Q&A: Creating a captive in Vermont

Graham Holdings’ Michael Baker, the Vermont Department of Financial Regulation’s Jim DeVoe-Talluto and Aon’s Jay Curtis reveal the key issues to be taken into account when creating a captive

 

Captive Review (CR): What function does your captive perform for the parent company?

Michael Baker (MB): Currently, we have only our casualty programme in the captive to cover the deductibles. This is to help with any large claims for our start up and smaller businesses.

CR: Why did you think setting up a captive could be a good option for your company?

MB: Two reasons – to assist with a potential large loss for our smaller businesses, and to manage our cost of insurance better.

CR: Having decided a captive was the right option for your company, what decisions were made around the type of captive it would become? And what key factors influenced these decisions?

MB: A single captive made sense for us as it means we can manage our losses and insurance costs ourselves. We chose an experienced domicile that is a very captive-friendly environment.

CR: How long did it take for you to get your new captive up and running? How easy or difficult would you rate the process?

MB: It took two tries for us to get approved internally. From the feasibility study to final approval, it took a good year to get the captive up and running.

CR: What were the biggest challenges you encountered when setting up your captive?

MB: The biggest challenges were understanding the state tax filings, premium allocation to our businesses, understanding the day-to-day work of the captive manager, and determining how much cash is needed up front to invest into the captive initially. The biggest challenge now is to maintain the profitability of the captive and complete a risk assessment of what insurance lines we should put into the captive.

 

CR: What does the regulator look for in a new captive application? What tips would you give new applicants so the approval process goes as smoothly as possible?

Jim DeVoe-Talluto (JD): On a fundamental level, we look first for the answer to the question: “What insurance problem is the company trying to solve with a captive?” Perhaps the company has strong risk management practices and an excellent claims history, but commercial quotes do not reflect those differentiating factors.

In another scenario, a company may already have a large self-insured retention, but they have the resources and capacity to retain even more risk and reduce their overall cost of insurance. In any case, the foundation of a strong application is the feasibility study.

In this study, an actuary engaged by the company typically uses internal and industry data to develop loss projections and determine appropriate levels of capital and premium for the risks the company is planning to insure in the captive.

This data can then be used to prepare five-year financial statement projections that indicate the viability of the captive programme in both expected and adverse loss scenarios. In addition to the feasibility study, the application includes details about planned corporate governance, as well as information about the financial strength of the parent company.

A well-run captive programme typically requires the support of service providers, so our recommendation to prospective captive owners is to identify and engage a strong team in the early stages of captive development. An approved Vermont captive manager will be your guide through the application process, and an actuarial consultant is essential for the feasibility work. A Vermont attorney will assist with corporate formation and development of governance documents.

CR: Once the captive is up and running in the domicile, what will the ongoing requirements be and how much ongoing contact will you have with the captive owner and captive manager?

JD: In addition to annual filing requirements (Vermont Captive Annual Report and premium tax return for pure captives), we also require an annual audit of the financial statements, due six months after captive year-end.

In addition, we regulate captives based on their business plan as filed. Any changes to the original plan (new lines of coverage or changes to policy limits, for example) require prior approval of the captive division. Typically, the captive manager will submit a letter detailing the proposed changes, and we will consider the request within one week, allowing companies to make timely decisions as commercial renewal deadlines approach.

In most circumstances, the captive manager is the primary point of contact with the captive division, but we welcome any periodic updates from the parent company’s risk managers or captive directors. The VCIA Annual Conference, held in early August, is a great time for informal meetings between captive owners and the division, and we look forward to the conference each year.

Every five years, the captive is subject to a statutory examination conducted by division staff. During each examination, our team will conduct informational interviews with key members of the board or other risk management staff.

During these interviews, we inquire about the captive’s ongoing role in the parent’s insurance programme and whether the captive is meeting their needs and objectives. We also enquire about prospective risks facing the captive or the parent and the ways in which the captive can mitigate those risks.

