Government policies enable growing use of captives by middle market businesses
IRVINE, Calif .— More than 90% of Fortune 1000 companies have a captive insurance company[1]. That fact says a lot about the viability and value of captive insurance operations. However, confusion and misinformation have kept many organizations from exploring the captive option.
What is a Captive?
A captive is a wholly owned subsidiary created to provide insurance to its non-insurance parent company (or companies). Captives are established to meet the risk-management needs of the owners or members. They are essentially a form of self-insurance whereby the insurer is owned wholly by the insured. Once established, the captive operates like any commercial insurer—i.e., it issues policies, collects premiums and pays claims, but it does not offer insurance to the public—and it is regulated as a captive, rather than as a traditional insurer.
The captive concept has been around for a long time. In the early 1500s, ship owners met in the London coffeehouses where they retained, shared and transferred the cost of risk associated with their ships, comparable to today’s captives. During the 1700s and 1800s, groups of particular industries got together to provide insurance coverage with the formation of mutual insurance companies. There are various types of captive structures. Most captives insure only the risk of its parent (single parent or “pure” captive). In addition to single-parent captives, there are group/association captives, special purpose capitves, risk retention groups, agency captives, branch captives, senior or diversified captive, protected cell captive and producer owned reinsurance companies (PORCs), to name a few. Variations continue to develop as companies come up with more innovative and sophisticated ways to use captives.
Why Companies Create Captives
Originally created to solve problems: Captive formation and utilization usually peaked during periods of rising commercial insurance costs and when there was difficulty in obtaining insurance coverage. Historically, after major events hit commercial insurers, such as the terrorist attacks, like the Twin Tower bombing, Sept. 11, 2001, or Hurricane Katrina in 2005, there was an increase in captive formation. With the introduction of Section 831(b), of the Internal Revenue code, captive formations continues to rise regardless of hard or soft markets, especially within the middle market companies, where Section 831(b) is most beneficial, allowing them access to more effeicient risk management, better risk control, and cost reduction, something the Fortune 500 companies have been benefitting from for decades.
Captives have become a popular risk-management tool for organizations seeking greater control over their insurance needs. Two main drivers for forming captives are risk management and risk financing. It also allows the parent company to respond quickly to changes in the commercial insurance market and to identify the most efficient way to finance and manage risk. This could mean a lower cost of coverage than standard insurance markets. The parent also could use a captive to obtain coverage for risks that, are unattainable or too costly. Additionally, with direct access to the reinsurance market, a captive can reduce the cost of insurance.
While certain tax advantages exist with respect to a properly formed captive, this is not the primary reason why captives are established. All U.S. jurisdictions require a business plan for regulatory approval and the premise for a captive must not be tax-related. Nevertheless, there are important incidental tax benefits associated with owning a captive.
Background – Why and How Small Captives Evolved
The “perfect storm” that hit the insurance industry in 1986 seriously limited the capacity of many commercial insurers to offer coverage to the middle market, thus helping to prompt the enabling legislation of the Tax Reform Act of 1986 (TRA 86). TRA 86 included Section 831(b), enacted to encourage smaller companies to finance their own risk. The result was the formation of hundreds of captive insurance programs that take advantage of Section 831(b). These smaller captive insurance companies are also known as “ enterprise risk captives,” or sometimes called, “micro-captives,” and are programs that have been formed to bring higher efficiency and more structured control to risk management. Thousands of mid-sized companies see them as an effective business tool to manage risk.
A series of events in the 1980s created a multiplier effect that spurred the U.S. Congress to enact 831(b) as a powerful tool for mid-sized businesses to form qualified small insurance companies. With interest rates at the time in the teens, insurance companies were keen on attracting as much premium as possible to invest in what is known as cashflow underwriting. However, this did not always turn out to be good for the insurance companies, especially as interest rates declined.
At the same time, a financial crisis of unprecedented proportion struck the industry when a huge number of underwritten liabilities, many stemming from asbestos and other enviormental exposures, began to emerge, which presented long term claims exposure It is estimated that more than 100 million people in the United States were occupationally exposed to asbestos, to which, more than $275 billion in asbestos-related claims have been paid out by insurers. As capacity shrunk, due to poor investment earnings and with the greater severity and volume of claims, than expected more firms went bankrupt, or were unable to continue to provide insurance to smaller businesses. These issues among others contributed to the multifacited liability crisis that lead to legislation changes.
Enter Section 831(b), designed by the government to offer a powerful tool to small and mid-sized businesses. All together there are now reportedly more than 5,000 captives currently being used by U.S. businesses.
The small captive comes with a wide range of benefits for middle market businesses – the same benefits that larger corporations have taken advantage of for years. In addition, under Section 831(b), insurance companies with under $1.2 million in premiums gain a significant tax benefit on their underwriting profits. Middle market captives are also being used to insure or reinsure workers compensation, general liability and auto liability exposure. Others are using captives to reduce health insurance costs by 15-20%.
Although the rapid growth of micro-captives has drawn scrutiny by regulators on the lookout for fraudulent operations, it’s worth remembering that the code was developed with a genuine interest in assisting businesses who otherwise were not able to afford commercial insurance, or were in a market that lacked the capacity to take on that line of risk. The regulatory community is actually supportive of captives that have a legitimate risk management business purpose and comply with all the regulations.
However, today, many companies that could be eligible to establish a captive program of their own have not yet done so. It is a challenge for the captive industry and a huge opportunity for many businesses looking for ways to be more competitive through an enhanced risk management program.
*Insurance Journal, January 24, 2011 http://www.insurancejournal.com/news/southcentral/2011/01/24/181705.htm
**http://wmsolutionsnow.com/what_is_a_captive_insurance_company.html
About Active Captive Management
Active Captive Management (ACM) was established in 2005 and handles the needs of a wide range of companies in the design, development and implementation of alternative risk solutions. ACM offers comprehensive management servicesencompassing insurance policy underwriting and administration, claims processing, company accounting and captive regulatory compliance management. ACM is an approved captive manager in 17 domestic and three offshore captive domiciles. For more information, visit http://www.activecaptive.com/
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[1] Forbes.com, 1/28/13 (http://www.forbes.com/sites/bmoharrisbank/2013/01/28/why-companies-are-opting-for-captive-insurance-arrangements/)
