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

Risk Report: Hospitality

Bridging the Protection Gap

When travelers stay home, hospitality companies recoup lost income through customized, data-defined policies.
By: | October 12, 2017 • 9 min read

In the wake of a hurricane, earthquake, pandemic, terror attack, or any event that causes carnage on a grand scale, affected areas usually are subject to a large “protection gap” – the difference between insured loss and total economic loss. Depending on the type of damage, the gap can be enormous, leaving companies and communities scrambling to obtain the funds needed for a quick recovery.

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RMS estimates that Hurricane Harvey’s rampage through Texas could cause as much as $90 billion in total economic damage. The modeling firm also stated that “[National Flood Insurance Program] penetration rates are as low as 20 percent in the Houston area, and thus most of the losses will be uninsured.”

In addition to uninsured losses from physical damage, many businesses in unaffected surrounding areas will suffer non-physical contingent business interruption losses. The hospitality industry is particularly susceptible to this exposure, and its losses often fall into the protection gap.

Natural catastrophes and other major events that compromise travelers’ safety have prolonged impacts on tourism and hospitality. Even if they suffer no physical damage, any hotel or resort will lose business as travelers avoid the area.

“The hospitality industry is reliant on people moving freely. If people don’t feel safe, they won’t travel. And that cuts off the lifeblood of the industry,” said Christian Ryan, U.S. Hospitality and Gaming Practice Leader, Marsh.

Christian Ryan
U.S. Hospitality and Gaming Practice Leader, Marsh

“People are going away from the devastation, not toward it,” said Evan Glassman, president and CEO, New Paradigm Underwriters.

Drops in revenue resulting from decreased occupancy and average daily room rate can sometimes be difficult to trace back to a major event when a hotel suffered no physical harm. Traditional business interruption policies require physical damage as a coverage condition. Even contingent business interruption coverages might only kick in if a hotel’s direct suppliers were taken offline by physical damage.

If everyone remains untouched and intact, though, it’s near impossible to demonstrate how much of a business downturn was caused by the hurricane three states away.

“Hospitality companies are concerned that their traditional insurance policies only cover business interruption resulting from physical damage,” said Bob Nusslein, head of Innovative Risk Solutions for the Americas, Swiss Re Corporate Solutions.

“These companies have large uninsured exposure from events which do not cause physical damage to their assets, yet result in reduced income.”

Power of Parametrics

Parametric insurance is designed specifically to bridge the protection gap and address historically uninsured or underinsured risks.

Parametric coverage is defined and triggered by the characteristics of an event, rather than characteristics of the loss. Triggers are custom-built based on an insured’s unique location and exposures, as well as their budget and risk tolerance.

“Triggers typically include a combination of the occurrence of a given event and a reduction in occupancy rates or RevPar for the specific hotel assets,” Nusslein said. Though sometimes the parameters of an event — like measures of storm intensity — are enough to trigger a payout on their own.

For hurricane coverage, for example, one policy trigger might be the designation of a Category 3-5 storm within a 100-mile radius of the location. Another trigger might be a 20 percent drop in RevPAR, or revenue per available room. If both parameters are met, a pre-determined payout amount would be administered. No investigations or claims adjustment necessary.

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The same type of coverage could apply in less severe situations where traditional insurance just doesn’t respond. Event or entertainment companies, for example, often operate at the whim of Mother Nature. While they may not be forced to cancel a production due to inclement weather, they will nevertheless take a hit to the bottom line if fewer patrons show up.

Christian Phillips, focus group leader for Beazley’s Weatherguard parametric products, said that as little as a quarter- to a half-inch of rain over a four- to five-hour period is enough to prevent people from coming to an event, or to leave early.

“That’s a persistent rainfall that will wear down people’s patience,” he said.

“A rule of thumb for parametric weather coverage, if you’re looking to protect loss of revenue when your event has not actually been cancelled, you will probably lose up to 20 to 30 percent of your revenue in bad weather. That depends on the client and the type of event, but that’s the standard we’ve realized from historical claims data.”

The industry is now drawing on data to establish these rules of thumb for more serious losses sustained by hospitality companies after major events.

“Until recently the insurance industry has not created products to address these non-physical damage business interruption exposures. The industry is now collaborating with big data companies to access data, which in turn, allows us to structure new products,” Nusslein said.

Data-Driven Triggers

Insurers source data from weather organizations that track temperature, rainfall, wind speeds and snowfall, among other perils, by the hour and sometimes by the minute. Parametric triggers are determined based on historical storm data, which indicates how likely a given location is to be hit.

“We try to get a minimum of 30 years of hourly data for those perils for a given location,” Phillips said.

“Global weather is changing, though, so we focus particularly on the last five to 10 years. From that we can build a policy that fits the exposure that we see in the data, and we use the data to price it correctly.”