 

CR: What responsibilities do you as captive manager take on in the process of getting a new captive licensed? What responsibilities must the captive owner take on?

Jay Curtis (JC): Our role as the chosen consultant to assist in the formation of a captive is to facilitate the preparation of the captive application to the selected domicile and seek licensure of the newly formed entity.

The process is comprehensive and involves revisiting the results of the captive feasibility study including, but not limited to, confirming the appropriate domicile, the insurance coverages and limits to be insured by the captive, and an introduction of the various experienced and qualified service providers anticipated to be engaged by the captive once operational.

As we progress through the application process, the captive owner will need to make decisions on items such as what legal form the captive will take, whether a stock corporation, limited liability company or other such form as permitted by the selected jurisdiction.

Other matters – such as who will be the initial officers and directors, or their equivalent; where the captive will reside in the corporate structure; evaluating the proper capitalisation of the captive; and what ongoing regulatory requirements will be – are also reviewed in depth. In our role as captive manager, we coordinate all of these activities with both internal and external stakeholders to consider the short- and long-term implications of these critical decisions.

We hold regularly scheduled calls to discuss the impact the captive will have on the various departments within the organisation, conducting calls with risk management, legal, treasury, accounting and tax.

These departments have their own considerations and our consultants work collaboratively with each one to develop the operational framework for the newly formed subsidiary.

CR: What is the process you go through with clients when they are deliberating over whether to form a captive?

JC: Our experienced consultants walk prospective captive owners through the various processes in evaluating whether a captive insurance subsidiary makes sense for their organisation. Throughout the captive feasibility process, we conduct discovery sessions wherein we gain critical insight into an organisation’s risk needs, tolerance and appetite for retaining risk.

The captive feasibility study process helps organisations clarify and document their risk-financing needs and expectations. The study process is collaborative and designed to formally ask and answer the key questions which need to be identified and documented for both the captive owner and for regulatory purposes.

The study will provide reasoned recommendations and support for:

  • Insurance programme structure
  • Domicile
  • Expected losses and premium pricing
  • Capitalisation
  • Five-year financial projections (both expected and adverse scenarios).

The outputs of the feasibility study are used to form the basis of the business plan supporting the captive application in the chosen domicile if the decision is made to move forward with formation of a captive.

Applying best practices, we will engage with actuarial consultants, insurance and reinsurance brokers to identify the most advantageous structure to see if a captive can enhance an organisation’s ability to manage their total cost of risk.

CR: What common mistakes do you see new captive owners making in the captive formation stage and how can they be avoided?

JC: One mistake some captive owners make in establishing a captive insurance subsidiary is bypassing the feasibility process. Although not a common occurrence, in more recent years and in other cyclical hard markets, there can be a pressing need for the captive to be established on relatively short notice as organisations navigate volatile commercial markets and declining capacity.

Though the feasibility study comes at a cost, the analysis covers critical areas that guide clients to making informed decisions, contemplating the short-and long-term objectives of the organisation.

In our experience, when this process is not completed, there tends to be more questions, challenges and delays in receiving senior leadership approval for moving forward with the captive or in receiving the approval for the appropriate level of capital needed to ensure the long-term success of the captive.

Another common mistake we see is organisations funding the captive based on a favourable or expected loss scenario rather than considering the potential for adverse loss experience.

Conceptually, one reason why companies look to form a captive is to reduce their total insurance spend, so it is understandable why a company would be hesitant to fund a captive more conservatively if the allocation of insurance costs to their business units increases when funding through a captive compared to market pricing.

The captive should be viewed as a long-term risk financing tool, so it is critical that total funding — including premium and capital — supports the potential for adverse loss experience, therefore avoiding or minimising the need for management to go back to senior leadership for additional funding of the captive.

Of course, if loss experience is favourable, then any profits that the captive achieves can be redeployed within the organisation or used to accumulate surplus for the potential of expanding the captive utilisation.

12 August 2024
5-6 November 2025

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