EY: Common captive formation crises and how to address them

Andrew Christie and Mikhail Raybshteyn of EY discuss how prospective captive owners can address the challenges of forming a captive

 

Forming a captive insurance company to formalise an organisation’s self-insurance programme is top of mind these days for many risk managers and tax directors. Captives offer organisations risk-management and risk-financing benefits, along with possible tax efficiencies when structured appropriately. To access these benefits, however, prospective captive owners must overcome three challenges. First, they must address the distinct concerns of other departments within the organisation about forming a captive. Second, they must consider how the company’s formation of a captive could be perceived by external stakeholders, such as ratings firms, stockholders or banks. Finally, they must understand and execute the steps for forming a captive.

Internal: stakeholder considerations

For an organisation that is not in the insurance sector, forming and operating an insurance company brings different considerations for different stakeholders. Based on our experience, the following are some likely concerns different stakeholders will want addressed:

  1. The executive team/owners: As every company’s leadership generally focuses on the best return on an investment, the executive team will want to know how forming a captive will benefit your company. To the extent the organisation has insurance challenges, raising deductibles and writing risk through a captive could save money. Using a captive could also give the organisation direct access to reinsurance markets, as well as providing more flexibility when it comes to coverage terms and conditions, the ability to settle and litigate claims in-house, and centralised risk funding, which could provide capital allocation efficiencies. The captive’s status as an insurance company for tax purposes could also benefit the organisation. If the captive qualifies as an insurance company for US federal tax purposes, under Subchapter L of the Internal Revenue Code, special tax rules apply that effectively permit the captive to recognise a large percentage of its income from gross contractual premiums rateably over the life of the policy as well as deduct currently established loss reserves. This is true even though policyholders may deduct insurance premiums paid to the captive when paid, provided certain criteria is met (eg policies are 12 months or less in duration, admitted as insurance contracts). The timing difference between when the organisation deducts the insurance premiums and when the captive recognises such premiums as income may provide additional value in a higher interest-rate environment. Certain tax savings may also exist at the state level, and some of these differences may result in permanent tax-rate savings.
  2. Treasury: In addition to return on investment, treasury will likely want to know whether the captive funding may allocate funds away from present endeavours, such as debt servicing or acquisition funding. The answer, generally, is no. The insurance premiums paid to the captive remain within the affiliated group. If the arrangement is properly structured, the group may access them, provided they are payable to the captive upon demand, among other criteria. Accordingly, cash on hand increases within the affiliated group as potentially lower economic outlays to the external insurance market combined with cash tax savings. Treasury may also want to know whether captive funds can be pooled with corporate investments. The answer is yes, but such pooling needs to be properly structured. As a general rule, the captive should have a certain portion of assets in its name or readily available to it, to meet solvency and liquidity needs. Funds can be invested in cash or investment pools or cash sweeps; such arrangements, however, need to be structured in a way that allows a captive quick and easy access to cash to satisfy claims.
  3. Tax: For the tax department, captive formation raises questions about whether the captive will file a separate tax return or join a group’s consolidated return if one is filed. Most often, the captive files as part of the parent’s consolidated tax return where a consolidated tax group exists. This may differ for tax-exempt organisations, group captives with multiple owners, certain captives organised and domiciled outside of the US, and any captive not qualified as an insurance company for tax purposes. Captive owners and the captive’s managers should consult with tax subject matter professionals to understand the filing requirements in each particular set of facts and circumstances. At the state level, captive owners should consider their own tax filing profile and how it may include or exclude a captive insurer based on income tax regimes in various states and individual states’ rules around admitted and non-admitted insurers. Additional tax considerations include whether self-procurement tax may apply and how, as each state has varying laws around the issue. Captive premium taxes and any similar indirect state tax obligations should also be considered. For a captive domiciled outside the US, a separate set of considerations needs to be examined; controlled foreign corporation (CFC) tax rules, federal excise tax, withholding tax regime and base erosion and anti-abuse tax are some of them.
  4. Accounting: For the accounting department, captive formation raises questions about how the captive will affect the group’s consolidated financial statements. The short answer is, not a great deal, as the intercompany transactions with a captive are generally eliminated at the GAAP (and IFRS) level. As insurance accounting can differ significantly from non-insurance accounting, however, doing elimination entries may require some assistance from a captive manager or competent technical accounting consultant.
  5. Human resources: With more companies putting some sort of benefits coverage in a captive, HR teams may be pulled more into the captive formation process. If any HR-related coverage or supplemental coverage is contemplated in a captive, the HR team must be integrated as early as possible. Structuring coverages like stop-loss and aggregate medical expense cost-containment programmes may be much simpler than true direct employee benefits programmes as such coverages are generally structured to have limited, if any, impact on existing processes and to not trigger ERISA regulations, nor require Department of Labor approval. With that said, most of the data generally sits with HR, so someone from HR, in most cases, needs to get comfortable with the proposed coverage and process.
  6. Legal: Generally the gate keepers of the organisational structure, the legal team should be consulted early about issues such as where the captive will sit within the organisation and if there is a preferred domicile for legal purposes. Other issues include what form the captive takes for state purposes, whether there should be multiple captives, and where the captive(s) will be domiciled. The larger and more complex the organisation, the more legal involvement is likely to be required. The sponsor of the captive programme planning should connect with internal legal team early in the formation process to mitigate any last-minute potential setbacks.
  7. Risk: Often the risk manager will present the captive case to the previously noted stakeholders. If this is not the case, the risk manager must be comfortable with the captive concept and how it interacts with the rest of the corporate insurance programme. The captive should complement, rather than complicate, the existing insurance programme.

