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

2017 RIMS

Resilience in Face of Cyber

New cyber model platforms will help insurers better manage aggregation risk within their books of business.
By: | April 26, 2017 • 3 min read

As insurers become increasingly concerned about the aggregation of cyber risk exposures in their portfolios, new tools are being developed to help them better assess and manage those exposures.

 One of those tools, a comprehensive cyber risk modeling application for the insurance and reinsurance markets, was announced on April 24 by AIR Worldwide.

Scott Stransky, assistant vice president and principal scientist, AIR Worldwide

Last year at RIMS, AIR announced the release of the industry’s first open source deterministic cyber risk scenario, subsequently releasing a series of scenarios throughout the year, and offering the service to insurers on a consulting basis.

Its latest release, ARC– Analytics of Risk from Cyber — continues that work by offering the modeling platform for license to insurance clients for internal use rather than on a consulting basis. ARC is separate from AIR’s Touchstone platform, allowing for more flexibility in the rapidly changing cyber environment.

ARC allows insurers to get a better picture of their exposures across an entire book of business, with the help of a comprehensive industry exposure database that combines data from multiple public and commercial sources.

The recent attacks on Dyn and Amazon Web Services (AWS) provide perfect examples of how the ARC platform can be used to enhance the industry’s resilience, said Scott Stransky, assistant vice president and principal scientist for AIR Worldwide.

Stransky noted that insurers don’t necessarily have visibility into which of their insureds use Dyn, Amazon Web Services, Rackspace, or other common internet services providers.

In the Dyn and AWS events, there was little insured loss because the downtime fell largely just under policy waiting periods.

But,” said Stransky, “it got our clients thinking, well it happened for a few hours – could it happen for longer? And what does that do to us if it does? … This is really where our model can be very helpful.”

The purpose of having this model is to make the world more resilient … that’s really the goal.”Scott Stransky, assistant vice president and principal scientist, AIR Worldwide

AIR has run the Dyn incident through its model, with the parameters of a single day of downtime impacting the Fortune 1000. Then it did the same with the AWS event.

When we run Fortune 1000 for Dyn for one day, we get a half a billion dollars of loss,” said Stransky. “Taking it one step further – we’ve run the same exercise for AWS for one day, through the Fortune 1000 only, and the losses are about $3 billion.”

So once you expand it out to millions of businesses, the losses would be much higher,” he added.

The ARC platform allows insurers to assess cyber exposures including “silent cyber,” across the spectrum of business, be it D&O, E&O, general liability or property. There are 18 scenarios that can be modeled, with the capability to adjust variables broadly for a better handle on events of varying severity and scope.

Looking ahead, AIR is taking a closer look at what Stransky calls “silent silent cyber,” the complex indirect and difficult to assess or insure potential impacts of any given cyber event.

Stransky cites the 2014 hack of the National Weather Service website as an example. For several days after the hack, no satellite weather imagery was available to be fed into weather models.

Imagine there was a hurricane happening during the time there was no weather service imagery,” he said. “[So] the models wouldn’t have been as accurate; people wouldn’t have had as much advance warning; they wouldn’t have evacuated as quickly or boarded up their homes.”

It’s possible that the losses would be significantly higher in such a scenario, but there would be no way to quantify how much of it could be attributed to the cyber attack and how much was strictly the result of the hurricane itself.

It’s very, very indirect,” said Stransky, citing the recent hack of the Dallas tornado sirens as another example. Not only did the situation jam up the 911 system, potentially exacerbating any number of crisis events, but such a false alarm could lead to increased losses in the future.

The next time if there’s a real tornado, people make think, ‘Oh, its just some hack,’ ” he said. “So if there’s a real tornado, who knows what’s going to happen.”

Modeling for “silent silent cyber” remains elusive. But platforms like ARC are a step in the right direction for ensuring the continued health and strength of the insurance industry in the face of the ever-changing specter of cyber exposure.

Because we have this model, insurers are now able to manage the risks better, to be more resilient against cyber attacks, to really understand their portfolios,” said Stransky. “So when it does happen, they’ll be able to respond, they’ll be able to pay out the claims properly, they’ll be prepared.

The purpose of having this model is to make the world more resilient … that’s really the goal.”

Additional stories from RIMS 2017:

Blockchain Pros and Cons

If barriers to implementation are brought down, blockchain offers potential for financial institutions.

Embrace the Internet of Things

Risk managers can use IoT for data analytics and other risk mitigation needs, but connected devices also offer a multitude of exposures.

Feeling Unprepared to Deal With Risks

Damage to brand and reputation ranked as the top risk concern of risk managers throughout the world.

Reviewing Medical Marijuana Claims

Liberty Mutual appears to be the first carrier to create a workflow process for evaluating medical marijuana expense reimbursement requests.

Cyber Threat Will Get More Difficult

Companies should focus on response, resiliency and recovery when it comes to cyber risks.

RIMS Conference Held in Birthplace of Insurance in US

Carriers continue their vital role of helping insureds mitigate risks and promote safety.

Michelle Kerr is associate editor of Risk & Insurance. She can be reached at [email protected]