Forming a captive: where to begin? – Special Supplement: Vermont Captives
Thomas J. Slattery
Pricing, taxes, coverage and a hard market make a case for captive formation.
Driven to choose between traditional insurance and an alternative risk mechanism, why opt for a captive insurance scenario? Then again, why not? And why now, in this hard market? And if you’re so disposed, how do you choose a domicile? And how does Vermont figure in that choice?
Risk & Insurance posed these questions to two experts in the field of captive formation.
John Prescott is a CPA with the public accounting firm of Johnson Lambert in Burlington, Vt. Joel Chansky is a principal and consulting actuary with Milliman USA in Wakefield, Mass. Here’s what they had to say.
Why would a commercial insured even consider forming a captive insurance company?
John Prescott: Of course, the need becomes more acute when the market is hard as it is now, but I think it’s control over the product being offered and, to a lesser degree, control over pricing.
Joel Chansky: It’s for a variety of reasons. One would be insurance pricing and coverage. The market is too expensive. The insurance market becomes overpriced and that’s what sends people to the captive market, first and foremost. What follows is stability. As insurance prices gyrate up and down, buyers want a stable budget for insurance costs, stability of pricing. When pricing goes so high, they achieve savings by not going to the traditional market.
Second, there are taxes. There are federal savings that can be achieved by setting up a captive. We’ve done a model of a typical basket of coverages for a company for workers’ compensation, general liability and auto liability, and we estimate federal tax savings of about 3 percent of underlying losses. If a company has a $10 million forecast for those lines, we estimate $300,000 in savings every year on average. It also depends on the payout pattern–how long it takes to pay those losses or, alternatively, how long you get to carry reserves, with some interest rate assumptions. You’re using the IRS’ money. As a self-insurer you pay less upfront.
The traditional wisdom is that captives aren’t for everyone. So, why not form a captive?
John Prescott: Right now, because the market is so hard, there are more people looking into the possibility of forming a captive. They have stayed away from the captive market traditionally. Some of them have a history of losses. Or they just may not have the premium volume to support a captive. If you do have the loss experience, or not enough volume, or if you have risks that are extremely volatile, with low frequency but high severity, then that can be difficult coverage to insure in a captive. Because captives have been around for so long, a lot of groups for whom it made sense have already formed. There are always companies looking at captives, companies reaching a certain size that now have the volume to support a captive. But you do have to be careful about a lot of new people coming to the market trying to do anything they can not to get caught up in the commercial hard market. You have to make sure it makes sense for those companies.
For small companies, it doesn’t make sense. Maybe a sponsored captive or a “rent-a-captive” does, where you run your losses through a segregated cell. A feasibility study is key here. Fifteen years of experience or more is most reliable.
Joel Chansky: Size is important. If your operation or your premiums aren’t of a certain size, it may not make sense to self-insure. If your losses aren’t predictable, the better way to budget and to stabilize is to transfer your risk to the insurance market. Size is key.
For example, a large corporation with a huge work force will have millions and millions of dollars of workers’ comp losses every year, and they’re fairly predictable. Then it becomes a question of whether you want to take advantage of the tax savings and the stability you have in your own losses by not transferring to an insurance market which might not be that stable. The insurance market might try to raise your prices by 50 percent even though your losses are fairly stable every year. A smaller company doesn’t have that stability–perhaps a million-dollar loss one year and a $50,000 the next year. That company is probably better off paying a couple of hundred thousand dollars in premium every year in the traditional market. Size is really critical.
Then, again, there are taxes. It takes some effort to set up the mechanism in such a way that satisfies IRS guidelines. It costs money to have a captive insurance company. There are fees and expenses, premium taxes, captive management fees, and fees for actuaries, accountants, and lawyers. And at the end of the day, the tax deduction and the savings are not guaranteed. An argument not to have a captive is that it may be more expensive to have a captive than not have one, usually, again, depending on size.
Another consideration is structure. If your structure and coverages don’t match up with the favorable scenarios for taking the deduction you might actually lose money. You might try to take the deduction and have the IRS disapprove it. Some companies don’t want to take that risk, Why spend that money?
Another way to achieve deductibility is to write “unrelated business,” or business outside your own corporation. That can be pretty risky. A typical captive is insuring itself for workers’ comp, liability and the like. But the IRS has looked more favorably on captive operations that insure exposures outside their operations, because that achieves what the IRS calls risk distribution and risk transfer.
The IRS historically has viewed insuring one’s self as insuring within the same economic family. There is no insurance. You’re transferring risk to yourself. So you shouldn’t be able to take a deduction. IRS has come down in various rulings that if you insure outside parties, then this whole concept of an insurance company takes on more validity. There’s more of a traditional spread of risk, risk transfer, and risk distribution. It makes the captive and all its transactions more defensible as insurance, as opposed to just inter-company movement of funds.
