Posted by Richard Klumpp on Thu, May 17, 2012
The selection of a domicile is one of the first decisions made by a captive owner. The decision typically results from an analysis conducted during the feasibility or formation process.
Once the captive’s license is obtained, many owners rarely give their choice of domicile a second thought. However, yesterday’s ideal domicile may not provide the best solutions for today’s insurance needs for these reasons:
- Change is accelerating – Business and insurance regulations are being examined and adjusted internationally. The IRS has increased its audit activity on overseas insurance transactions involving federal excise tax. Initiatives such as Solvency II have yet to be finalized, and their potential impact on captives is unknown. Simply put, captive owners cannot ignore the need for constant domicile evaluation and re-evaluation.
- Flexibility is a virtue – Well-managed captives remain flexible. They maintain the ability to adapt quickly to their owners’ business needs -- for instance, to act fast when business opportunities such as those offered by a new domicile location arise.
- Competition is increasing – Some domiciles now offer more significant regulatory benefits than others, especially with respect to lines of business. For example, employee benefit stop-loss coverage is not allowed in certain domiciles. Although your captive operates in a regulated environment, this should not mean sacrificing the agility of your business plan and your willingness to change domiciles.
In evaluating or re-evaluating a domicile, owners should annually review the location’s regulatory environment, effect on operational costs, available logistics and support, political environment, and reputation.
Owners should pay close attention to how each of these factors impacts both their current business plan and possibilities that may be on the horizon.
Free Download: Offshore to Onshore -- For an informative look at the latest trends in captive insurance domiciles, download “Offshore to Onshore: Re-Domestication of Captive Insurance Programs."
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.
Posted by Richard Klumpp on Thu, Apr 26, 2012
In the past few years, captive licenses in almost every domestic on-shore location have grown, while many off-shore jurisdictions report declines.
To understand the growth of on-shore captive domiciles, it is important to focus on some of the factors that have recently altered how captive owners approach the process of evaluating locations. These include:
1. The Terrorism Risk Insurance Act – Available only to on-shore captives, this legislation was designed to help the insurance market recover from the effects of September 11 and to provide a practical way to insure terrorism risks. The act set up a shared system of compensation for insured terrorism losses to protect customers and create a transitional period for market stabilization. These benefits alone caused some companies to set up domestic captive insurance companies to insure terrorism risks.
2. Employee benefit liability funding – The creation of a captive insurance company allows certain organizations to lessen their exposure to rapidly rising employee benefits costs. A U.S. branch captive is required for a firm to take advantage of this strategy, since ERISA requirements limit funding to on-shore jurisdictions.
3. State economic growth creation – As a result of the 2008 financial crisis, many U.S. states searched for ways to create in-state economic growth. State legislation to create or revise captive insurance entities began to be enacted on a regular basis. New states without current captive laws sought ways to enter an industry and capitalize on its potential to create jobs and generate business activity.
4. Increased on-shore competition – As the number of on-shore captive domicile alternatives increased, so too did competition. While most U.S. states maintained similar core elements within their captive laws, each made an effort to differentiate itself in some fashion. Common competitive options include reduced premium tax rates, lower minimum capital requirements, authorized lines of business, creative organizational entity structures, and guaranteed timeframes for turning around business requests. Increasingly, companies are finding fewer reasons to look off-shore to find a jurisdiction that fits their needs.
5. Political considerations – For some firms, the political risk of doing business off-shore is simply too great to ignore. The Enron collapse and the negative involvement of its off-shore business vehicles were widely publicized. Statements from the president’s office regarding off-shore tax shelters increased negative public opinion. These factors prompted many owners to give the nod to domestic domiciles -- even without analyzing the financial impact of such a decision.
The decision to choose an off-shore or on-shore location is complex, especially as the business climate continues to be clouded by uncertainty. Business regulation, including laws that govern the insurance industry, is being examined and adjusted across the globe. It is important for captive owners to periodically review whether their current domicile remains their best choice.
