An important first step in delivering strategic risk management value
The growth of insurance captives has surprised many in the traditional insurance marketplace. The soft insurance market, people expected, would reduce the interest in captives. Despite conventional wisdom, the captive sector has continued to grow.
Along with this growth has come interest from organizations and their agents and brokers in how to make use of captives. But many potential owners had a problem as they started exploring the concept. They didn’t know where to start.
For many, the answer is simple: Conduct a feasibility study. Such a study will document the decision-making process used to justify whether or not to go forward with a captive. It’s a good way to shed light on various types of captives, past loss experience, projected exposures, captive ownership, and more. The feasibility study on its own is important. It also should be included as part of the business plan required by the domicile where the captive is to be registered.
One of the first decisions to make is who will perform the feasibility study. Some potential owners have retained the services of a qualified independent captive consultant. Lawyers, actuaries, and third-party claims professionals can help as well. Most big box brokers have established separate divisions toassist potential owners in determiningwhether creating a captive makes sense.
Location, location, location
A good feasibility study will address a number of important elements, but one stands out and should be addressed early on: the selection of a captive domicile. Not that many years ago this was a rather easy decision: You could domicile onshore or offshore. But the captive landscape has changed. Today, a half dozen or more offshore domicile options exist; and there are well over 30 onshore choices. Vermont is the undisputed domestic champ. But another eight to 10 onshore domiciles could be described as major. Heading the offshore list are Bermuda and the Cayman Islands.
When considering a captive domicile, it’s important to consider several major factors, including location, capital requirements, and investment restrictions. Operating costs, taxes, perception of the domicile, and flexibility of regulations also are important features.
Perception of the domicile has become an increasingly important consideration and is a key aspect of a feasibility study. For example, some corporations are not interested in having a captive that makes the Internal Revenue Service’s “Dirty Dozen” list of tax scams. Captive capitalization should be one of the major aspects of the study as well. Generally speaking, the traditional amount required for offshore domiciles has been about 50% less than the amount for onshore locations. However, the gap is narrowing as competition has increased.
A good feasibility study will address a number of important elements, but one stands out and should be addressed early on: the selection of a captive domicile.
Running the numbers
The financial aspects of the study ultimately will help to determine whether or not a captive is the right option. Among the financial information required is the very basic determination of coverage. Is the captive going to write liability-only coverage? Or will it offer some combination of liability and property? A more recent approach has been to use a captive for unique exposure, such as cyber or reputation risk. In this way, the captive can be a much more strategic element of an organization’s overall risk management program.
The size of the captive has, for the most part, become a moving target. Initially—50 or so years ago, when companies first began using captives—they were the exclusive territory of Fortune 500 corporations. Few agents, brokers or consultants gave more than passing lip service to captives if the premium was less than $500,000. But then the hard market of the 1980s began in earnest, and some organizations saw a captive as a way to manage their liability exposures. Minimum premiums have been going down since then. Today, middle market accounts are responsible for most of the growth in the arena.
One issue that will require some serious consideration is taxes. If you retain the services of a qualified captive consultant, it will be sure to point out that taxes will not be a part of the study, the thought being that taxes are quick to change. Further, for the most part, taxes are beyond the control of the owner. While taxes should not be viewed as the rationale for captive formation, care must be taken with risk transfer and risk distribution, since issues here could endanger tax deductibility.
It’s important to remember that significant differences exist—and not only in domiciles and captive makeup. As one long-time legal expert so aptly notes, “If you have seen one captive, you have seen one captive.” While many of the options considered in a feasibility study may seem similar to each other, there are differences. And those differences will define not only the captive, but the unique direction it takes.
As mentioned earlier, most domicile regulators will not approve formation of a captive without a current feasibility study. Even so, some potential owners see captive feasibility studies as a necessary evil. Nothing could be further from the truth. If a captive owner uses the information uncovered during the feasibility phase, it will be that much closer to understanding the role the captive plays in the organization’s overall long-term risk management plan.
That’s why it’s important to not just pay lip service. Take a comprehensive approach to developing and conducting a feasibility study. From there, it’s possible—easy, even—to incorporate the findings into a strategically designed risk management approach.
Michael J. Moody, MBA, ARM, is the retired managing director of Strategic Risk Financing, Inc. (SuRF), a firm that was established to provide consulting services to captive and other alternative risk transfer mechanisms. As a regular columnist, he continues to actively promote the benefits of the ART market by providing current, objective information about the market, the structures being used, and the players involved.