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

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R&I Profile

Achieving Balance

XL Catlin’s Denise Balan stays calm and focused when faced with crisis.
By: | January 10, 2018 • 6 min read

In the high-stress scenario of kidnap or ransom, the first image that comes to mind isn’t necessarily a yoga mat — at least, not for most.

But Denise Balan, senior VP and head of U.S. kidnap & ransom, XL Catlin, who practices yoga every day, would swear by it.

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“I looked at these opposing aspects of my life,” she said. “Yoga is about focus, balance, clarity of intent. In a moment of stress, how do you respond? The more clarity and calmness you maintain, the better positioned you are to provide assistance in moments of crisis.

“Nobody wants to be speaking to a frenetic person when either dealing with a dangerous situation or planning for prevention of a situation,” she added.

“There’s a poem by [Rudyard] Kipling on that,” added Balan’s colleague Ben Tucker. “What it boils down to is: If you can remain calm, you can manage through a crisis a lot better.”

Tucker, who works side by side with Balan as head of U.S. terrorism and political violence, XL Catlin, has seen how yoga influences his colleague.

“The way Denise interacts with stakeholders in this process — she is very professional and calm in the approach she takes.”

Yin and Yang

Sometimes seemingly opposite or contrary forces may actually be complementary and interconnected. In Balan’s life, yoga and K&R have become her yin and yang.

She entered the insurance world after earning a juris doctor degree and practicing law for a few years. The switch came, she said, when Balan realized she wasn’t enjoying her time as a commercial litigator.

Denise Balan, senior VP and head of U.S. kidnap & ransom, XL Catlin

In her new role, she was able to use her legal background to manage litigation at AIG, where her transition from law to insurance took place. She started her insurance career in the environmental sector.

In a chance meeting in 2007, Balan met with crisis management underwriters who told her about kidnap and ransom products.

She was hooked.

Because of her background in yoga, Balan liked the crisis management side of the job. Being able to bring the calmness and clearness of intent she practiced during yoga into assisting clients in planning for crisis management piqued her interest.

She then joined XL Catlin in July 2013, where she built the K&R team.

As she became more immersed in her field, Balan began to notice something: The principles she learned in yoga were the same principles ex-military and ex-law enforcement practiced when called to a K&R-related crisis.

She said, “They have a warrior mentality — focus, purpose, strength and logic — and I would say yoga is quite similar in discipline.”

“K&R responders have a warrior mentality — focus, purpose, strength and logic — and I would say yoga is quite similar in discipline.” — Denise Balan, senior VP and head of U.S. kidnap & ransom, XL Catlin

Many understand yoga to be, in itself, one type of meditation, but yoga actually encompasses a group of physical, mental and spiritual practices. Each is a discipline. Some forms of yoga focus on movement and breathing, others focus on posture and technique. Some yoga is meant to relax the mind and create a sense of calmness; other yoga types make participants sweat.

After having her second child and working full-time, Balan wanted to find something physical and relaxing for herself; a friend suggested yoga. During her first lesson, Balan said she was enamored with it.

“I felt like I’d done it all my life.”

She dove into the philosophy of yoga, adopting the practice into her daily routine. Every morning, whether Balan is in her Long Island home or on a business trip, she pulls out her yoga mat to practice.

“I always travel with my mat,” she said. “Daily practice is the simplest form of connection to routine to maintain my balance — physically and mentally.”

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She said the strangest place she has ever practiced was in Lisbon. She was on a very narrow balcony with a bird feeder swarming with sparrows overhead.

After years of studying and practicing, Balan is considered a yogi — someone who is highly proficient in yoga. She attends annual retreats with her yoga group, where she is able to rejuvenate, ready to tackle any K&R event when she returns.

In 2016, Balan visited Tuscany, Italy, where she learned the practice of yoga nidra, a very deep form of meditation. It’s described as the “going-to-sleep stage” — a type of yoga that brings participants to a state of consciousness between waking and sleeping.

“It awakens a different part of your brain,” Balan commented. “Orally describing it doesn’t quite do it justice. One has to practice Nidra to fully understand the effect it has on your being.”

Keeping a level head during a crisis is key in their line of business, Tucker said. He can attest to the benefit of having a yogi on board.

“I’ve seen her run table-top exercises where there is this group of people in a room and they run an exercise, a simulation of a kidnap incident. Denise is very committed to what we’re doing,” said Tucker.

“She brings that energy. She doesn’t get flustered by much.”

Building a K&R Program

When Balan joined XL Catlin, she was tasked with creating the K&R team.

Balan during a retreat in Sicily, Italy, 2017

She spent time researching and analyzing what clients would want in their K&R coverage. What stuck out most to Balan was the fact that, in these situations, the decision to purchase kidnap and ransom cover is rarely made because of desire for reimbursement of money.

“I asked why people buy this type of coverage. The answer was for the security responders,” she said.

“These are the people who sit with the family. They’re similar to psychologists or priests,” Balan further explained. “Corporations can afford to pay ransom. They buy [K&R] because it gives them access to these trained and dedicated professionals who not only provide negotiation advice, but actually sit with a victim’s family, engaging deep levels of emotional investment.”

“I’ve learned to appreciate all moments in life — one at a time. The ability to think clearly and calmly guides my work, my practice and my personal life.” — Denise Balan, senior VP and head of U.S. kidnap & ransom, XL Catlin

Balan described these responders as people having total clarity of purpose, setting their intentions to resolve a crisis — a practice at the very heart of yoga. She knew XL Catlin’s new kidnap program would put stock in their responders.

“I’ve worked closely with the responders to better understand what they can do for our clientele. These are the people who run into danger — warrior hearts married to dedication to our clients’ best interests.”

But K&R is more than fast-paced crisis and quick thinking; Balan also spent a good deal of time writing the K&R form and getting the company’s resources in order. This was a huge task to tackle when creating the program from the ground up.

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“A lot of my day-to-day is speaking with brokers and finding ways to enhance our product,” she said.

After a few months, she was able to hire the company’s first K&R underwriter. From there, the program has grown. It’s left her feeling professionally rewarded.

“People don’t often get that opportunity to build something up from scratch,” she said. “It’s been an amazing experience — rewarding and fun.”

“She brings groups of people together,” said Tucker. “She’s created a positive environment.”

Balan’s yogi nature extends beyond the office walls, too. Her pride and joy, she said, are her kids. And while it may seem like two large parts of her life are opposite in nature, Balan’s achieved balance through her passions.

“[Yoga] has given me the ability to see beyond only one aspect of any situation” she said. “I’ve learned to appreciate all moments in life — one at a time. The ability to think clearly and calmly guides my work, my practice and my personal life.” &

Autumn Heisler is a staff writer at Risk & Insurance. She can be reached at [email protected]