Bryan Ridgway, managing partner at CIC Services, on the issues to think about and steps to take before establishing a new captive insurance company
For over 70 years, captive insurance companies have enabled businesses to protect themselves from complex and ever-evolving threats.
While captives continue to accomplish this in today’s world of precarious supply chains, pandemic disease, war, economic and political strife, and emerging cyber and technological risk, times have changed — and so has the overall captive insurance.
Merely two decades ago, captives were a solution only available to Fortune 500 companies due to the cost and complexity of managing a captive.
Today, however, barriers have fallen and made way for small to mid-sized businesses to have the same opportunity for protection, cost control and wealth accumulation as those Fortune 500 brethren.
In fact, captive insurance is growing now more than ever. The 2021 Captive Benchmarking Survey from Aon found a 73% increase in premium retention among captives with a sizeable growth level not seen in two decades.
Captives also are used across a growing number of industries and to address new perils as innovation poses increased risks (such as robotics, AI and telehealth).
Just as captive insurance has evolved, so have the best practices, and it’s important for captive managers to be aware of trends that will ensure their captives are positioned for success.
At CIC Services, we’ve helped business owners, CEOs, CFOs and risk managers take control of their risk management through captive insurance, and the below are five of the best practices we find are critical in ensuring success.
Follow proper compliance
I can’t stress enough the importance of compliance when it comes to the forming and management of a captive.
Captive owners and those tasked with captive management need to understand all applicable state/domicile-imposed regulations, relevant court cases, and safe harbours published by the Internal Revenue Service (IRS) and apply what is gleaned to the structure.
To do this, there are two primary options: become captive experts or hire a captive manager – a third-party organisation that can manage the intricacies of setting up and maintaining future compliance and operations of the captive.
Qualified captive managers will handle the captive’s day-to-day functions, oversee all other third-party providers and ultimately support the captive’s board of directors and officers in the fulfilment of their fiduciary responsibilities to their shareholders.
In turn, shareholders of the captive are then able to reap the benefits of turning their company’s insurance and risk management programmes into a new profit center.
Another component of compliance that needs to be considered is avoiding self-dealing and ensuring you and your business have arm’s-length transactions with the captive. For this, independent experts (such as attorneys, actuaries and CPAs) should work directly for the captive, not the captive manager, which ensures fair dealings within regulatory guidelines between your business and its captive.
Instead of trying to identify these third party providers on your own, experienced captive managers will make introductions to experts best suited for the intended design and use of your captive.
Choose an appropriate domicile
A captive domicile is the territory, state or country which monitors and regulates captive insurers and would provide the licensure needed to start a captive of your own.
Suffice it to say, understanding the unique regulations and risks associated with the creation and ownership of a captive insurer are essential.
When selecting a potential domicile for your captive, items such as regulatory environment, political stability, tax regime, access to regulators, active industry associations, overall cost and perception of the domicile all must be taken into consideration.
Equally as important is the decision whether to form your captive onshore (selecting from over 30 states and jurisdictions within the US) or offshore, as each option has its own potential tax and related consequences.
Failure to understand any of these aspects may result in the collapse of your captive before you’ve even started.
Here again, I cannot emphasise enough the importance of working with an experienced captive manager to assist in the domicile decision-making process.
As well as helping navigate the litany of considerations discussed previously, your captive manager should also have good rapport and a solid working relationship with the domicile’s regulators.
Thus, your captive manager should ensure a smooth experience from a regulatory perspective while helping to avoid any adverse outcomes during domicile-imposed examinations.
Review and adjust captive-issued policies
Another best practice for captive success is to continually monitor your business and its potential weaknesses and subsequently expand captive-issued policies where your business needs it most.
Considering the business environment is in a state of constant change and evolution with new regulations and requirements entering the equation every day, you need insurance that is versatile.
Captive insurance can help address the risks of operating a successful business in many different areas, including:
- Commercial insurance: Many commercially issued insurance policies can be fully replaced by captive-issued policies. For those policies where commercial insurance is a requirement, such as worker’s comp and auto liability, the captive may be able to insure deductibles, gaps, wholes, and/or other exclusions not covered by the commercial policies.
- Warranties, guarantees, and/or service contracts: Businesses that offer any of these types of contracts to their customers may benefit from formally insuring their risk of loss through their captive via a contractual liability insurance policy (CLIP). This arrangement is one of the most common forms of captive insurance programmes used by manufacturers and retailers throughout the US.
- Surety bonding: Depending on the requirements of your business, a captive insurance programme may be established to either directly bond your work or bond the work of any subcontractors used by your company. Bonds which may potentially be issued by a captive include bid, payment, performance, and fidelity bonds.
- Healthcare and employee benefits: Since captives allow for such fluidity in insurance premiums and plan selection/creation, captives can streamline the challenges of setting up healthcare and employee benefit offerings. Our article in CPA Advisor explains how captives help mitigate and eliminate inefficiency, cash flow challenges and the increasing costs employers are seeing in employer-sponsored healthcare benefits per employee.
- Enterprise risks: Captive insurance can be used as an enterprise-wide strategy to address any and all risks impacting a company which aren’t typically covered by their commercial insurance programme.
Utilising a captive insurance programme to address any or all of the above areas of risk will certainly pay dividends to your company.
And, in comparison to traditional insurance, captive policies can be implemented in a much quicker and more efficient way.
In fact, an article from Deloitte reports that traditional insurers take 12-18 months on average to offer new products and 3-6 months to modify existing insurance products.
With the amount of liabilities and new regulations that can become a factor in that amount of time, the risks are then truly compounded by a slow system.
Stand up to government agencies
Firms with a captive insurance company can and should challenge government agencies when they feel their captive is subjected to undue or over-regulation.
Within my own experience at CIC Services, we stood up to the IRS and achieved both US Supreme Court and Federal District Court victories. In our case, the issue presented to the court was whether the IRS possessed a special privilege no other government agency did.
That being, to pass and enforce even illegal regulations without interference from the courts via the IRS’s interpretation of the Administrative Procedures Act and Anti-Injunction Act, which we disagreed with.
Our general counsel, Sean King, emphasised the tyrannical unconstitutionality of that sort of power and so did the US Supreme Court, which, in a unanimous decision, agreed with our position and set a precedent in stating that the Anti-Injunction Act does not, in fact, prevent federal courts from entering to challenge the lawfulness of some IRS enforcements.
This case was not only huge for us, but it also opened the floodgates and made it possible for captives and businesses everywhere to challenge the IRS in court.
The full lifecycle of your captive
The SC Johnson College of Business at Cornell reports that 40% of businesses transition to second-generation businesses and from there only 13% of those successfully are passed down to a third generation.
Beyond that, the article from Cornell reported that only 3% of businesses are successfully passed down to a fourth generation or beyond.
With the complications included in the transition of business ownership, it is incredibly important to know how to exit a captive as well.
To close a captive, the International Risk Management Institute (IRMI) states that all claimants, actuaries, auditors and regulators must be satisfied and there must be no further obligations of the captive.
This can be a complicated process and there are companies that specialise solely in the close of a captive. If your captive was set up by a captive manager, then they will be able to handle the exit of your captive to ensure an effective transition of assets to future generations.