The components required to obtain final approval from the key internal stakeholders should all ideally be addressed by a captive feasibility study, which, along with the overall process, should assess what risks should (or should not) be written in the captive, providing limits, deductibles and retentions.

Actuarial modelling for these risks should outline adverse, expected and favourable scenarios, which are then incorporated into projected financial statements, with associated capital contributions based on the risk exposures. A complete feasibility study should include a tax analysis with respect to the captive’s stand-alone operations and the captive’s effects on the larger organisation.

If service providers don’t have the ability to comment on tax, the project sponsor should secure assistance of a captive-insurance-focused tax-consulting firm to work with primary providers to deliver a holistic feasibility assessment, which could include a tax opinion.

A tax opinion may provide clients with comfort – and support, if challenged – on the captive insurance company’s tax position, deductibility of insurance premiums paid by the insureds, and possible penalty protection if a future tax authority audit results in an unfavourable outcome.

A feasibility study always needs to include a domicile analysis, providing practical insights as to the most beneficial captive domicile for a particular company, which may differ according to the nuances of the organisation. Tax considerations may also impact the choice of domicile.

External perception

In addition to addressing concerns of internal stakeholders, prospective captive owners must be mindful of how a captive could affect the organisation’s image externally. The following are examples of how a captive can help, or harm, a company’s image:

  1. Environmental, social and governance: ESG is one of the key concerns inside company boardrooms today when it comes to external perceptions, both from regulatory and profit perspectives. The captive can play a decisive role in the ESG discussion, potentially by writing tailored ESG risk policies to insure ESG risks specific to the firm or merely by advancing the governance framework of the company as captives are regulated, audited entities that have direct communications with the state of domicile.
  2. Optics: Some foreign jurisdictions are classified as tax favourable due to having a low or zero corporate income tax rate. While this generally does not result in a tax benefit to US companies under the current CFC regime, some offshore captives domiciled in these low or no tax jurisdictions may not be looked at favourably by the business community, despite well-known benefits. For example, court cases may allege potential tax evasion using captive structures established in those domiciles. Captive owners need to weigh these considerations when deciding which domicile is the best fit. Pursuing this approach on a policy basis, captives can, for example, write punitive-damages coverage in certain offshore domiciles, but not in the US. Writing this risk offshore, while protecting the organisation and its executives, may again be viewed negatively. Similarly, using a captive primarily to achieve tax savings may negatively impact the company’s public persona, particularly if the captive comes under IRS or regulatory scrutiny. As such, captives should never be set up for tax reasons.

Forming the captive

Once leadership gives the green light for captive formation, there are many practical items to consider, starting with the regulatory application. Here are some key items:

  1. Disclosure of parent company financial statements: This can cause concern for some privately owned companies or companies owned by a sole shareholder or a family. Regulators aim to offer flexibility in how this information is provided; as an example, an in-person meeting to discuss a set of printed financial statements may sometimes suffice, compared to providing an electronic set of financials, if the financial information is sensitive. Ultimately, the regulator has to be comfortable with the financial standing of the parent/owners in order to issue the captive an insurance licence.
  2. Financial standings: If the captive is owned by an individual(s), the regulator will need to assess the financial standing of the individual(s), which means requesting supporting documentation to substantiate net worth – business holdings, investments, other assets. Further, some applications require affidavits and other personal items that some board members may be reluctant to provide. It’s important to pre-emptively assess these requirements to ensure the application doesn’t get delayed or derailed.
  3. Fronting policy requirements: While a captive insurance company can write many risks directly, some will require fronting. The need for fronting will depend on different factors, such as whether the captive can write the insurance by the state, country or territory; whether any additional regulatory bodies prohibit the captive from writing the insurance directly; whether any third parties object to the captive writing the insurance directly; and whether any stakeholders are uncomfortable with the captive providing the insurance directly. If a fronting policy is required, are partners available and willing to front the programme? For esoteric programmes without much history, or programmes with poor loss history and/or large exposures, this may be challenging. Assuming fronting partners are available, the additional fronting expense should be assessed. There could be fronting policy provisions to which the captive must adhere. The fronting insurer imposes collateral requirements on the captive for issuing the fronting paper. This may not prohibit the prospective transaction, but it should be understood and factored into both the overall cost of the captive and the application time frame, as the regulator will need to see a draft fronting agreement with the application.
  4. Timing: Many prospective captive owners aim to set up a captive within a prescribed time frame. If a captive is writing primary insurance, meeting the time frame is critical so the company can evidence needed-insurance requirements for conducting its business, aside from the potential financial implications. In this case, planning is vital and picking the right domicile and competent service providers will prove invaluable.
  5. Cash and banking: The captive needs to be funded with the requisite capital before its licence can be issued. This is an important detail if timing is a key consideration. Assuming internal communications are moving the process forward, treasury will be aware of the captive formation and ready to send funds per a pre-agreed schedule. The bank must normally provide direct communication to the regulator once funds are received.

Conclusion Over the last 50 years, more companies implemented captives, particularly those among the Fortune 500 and S&P 500. The increased use of captives, however, doesn’t obviate the need for proper implementation planning.

Companies that plan ahead and address the considerations outlined in this article are likely to have a much easier time convincing internal and external stakeholders of the captive’s value. They are also likely to have a smoother implementation process. Those that do not, however, could jeopardise their captive’s formation for a time, if not altogether.

12 August 2024
5-6 November 2025

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