Single parent captives: Still viable?

Soft market brings on strategic reviews

By Michael J. Moody, MBA, ARM

The soft insurance market typically provides a number of challenges for captive insurance companies. For group captive and risk retention groups, it is sometimes difficult to maintain their members in a soft insurance market. Frequently, they struggle to retain competitive advantages. But it’s not just group captive programs that must justify their existence. Single parent captives also feel the pressure during soft markets. Worldwide there are more than 5,000 captives and it is estimated that over 70% are single parent captives, so it is important to continue to justify their need to their parents.

Most captive consultants believe that a strategic review of captives should be done every five to six years. However, these discussions about reviews usually intensify during soft markets. Such is the case today. Most captive consultants have been working overtime to keep up with the demand for strategic reviews of single parent captives.

And while the current soft market conditions have stimulated much of the review conversation, it has also arisen due in part to a potential change in the IRS’s position with regard to consolidated financial statements. Late in 2007, the IRS made known that it was considering legislation known as Proposed Regulation on Intercompany Insurance Obligations [1.1502-13 (e)] that would eliminate the tax deductions for reserves established by captive insurers. These applied to captives that sold insurance to affiliate organizations but ultimately consolidated their financials into a single return. After the release of the proposed legislation, the IRS was subjected to significant industry opposition to the changes and in February 2008 withdrew its proposal. The concern that this has caused with some captive owners remains, however. As a result, some owners are looking at reviewing the continued viability of their captives.

Single parent captive 101

First, it’s important to provide a basic definition of the single parent captive. For this purpose, we will define a single parent captive, or, as they are referred to in some state regulations, a “pure” captive, as a captive that is established to insure the risk of its owner. In its most basic form, single parent captives typically are required to have an admitted carrier (i.e., the fronting carrier) issue a guaranteed cost policy. The fronting carrier then cedes a portion of the premium to the captive. Typically, the amount represents the premium for the captive’s share of expected losses. The captive may choose to transfer some of the other risk on to other reinsurers to better manage its capital and surplus.

More recently, single parent captives have been used in conjunction with large deductible insurance programs. In this example, admitted carriers also issue a policy, but it is subject to a deductible. The captive is established so it can issue a deductible buyback policy to the pair. In this instance, the captive reimburses the parent company for losses up to the amount of the deductible. These types of captives frequently have come to be used in conjunction with large deductible workers compensation programs. One of the major attractions of the deductible buyback program is that it negates the need for a fronting carrier. According to Derick White, president, Strategic Risk Solutions (Vermont) Ltd., the deductible buyback type captive has been the most popular in recent years. He says that many of the single parent captives that have been formed in Vermont, as well as a number of other domiciles, have used the deductible buyback approach.

Originally single parent captives were used almost exclusively by Fortune 500-type companies. However, recent years have seen a significant number of formations of single parent captives by much smaller corporations. Simon Owen, managing director of Hyperion Risk Solutions, British Virgin Islands (BVI), says that one of the key reasons for this movement is a very favorable tax situation for smaller captives. He points out that there are two specific tax sections directed at small captives.

The first section is 501(c)15, which deals with captives that have premiums of less than $350,000. But the second section has been getting the majority of attention, according to Owen. This section, 831(b) applies to captives with annual premiums less than $1.2 million. These captives can elect to be taxed only on their investment income. Owen says there are significant advantages to these captives since they can accumulate surplus from underwriting profits free of tax. And he points out, that the 831(b) captives represent the majority of new formations within the BVI in recent years.

Current situation

In the past few years there have been a number of innovative uses for single parent captives. One of the most noted was the use of captives to reinsure a portion of the cost of employee benefits. While this aspect has gotten significant attention within the captive community, progress in this area has been slow. Most experts agree, however, that the employee benefit aspects may well represent the future of single parent captives and, as progress continues, it will become easier for others to implement.

One of the most important aspects of risk management in recent years has been the expansion to a broader view known as enterprise risk management (ERM). Some consultants believe that the single parent captive can begin to serve as the focal point for an ERM program. Many believe that ERM needs to have this centralized approach to be able to fulfill its strategic vision.

The use of the single parent captive for wealth preservation also has been gaining favor over the past few years. The single parent captive owner can employ a number of strategies to both enhance their ability to retain wealth as well as be able to pass wealth on to others. single parent captives have proven to be an effective asset protection mechanism as well. It is anticipated that small corporations will continue to utilize and expand these applications.

Conclusion

As the use of captives continues to be placed under strategic review, some observers have wondered if single parent captives are still viable. While most of the strategic reviews provide, in effect, a re-do of the original captive feasibility study, they can be helpful for the manager of the captive. In addition to the traditional concerns about whether the captive is a prudent deployment of capital, reviews should also address expanded areas of usage for the captive. That being the case, one would expect to find that not only are single parent captives still viable, but in many instances they should be broadened in their scope and provide additional uses for the parent.

Bottom line, the captive move-ment, for the most part, grew out of insurance buyers’ frustration with the unpredictability and, even worse, the undependability of the commercial insurance market. At this point, there appears to be little evidence that this issue has been resolved by the insurance industry, thus indicating that a captive would still be a good bet for many business owners.