Free Download: Offshore to Onshore -- For an informative look at the latest trends in captive insurance domiciles, download “Offshore to Onshore: Re-Domestication of Captive Insurance Programs."
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.
Posted by Richard Klumpp on Thu, Apr 12, 2012
Recent data show an emerging trend of re-domestication as captives continue to move from off-shore jurisdictions to on-shore domestic domiciles.
Whether this is a newsworthy development or just a symptom of the poor economy is unclear. Certainly, some of the recent decline in the number of active captives licensed in major off-shore domiciles, including Bermuda and Cayman, may be attributable to:
- Weak market conditions – The continued soft market has been a drag on the usual steady growth of new captive formations.
- Capital conservation – The volatile economy has kept some potential formations on the sidelines as their principals conserve capital.
- Low level of M&A activity – The appetite for merger and acquisition activity that would normally contribute to combining current captive programs has been weak.
While off-shore captive formations have declined, the growth in active captives licensed in domestic on-shore domiciles has been steady.
It is too soon to say with certainty that we are witnessing the beginning of a mass migration of captives to domestic domiciles. Nor is it possible to predict if this trend will continue. Nonetheless, a few things are certain:
- The captive landscape is changing – The birth of new captive structure technologies, the development of revised regulatory regimes, and the emergence of new captive domiciles have greatly increased the importance of where a captive operates.
- More frequent domicile evaluations – The selection of an appropriate domicile has now become the subject of continuous evaluation, rather than a choice previously made only during captive creation.
As a captive evolves, improvements are made, lines of business are added, efficiencies are gained, and goals are adjusted to align with strategic objectives.
Because of today’s need for constant captive evolution, owners need to be sure that their domicile provides them with maximum benefits at the lowest possible cost.
Free Download: Offshore to Onshore -- For an informative look at the latest trends in captive insurance domiciles, download “Offshore to Onshore: Re-Domestication of Captive Insurance Programs."
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.
Posted by Richard Klumpp on Thu, Mar 29, 2012
A captive can provide the greatest benefits if designed and managed as a long-term entity with the versatility to adjust to changing risk needs.
Successful captive programs have some or most of the following attributes. Some can be planned for at inception, while others need to be managed and realized over time. Success factors include:
1. Spread of risk with predictable losses – Successful captive owners focus on the risks they understand best – their own – and avoid the temptation to compete against commercial insurers. Successful captives also can enjoy a favorable risk spread either by having a sizeable exposure base or by incorporating a number of lines of coverage with limited correlation.
2. Good loss experience and control -- The success of a captive program can only be as good as its underlying loss experience. The best way to manage underwriting results is via targeted and rigid loss control and safety programs. Poorly managed risk programs are probably better insured by the commercial markets, no matter how over-priced the market might appear.
3. Fronting and reinsurance support -- Some captive programs cannot operate or grow without adequate fronting and/or reinsurance support. Accordingly, captive owners should look to identify fronting insurers or reinsurers with whom they can partner even if the affiliation might mean paying slightly more in any given year. It is important that the front or reinsurer be there through both good and bad years.
4. Financially stable parent(s) -- Most successful captive programs have financially sound parent(s) or insureds that are able to pay the premium for the risk insured each year and provide additional capital for growth or to weather bad years. A captive should not be viewed as a piggy bank that can be plundered whenever a new pet project comes along or to subsidize other divisions when they experience difficulties.
5. Credible non-tax business purpose -- Successful captives are formed for true and identified risk management reasons. Those formed solely for tax reasons rarely survive over time. Tax benefits, if any, should be viewed as a bonus.
6. Strong business partners -- Since captive owners are seldom proficient in the business of insurance, very few captives are self-managed. It is crucial that a prospective captive owner retain strong business partners who possess both industry knowledge of the captive’s parent as well as a good understanding of the captive industry and how it is evolving. Business partners should be innovative and focused solely on the success of the captive itself.