New Paradigm Underwriters collects their own wind speed data via a network of anemometers that stretch from Corpus Christi, Texas, all the way to Massachusetts, and works with modeling firms like RMS to gather additional underwriting information.

The hospitality industry is reliant on people moving freely. If people don’t feel safe, they won’t travel. And that cuts off the lifeblood of the industry.– Christian Ryan, U.S. Hospitality and Gaming Practice Leader, Marsh

While severe weather is the most common event of concern, parametric cover can also apply to terrorism and pandemic risks.

“We offer a terror attack quote on every one of our event policies because everyone asks for it,” said Beazley’s Phillips.

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“We didn’t do it 10 years ago, but that’s the world we live in today.”

An attack could lead to civil unrest, fire or any number of things outside an insured’s control. It would likely disrupt travel over a wide geographic region.

“A terrorist event could cause wide area devastation and loss of attraction, which results in lost income for hospitality companies,” Nusslein said.

Disease outbreaks also dampen travel and tourism. Zika, which was most common in South America and the Caribbean, still prevented people from traveling to south Florida.

“Occupancy went down significantly in that region,” Marsh’s Ryan said.

“If there is a pandemic across the U.S., a parametric coverage would make sense. All travel within and inbound to the U.S. would go down, and parametric policies could protect hotel revenues in non-impacted areas. Official statements from the CDC such as evacuation orders or warnings could qualify as a trigger.”

Less data exists around terror attacks and pandemics than for weather, though hotels are taking steps to collect information around their exposure.

“It’s hard to quantify how an infectious disease outbreak will impact business, but we and clients are using big data to track travel patterns,” Ryan said.

Hospitality Metrics

Any data collected has to be verified, or “cleaned.”

“We only deal with entities that will clean the data so we know the historical data we’re getting is accurate,” Phillips said.

“There are mountains of data out there, but it’s unusable if it’s not clean.”

Parametric underwriters also tap into the insured’s historical data around occupancy and room rates to estimate the losses it may suffer from decreased revenue.

Bob Nusslein, head of Innovative Risk Solutions for the Americas, Swiss Re Corporate Solutions.

“The hospitality industry uses two key metrics to measure loss of business income. These include occupancy rate and revenue per available room, or RevPAR. These are the traditional measurements of business health,” Swiss Re’s Nusslein said.  RevPAR is calculated by multiplying a hotel’s average daily room rate (ADR) by its occupancy rate.

“The hotel industry has been contributing its data on occupancy, RevPAR, room supply and demand, and historical data on geographical and seasonal trends to independent data aggregators for many years. It has done an exceptional job of aggregating business data to measure performance downturns from routine economic fluctuations and from major ‘Black Swan’ events, like the 9/11 terrorist attacks, the 2008 financial crisis or the 2009 SARS epidemic.”

Claims history can also provide an understanding of how much revenue a hotel or an event company has lost in the past due to any type of business interruption. Business performance metrics combined with claims data determine an appropriate payout amount.

Like coverage triggers, payouts from parametric policies are specifically defined and pre-determined based on data and statistical evidence.

This is the key benefit of parametric coverage: triggers are hit, payment is made. With minimal or no adjustment process, claims are paid quickly, enabling insureds to begin recovery immediately.

Applying Parametric Payments

For hotels with no physical damage, but significant drops in occupancy and revenue, funds from a parametric policy can help bridge the income gap until business picks up again, covering expenses related to regular maintenance, utilities and marketing.

Because payment is not tied to a specific type or level of loss, it can be applied wherever insureds need it, so long as it doesn’t advance them to a better financial position than they enjoyed prior to the loss.

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Parametric policies can be designed to fill in where an insured has not yet met their deductible on a separate traditional policy. Or it could function as excess coverage. Or it could cover exposures excluded by other policies, or for which there is no insurance option at all. Completely bespoke, parametric coverages are a function of each client’s individual exposures, risk tolerance and budget.

“Parametric insurance enables underwriting of risks that are outside tolerance levels from a traditional standpoint,” NPU’s Glassman said.

The non-physical business interruption risks faced by the hospitality industry match that description pretty closely.

“Hotels are a good fit for parametric insurance because they have a guaranteed loss from a business income standpoint when there is a major storm coming,” Glassman said.

While only a handful of carriers currently offer a form of parametric coverage, the abundance of available data and advancement in data collection and analytical tools will likely fuel its popularity.

Companies can maximize the benefits of parametric coverages by building them as supplements to traditional business interruption or event cancellation policies. Both New Paradigm Underwriters and Beazley either work with other property insurers or create hybrid products in-house to combine the best of both worlds and assemble a comprehensive risk transfer solution. &

Katie Siegel is an associate editor at Risk & Insurance®. She can be reached at [email protected]