Jim Bulkowski and Andrew Christie of EY discuss certain strategies to assess if your captive should take on additional risks

So, your organisation has had a captive in place for a few years, or 20 or 30 years, and not much has changed in its usage. While your captive may still fulfil its original purpose, its surrounding environment has changed.

The insurance market has hardened; the federal and state tax landscapes have changed; the pandemic has shifted organisations’ focuses; environmental, social and governance (ESG) adherence is more critical; supply chain challenges exist due to global unrest; cyber threats are increasing due to technological advancements, and so on.

Your organisation has also likely changed, such as the ownership structure, rebranding, mergers and acquisitions, and new products and territories. All or some of these factors favour a review of the captive programme to determine whether it makes sense to expand the captive’s scope to insure additional risks.

This article examines how companies can potentially identify new risks for their captive to insure. It also identifies common risks that captives currently insure, as well as risks that are not suitable for a captive insurer.

New captive risk opportunities

Firstly, review the organisational risk framework from an enterprise risk management perspective. This is important with or without a captive, however, the captive may provide insurance support that the commercial market will not.

Companies may be able to identify new captive risk opportunities by reviewing the following:

• Form 10-K: If the entity is a public company, look at the Form 10-K section titled ‘risk factors’. This provides a narrative of the C-suite’s risk concerns. These risks can often be insured through a captive. The Form 10-K also lists liabilities labeled ‘non-deductible liabilities’ such as casualty reserves, environmental, asset retirement obligations (AROs), warranties, etc. These liabilities can often be insured in a captive.
• Internal networks: Talk to the enterprise risk management group and read their risk reports. Supply chain colleagues can identify pain points throughout the product lifecycle that may not be currently covered by commercial insurance (eg business interruption that’s not tied to a physical damage event). Most organisations are cognisant of pending ESG targets and ESG financial disclosure requirements; if not, the conversation should be started with stakeholders (namely, the C-suite). Employee-related risks can be discussed with human resources. Treasury, tax, legal and important stakeholders in the captive (expansion) discussions may already sit on the captive’s board of directors.
• External networks: Talk to peers in your space, such as industry groups, the Risk and Insurance Management Society, the American Bar Association, the Casualty Actuarial Society, the Federal Bar Association, the National Association of Tax Professionals or the LinkedIn CFO Network to name a few.

While there are only 24 hours in the day, this diligence could significantly benefit an organisation. Just the process of analysing risks in order to insure in a captive is beneficial, regardless of whether the captive’s scope changes.

Risks to consider when contemplating captive utilisation/expansion

The risks an organisation faces are exhaustive and only continue to grow, as seemingly evidenced by the thousands of risks identified in recent ESG reporting. Not all risks make sense to be insured, so it’s important to prioritise.

The following are some of the more common risks, usually with a high dollar spend or risk potential, into which captives are venturing:

• Medical and pharmacy self-insured risks (not attracting ERISA), including medical stop-loss: This merges property and casualty with health-related risks, cultivating a collaborative risk focus throughout the organisation (as treasury, tax and legal may also be involved). This may also provide third-party risk in a captive, which could further strengthen a captive’s qualification as an insurance company from a federal tax perspective.
• ARO cost overruns for oil and mining companies: AROs occur once the shovel hits the ground or a well is dug. In these industries, such future obligations may collectively run into the hundreds of billions of dollars. Future reclamation costs are uncertain and insurance for cost overruns may be prudent. Funding AROs may provide an opportunity to realise capital management and tax efficiencies on ARO captive premiums (assuming appropriate structuring).
• Shrinkage and theft of goods for retailers: Large retailers often have over $500 million in shrinkage annually, with considerable variability in this number. A captive can provide budget certainty at the district or store level for swings in shrinkage costs. There may also be additional cash tax efficiencies for those with a strong captive insurance company tax fact pattern.
• Pandemic coverage: Who would have thought five years ago this would be a realistic risk? Each new Covid-19 variant has the potential to create another shutdown or some new virus that is yet unknown and unforeseen. Expanding your existing captive to cover these eventualities could mean the difference between a company surviving and/ or bankruptcy.
• Supply chain tied to non-damage business interruption: Business interruption lawsuits are still ongoing from companies being shut down due to Covid-19-related supply chain issues. Raw material and transportation shortages caused by global unrest have exacerbated the problem. Any company with a physical supply chain has, without any doubt, had issues.
• Parametric risks: This is a fancy way of saying that the occurrence of a specific triggering event will result in an insurance payout without all of the ensuing litigation. For example, an earthquake that hits 7.0 on the Richter scale in a certain geographic zone, as measured by the US Geological Survey, will generate a payout of $50 million. The same payout could result from power outage, floods, etc. A captive that couples this with reinsurance could strategically limit its exposure.
• Brand damage: Thousands of risks can affect brands, which leads to a revenue shortfall. These risks are further compounded by ESG as well as social inflation considerations. Limits on insuring risks through captives A word of warning — not all risks are suitable for captive inclusion. The following require purchase of commercial insurance (or some other hedging product):
• a regulatory mandate (like US workers’ compensation or auto liability)
• compliance with a contract mandating purchase of insurance
• liquidity concerns and not wanting to retain significant risk, eg large property risk, excess liability, directors and officers of public companies
• special service or added benefit the insurance company offers, like kidnap and ransom negotiation or trade credit
• C-suite mandate to buy insurance Considerations that may be viewed as deterrents to writing a new risk in a captive may include the following:
• Difficulty quantifying the risk: It is clear a risk exists, but the loss and associated insurance premium must be actuarily quantified to adequately price the risk and support regulatory and tax authority scrutiny. The analysis time and vendor cost, coupled with regulatory and tax risk, may not pass the risk and reward threshold. No single factor should be a driver or a deterrent from forming a captive structure – the assessment of the benefit should be multilateral and holistic for all the organisation.
• Capital requirements: New risk structures may cause concern with regulators, with uncertain loss potential and frequency generating a requirement for more capital than the rule of thumb 4-to-1 ratio of premium to capital.
• Year-over-year maintenance requirements: Policies will often require an actuarial analysis to be done every year, generating consulting expenses. Policies with long tail or discovery periods will also need to be maintained to ensure payment accuracy.

Conclusion

Certainly, there are endless risks and opportunities for potential captive expansion into new areas. This expansion, however, needs to be approached prudently, weighing the benefits and costs and taxpayer fact patterns.

A phased approach is often recommended, prioritising new risks that provide clear benefit to the organisation, being mindful of regulatory and tax concerns. Of course, the risk identified today may change entirely tomorrow, so be vigilant and always be aware that you have a tactical and strategic tool at your fingertips — the captive!