Alternative Risk Management

Repurposing Aging Captives

Companies that let their captives gather dust could be missing out on savings opportunities.
By: | November 2, 2016 • 6 min read

Many companies could be losing out on thousands or even millions of dollars in tax benefits as well as significant cash flow and cost savings by neglecting or leaving their old captives dormant, according to industry experts.

Captives are effectively insurance subsidiaries used by a parent company to insure against its own and affiliates’ risks.

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Such is their popularity, particularly in property and casualty, that it’s estimated that more than 90 percent of Fortune 500 companies now have at least one captive.

However, there are many dating back to the 1970s, domiciled offshore in places like Bermuda or the Cayman Islands, that are no longer used or have been put into runoff.

The risks of having an older captive are numerous — exposure to long-tail claims, the loss of institutional claims knowledge and records, and many are written without an aggregate limit.

But increasingly now instead of putting the captive into runoff or a solvency scheme, risk managers are starting to use them as part of a broader risk management strategy to deal with their legacy and emerging liabilities.

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As a spin-off, this enables companies to potentially derive an accelerated tax benefit if the captive is properly structured, increase their cash flow, use their capital more efficiently and see significant cost savings.

“It’s fundamentally about using the captive to provide a dedicated funding source to meet legacy liability claims in a tax-efficient manner,” said Daniel Chefitz, partner at Morgan Lewis & Bockius.

Dormancy Risks

Michael Serricchio, senior vice president of Marsh Captive Solutions’ captive advisory group, said that the main reason for a captive becoming dormant is a company not realizing its intended purpose or value.

“Maybe there’s been a change of risk manager or the management team and whoever set up the captive is no longer there and the captive is sitting there doing nothing because there’s no perceived value or it’s not properly understood,” he said.

“But even if the captive is just sitting there dormant or it is in runoff, you are still incurring running costs and claims, not to mention the capital that’s tied up in it.”

Chefitz said that among the main risks associated with a dormant captive are obligations to meet new legacy claims, a lack of control over the flow and handling of claims following a merger or acquisition, and exposure to liability from released trapped equity.

Sean Rider, executive vice president and managing director of consulting and development at Willis Towers Watson, said that the biggest risks of having a dormant or older captive were adverse claims development and investment outcomes.

“The main risk is leaving it dormant for too long. Then it’s ultimately harder to get it started up again and ready for when you really need the coverage.” — Gloria Brosius, corporate risk manager, Pinnacle Agriculture Holdings

Gloria Brosius, corporate risk manager at Pinnacle Agriculture Holdings and a RIMS board member, said that the longer a captive is left dormant, the harder it is to get it up and running again.

“The main risk is leaving it dormant for too long,” she said. “Then it’s ultimately harder to get it started up again and ready for when you really need the coverage.”

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Chefitz said that dormant captives are often revived because of a need for additional insurance to cover legacy liabilities such as asbestos, product liability, toxic tort and environmental claims.

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“Typically this arises when a company has a large reserve on its books, and a need for additional risk transfer,” he said.

But oftentimes risk managers and companies will be prompted into action when a loss occurs, said Jason Flaxbeard, executive managing director of Beecher Carlson.

“What will usually happen is that something bad occurs,” he said. “Companies will then start to question why they have that captive and that’s when decisions need to be made. But a well-managed captive shouldn’t have that issue.”

In this situation, Serricchio said that it was essential to undertake a thorough strategic review of the captive.

Sean Rider, executive vice president, Willis Towers Watson

Sean Rider, executive vice president, Willis Towers Watson

“The first question you need to ask is, ‘Does it make sense to keep the captive or even have it in the first place?’ ” he said.

Rider said that risk managers need to decide whether these older or dormant captives can be used as an execution tool within the company’s risk financing strategy.

“It’s really about understanding the captive’s role in facilitating an evolving risk financing strategy and how it can be used going forward,” he said.

Managing Legacy and Emerging Liabilities

The main advantage of resurrecting a dormant captive is for a company to deal with its legacy liabilities by fully insuring against any outstanding or future claims, said Chefitz.

This can be achieved by using the captive to establish a dedicated funding source to supplement the existing insurance coverage or to fill in any gaps in a tax-efficient manner, he said.

It also enables the company to maximize the value of its historical insurance coverage by smoothing the cash flow, he added.

“If a company has legacy liabilities, rather than trying to avoid or defer it, a sensible approach is to use the situation to your advantage by fully funding the legacy liability. This will then enable you as a risk manager to focus on your emerging and ongoing liabilities instead.”

Serricchio said that a dormant captive could also be used for writing emerging and non-traditional risks such as employee benefits, supply chain, cyber security, medical stop-loss and environmental risks.

Flaxbeard added that the current soft market allowed risk managers to be more creative with their captives through the sale of add-on products.

“Many companies are going into ancillary products that they can sell to their clients alongside their core products, such as extended warranties,” he said.

Tax Benefits and Issues

If qualified as an insurance company for tax purposes, captives can also provide a host of other benefits, said Chefitz.

By insuring these existing reserves on a company’s balance sheet with a captive, they are then effectively moved from the parent to the captive’s balance sheet, he said.

Daniel Chefitz, partner, Morgan Lewis & Bockius

Daniel Chefitz, partner, Morgan Lewis & Bockius

He added that the loss reserves from a captive were immediately deductible, thus accelerating the tax deduction within the parent’s consolidated group and monetizing the associated deferred tax asset.

