,000,000 for all claims in a year. ? Specific Stop Loss- Used to provide capitation for large single claims. These policies usually attach at $250,000 on a per claim basis. ? Loss Fund- There must be a fund in place to pay all current and future claims. The fronting company will only accept a properly secured and maintained fund. A captive is often used here.
Captives
A "Captive" is a closely held insurance company whose insurance business is primarily supplied by and controlled by its owners, and in which the original insureds are the principal beneficiaries. In a captive, the shareholders-insureds actively participate in decisions influencing underwriting, operations and investments. There are two types of captives generally used for workers' compensation. A company that wants to retain complete control over the operation, investment activity, and claims payments of the owned captive should seriously consider the single owner or pure captive. The pure captive will cost more to set up and, depending on the level of involvement the firm elects, involves more hands on time for administrators. A company can operate its own insurance division to maintain complete control over the captive, but a TPA must be employed for claims management. The other and by far more popular type used in the workers' compensation arena is the captive owned by an organization that is not one of the policyholders, commonly referred to as the rent-a-captive. These captives can be run by a broker, a re-insurer, or, more commonly, by a fronting insurance carrier. The fees for this type of captive are usually much lower than the initial capital required to start a single owner captive. However, they do not offer nearly the same amount of flexibility. Investment opportunities are limited, and the managing company controls stock options and dividend payments.
Factors Prompting the Formation of a Captive
The major driving force in pushing companies to the captive market has been the high cost of premiums. Several other factors are also contributing to the movement. There has been an overall lack of broad coverage availability as carriers leave the market, resulting in a loss of competition and a reduction of capacity, and thereby driving premiums up. With the implementation of new rules, this flight is beginning to reverse itself. But, many firms have begun to realize that insurance is a very poor investment of company funds, and retaining at least some of the risk is a sound business practice. There has also been a general lack of flexibility on the carrier's part. They are often unable to satisfy specialized needs for services and coverage. These needs encompass requirements, such as higher retention levels, more closely targeted loss control services, and greater control of claim settlements.
Company Profile for Workers' Compensation Captives
In order to seriously consider the formation of a captive, a company must be financially sound and ready for the commitment involved. Firms that succeed in the captive world will be forward thinking with a serious focus on loss control, safety, and risk management. They will be willing to share the risks involved in compensation and have the organizational ability to deal with uncertainty. Their top managers will be committed to a long-term solution that will build a financial base to allow for a greater level of risk acceptance in the future. The company's losses must be fairly predictable, and the total expected losses cannot be more than the anticipated premium. Last, but far from least, in order for the captive to work as a vehicle for tax savings, the firm must have a workers' compensation premium in excess of $1,000,000 and have a need for moving assets off the company's books.
Tax Advantages of Captives
A Captive is formed to allow a firm to place aside the funds needed to pay present and future claims. Why go to all the trouble and expense? Why not just open a bank account? Placing funds aside or obtaining an LOC for current and future claims payments works well for a firm with low earnings, but leaving assets on the books can be detrimental to other companies. Formation of a captive will basically allow a company to pay premiums to itself. The IRS allows these premiums to be deducted as expenses. And, while the captive must file a tax return and recognize income, the IRS allows insurance companies to deduct for reserves placed aside for claims. The IRS also allows for reserves to be placed aside for claims that are "incurred but not reported". These are reserves placed aside for claims per industry standard that will probably happen, but you do not know about yet. IBNR reserves are also deducted. The captive will accrue interest, and, with careful planning, investment income. But, accounting principles for insurance companies allow for deducting claims reserves. Therefore, unlike the bank account, reserves set aside for future claims payments are deducted immediately. Alternatively, if a firm sets aside cash to pay claims, it must pay tax on those funds before paying the claim. These deductions, along with other normal expenses, will drive up the amount of cash a firm can place in the captive. For a large firm, the amount of capital set aside can be substantial. This is the reason many Fortune 500 firms have entered the captive market and taken on their own risk.
Benefits of a Captive
The primary benefit of a captive is tax control and is not just the fact that a company can set aside capital. A firm with a captive insurance company has taken positive steps in setting aside funds for inevitable expenses in a tax-reduced environment. There is also a greater incentive for management to implement effective loss control and return to work programs. Coordination with claims administrators to reduce or eliminate loses becomes paramount. In this way, senior management will develop a greater understanding of insurance, risk management, and the risk financing process. A captive operates more efficiently for the parent than conventional insurance and can apply a higher percentage of the premium dollar to claims. This, along with accrued investment income, will result in a reduction of the overall cost of insurance. As an insurance company, the captive has direct access to the wholesale insurance market. This will not only lower costs, but it will allow for additional negotiating leverage in dealing with underwriters. There are fewer regulatory restrictions for captives than there are for normal insurers. This is due to the simple fact that captives are generally not dealing with the public, and Departments of Insurance in the captive domiciles feel that a captive will try very hard to "do no harm" to the parent company. When a captive formulates coverage for the parent company, it is generally very favorable. There are some limits, of course. A firm participating in a rent-a-captive has limited control over the insurance form, whereas the owner of a pure captive can cover almost any risk.
Disadvantages of a Captive
When the captive is funded, the company must allocate funds into an area of operation that is not part of the mainstream activities. It is entirely possible that these funds will be needed to cover underwriting losses, albeit on a controlled basis. When a company decides to use a captive, there must be a firm commitment to a long-term goal of lowering costs and absorbing new administration costs. The captive is in no way a short-term price fix. Without a senior management commitment, the firm may face unintended tax consequences as well as unforeseen legal exposure.
In Conclusion
While captives are not right for every company, the tax advantages can be substantial. Captive programs can be funded as needed throughout the year. These funds are considered premium payments by the IRS and are therefore tax exempt, saving the company 38% to 40% up front. A reputable Risk Management firm, in conjunction with a good CPA, should perform a thorough evaluation of your company's insurance needs and financial situation.
Orion Risk Management has the experience and knowledge to evaluate your position and advise you on available avenues of coverage that will suit your particular needs. We work closely with our clients to form the type of coverage best suited to their specific situation. Bill Campbell works in conjunction with the risk management team of Orion Risk Management, Inc. Orion is a leader in alternative risk plans that allow their clients the opportunity to more closely control costs and coverage.