Though it’s not in the IRS Code, the conventional wisdom is that if you have 30 percent or more of this unrelated premium it will probably allow you to justify all transactions and take the corresponding deductions.
Having said all that, this can be risky. Companies paid the price back in the ’70s and ’80s trying to meet those percentages. They went out and said, “We’ll take whatever we can find to meet this test,” and they lost more money on that than they possibly could have made by getting the tax deduction.
As an example, Vermont pays careful attention to the business plans submitted. They make sure there’s unrelated business and checks-and-balances and controls. Vermont particularly likes what they call “related unrelated business,” which is business that’s not legally connected to the corporation, though there are ties. For example, a vendor who supplies the corporation. That vendor might become a purchaser of insurance from the captive–unrelated business, yet there’s a clear connection.
Another example is construction. You might have an organization that builds retail stores and warehouses in various locations. Essentially, they’re in the construction business, though they don’t do it themselves. They hire third-party contractors. And while those contractors are building those stores, they can insure the contractors’ liability and workers’ comp. They call them owner-controlled insurance programs, and they have a lot of say as to what goes on at the worksite and how the construction is done. Regulators have looked favorably on things like that as well.
Why form a captive now, in a hard market?
John Prescott: If your feasibility study doesn’t make sense or if you don’t have at least a five-year commitment, don’t do it. It’s not a short-term solution. You don’t jump back and forth between the commercial market and a captive. We do see companies that have left their captives dormant for five to seven years, so there’s nothing to say that you can’t, if times permit, go back to the commercial market. But it’s nothing you want to do long term.
Joel Chansky: Hard market captive formation avoids potential over-charging by the insurance industry. That’s a short-term solution. What can stay behind, long term, is that it becomes a stability mechanism.
Most companies are in it for life. We’ve seen when the market was soft, some captive companies wound down and went back to the traditional market or were left dormant. I’d say maybe somewhere around 5 percent of captives either wind down lines of business or just put their business on the shelf for a few years before reactivating because the traditional market is better.
They go into it because of the hard market, pricing and availability. If prices are too high they go into it to save money. Instead of paying $3 million in premium, they pay $2 million, and if that $2 million is the long-term average, they’ll continue to pay $2 million over the next how many years. And if they have the captive setup, they don’t have to deal with the insurance market anymore. They’ve taken the variability of pricing out of the equation, which is a great thing for anyone who lives and dies by setting up budgets every year.
That’s the pricing side. On the availability side, sometimes the insurance market says we’re not going to write that coverage anymore. So now you don’t have any insurance. And then the question is, do you operate without any insurance at all or do you set up a captive insurance company and write your own policy. A lot of companies do that and achieve the tax savings.
Are there reasons not to consider forming a captive insurance company in a hard market?
Joel Chansky: It costs money to investigate and to form a captive. It could be that the savings associated with forming a captive isn’t that great. If it’s an availability issue, a corporation might prefer not to have any coverage at all. A captive would cause them to set up a whole company and file applications and tie up capital in a regulated environment. A captive is an insurance company. It’s going to be regulated by an insurance department wherever it goes and you’re going to have to put up capital to support it.
There’s a middle road: a sponsored captive, or segregated cell, where the owner of the facility, not you, is regulated. If you have your own captive, you have to deal with corporate governance issues, with board meetings, and it uses up time. If you’re in a rent-a-captive, someone else does that for you.
So you decide to form a captive. Where do you locate? How do you choose among domiciles like Bermuda, Vermont and others?
John Prescott: We work with the District of Columbia and South Carolina as well as Vermont. Reputation is important, as is an effective regulatory environment. You want a relationship where you can partner with the State of Vermont, say, but also with the service providers there–the management companies, the lawyers and the accountants who can tell you how you should run these captives and what lines you should you be in.
Joel Chansky: The key considerations are infrastructure and cost.
Third is something unique that points you to one domicile or another.
Is there a mature insurance department or regulator that can respond to issues? Are there providers for accounting, actuarial, legal and captive management services? Vermont scores an “A” on all those. So does Bermuda, and some other domiciles.
In Vermont, for example, if you want to pick up the phone during the formation stage and you have questions about how the company is going to be regulated, someone’s going to be there to answer the call and set up a meeting. They’ll point you to service providers who might help. They’re good at that. They’re user -friendly. They compare favorably with other domiciles. Part of it is that they’ve been at it the longest. Vermont had a big growth spurt in the ’80s. Others have been at it as long, but they never flourished or matured. Vermont promoted its market in the ’80s and continues into the ’90s and into the ’00s. They’re just a step ahead of the other domiciles. Now Hawaii is pretty well along, with over 100 captives. South Carolina too is developing an infrastructure, and then there’s the new District of Columbia captive law that’s getting ramped up.
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