Furthermore, the premium paid to a captive is also tax deductible if certain tests are met, he said.

“The increased cash flow as a result of the accelerated tax deduction can be invested in a tax-efficient manner and used to support the treasury goals of the organization,” he said.

When added up, all of these deductibles could potentially provide companies with thousands or even millions in tax benefits.

Meanwhile, another advantage has been provided under the recent 831(b) tax code change, with the annual limit at which captives and insurers can elect not to be taxed on their premium income being increased from $1.2 million to $2.2 million, effective from 2017, said Gary Osborne, president of USA Risk Group.

“This is a real opportunity for companies to put some good risks into their captive and to derive the tax efficiencies,” he said.

Domicile Choice

Another key consideration for companies looking to redomicile their captive is the self-procurement tax under the Nonadmitted and Reinsurance Reform Act for surplus and excess lines, said Flaxbeard.

“This is a problem for many companies who may look to redomesticate to their home state,” he said.

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“Some have got around this by setting up a branch to write direct policies to the parent company incurring captive premium tax rather than a self-procurement tax.”

Among the other factors when considering a domicile are the captive’s legal, management and operational structure, as well as its capital use, said Chefitz.

Ultimately though, Rider said, companies need to consider whether it’s worth changing the captive’s structure or moving it at all.

“You need to consider whether the original domicile is still the best domicile and whether the original structure is still the best structure for you, or should you abandon the captive altogether and transfer the liabilities to a new one,” he said. &

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Alex Wright is a U.K.-based business journalist, who previously was deputy business editor at The Royal Gazette in Bermuda. You can reach him at [email protected]

More from Risk & Insurance

More from Risk & Insurance

2018 Most Dangerous Emerging Risks

Emerging Multipliers

It’s not that these risks are new; it’s that they’re coming at you at a volume and rate you never imagined before.
By: | April 9, 2018 • 3 min read

Underwriters have plenty to worry about, but there is one word that perhaps rattles them more than any other word. That word is aggregation.

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Aggregation, in the transferred or covered risk usage, represents the multiplying potential of a risk. For examples, we can look back to the asbestos claims that did so much damage to Lloyds’ of London names and syndicates in the mid-1990s.

More recently, underwriters expressed fears about the aggregation of risk from lawsuits by football players at various levels of the sport. Players, from Pee Wee on up to the NFL, claim to have suffered irreversible brain damage from hits to the head.

That risk scenario has yet to fully play out — it will be decades in doing so — but it is already producing claims in the billions.

This year’s edition of our national-award winning coverage of the Most Dangerous Emerging Risks focuses on risks that have always existed. The emergent — and more dangerous — piece to the puzzle is that these risks are now super-charged with risk multipliers.

Take reputational risk, for example. Businesses and individuals that were sharply managed have always protected their reputations fiercely. In days past, a lapse in ethics or morals could be extremely damaging to one’s reputation, but it might take days, weeks, even years of work by newspaper reporters, idle gossips or political enemies to dig it out and make it public.

Brand new technologies, brand new commercial covers. It all works well; until it doesn’t.

These days, the speed at which Internet connectedness and social media can spread information makes reputational risk an existential threat. Information that can stop a glittering career dead in its tracks can be shared by millions with a casual, thoughtless tap or swipe on their smartphones.

Aggregation of uninsured risk is another area of focus of our Most Dangerous Emerging Risks (MDER) coverage.

The beauty of the insurance model is that the business expands to cover personal and commercial risks as the world expands. The more cars on the planet, the more car insurance to sell.

The more people, the more life insurance. Brand new technologies, brand new commercial covers. It all works well; until it doesn’t.

As Risk & Insurance® associate editor Michelle Kerr and her sources point out, growing populations and rising property values, combined with an increase in high-severity catastrophes, threaten to push the insurance coverage gap to critical levels.

This aggregation of uninsured value got a recent proof in CAT-filled 2017. The global tally for natural disaster losses in 2017 was $330 billion; 60 percent of it was uninsured.

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This uninsured gap threatens to place unsustainable pressure on public resources and hamstring society’s ability to respond to natural disasters, which show no sign of slowing down or tempering.

A related threat, the combination of a failing infrastructure and increasing storm severity, marks our third MDER. This MDER looks at the largely uninsurable risk of business interruption that results not from damage to your property or your suppliers’ property, but to publicly maintained infrastructure that provides ingress and egress to your property. It’s a danger coming into shape more and more frequently.

As always, our goal in writing about these threats is not to engage in fear mongering. It’s to initiate and expand a dialogue that can hopefully result in better planning and mitigation, saving the lives and limbs of businesses here and around the world.

2018 Most Dangerous Emerging Risks

Critical Coverage Gap

Growing populations and rising property values, combined with an increase in high-severity catastrophes, are pushing the insurance protection gap to a critical level.

Climate Change as a Business Interruption Multiplier

Crumbling roads and bridges isolate companies and trigger business interruption losses.

 

Reputation’s Existential Threat

Social media — the very tool used to connect people in an instant — can threaten a business’s reputation just as quickly.

 

AI as a Risk Multiplier

AI has potential, but it comes with risks. Mitigating these risks helps insurers and insureds alike, enabling advances in almost every field.

 

Dan Reynolds is editor-in-chief of Risk & Insurance. He can be reached at [email protected]