7. Long-term commitment – The captive should be managed and viewed as an ongoing entity. Depending upon the lines of coverage insured, the success of a captive may not be quantifiable for five or ten years – perhaps longer. The long-term view can be difficult to master given the often-narrow business focus that demands meeting next quarter’s budget targets.
8. Positive financial return -- While many captive programs are primarily cost centers, they should be evaluated constantly against the benefits they provide to the organization as a whole. Only captive programs with positive financial returns will achieve full upper-management support and be allocated the resources needed to reach their full potential.
9. Continuous evaluation -- The captive should be evaluated regularly to ensure efficient management of retained risk across the enterprise. Often, risks originally retained by the captive may be more economically insured by commercial markets. Alternatively, risks previously deemed non-existent or minor may be ideal for the captive.
Only a well-planned and carefully managed captive can both achieve its full potential and be in a position to adjust to changing risk needs. The benefits of a well-managed captive can be substantial, and in most cases, well worth the cost, time and effort.
Free Download: Captive 101 – For a complete guide to the pros and cons of establishing a captive insurance company, download “What to Consider When Establishing and Operating Captives”
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.
Posted by Richard Klumpp on Thu, Mar 15, 2012
The cost of preparing a captive application can vary widely depending upon program complexity and the domicile selected.
The captive application is typically prepared by a captive manager with the help of a domicile attorney. More complex captives require additional professional assistance at added cost.
If contracted for separately, captive manager fees can range from $5,000 to $20,000, while domicile attorney billings could range from $5,000 to $15,000 – again, depending upon the type of captive, program complexity, and needed components.
Captive application filing and review fees typically fall between $3,000 and $10,000, depending on the domicile. Offshore domiciles tend to have higher application review and annual license fees. The four key factors that can affect the time and cost require for captive application include:
1. Program Complexity -- A single parent captive writing one line of business should be reviewed in no more than 30 days. The application for a group captive or risk retention group writing several lines of business will likely take at least 45 or 60 days -- possibly longer.
2. Time of The Year -- Most domiciles tend to be busy in the fourth quarter as many prospective captive owners attempt to have their program implemented for January 1 insurance renewals. An application that could be quickly reviewed early in the year may take much longer during busy periods.
3. Market Cycles -- The number of captives formed often increases significantly during difficult market cycles. Most domiciles have limited staff dedicated to their captive divisions and can experience significant delays during challenging market cycles.
4. The Domicile Chosen -- Prospective owners with tight deadlines should check with local service providers to make sure that the chosen domicile can review their application within the time available.
Many factors impact the time needed and, therefore, the ultimate cost of forming a captive. For this reason, the captive manager and/or consultant should review the various alternatives with the prospective captive owner as part of the feasibility study process.
Free Download: Captive 101 – For a complete guide to the pros and cons of establishing a captive insurance company, download “What to Consider When Establishing and Operating Captives”
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.
Posted by Richard Klumpp on Tue, Mar 06, 2012
The final step in establishing a captive insurance entity is regulatory approval and licensing within its chosen domicile.
The three key documents that determine whether an application will be approved by regulators in a chosen domicile are the feasibility study, the captive business plan, and financial pro formas.
1. Feasibility Study -- Often regarded solely as an actuarial analysis, the captive feasibility study in reality includes both an actuarial analysis and a financial and operations evaluation. The actuarial analysis quantifies whether the prospective owner is being overcharged by the commercial insurance market. The financial and operations evaluation determines whether a captive could best manage potential risk. For details, see “What Should a Captive Feasibility Study Contain?”
2. Captive Business Plan -- Normally drafted by the captive manager working with the future owner, the business plan details both the proposed structure of the captive and the lines of business it will insure.
The plan ideally describes the type of captive and its proposed ownership; the program rating methodology or how premiums will be derived and allocated; the loss control and safety programs to be established; whether the program will be fronted or written directly; the type and amount of reinsurance protection, if any; and the proposed capitalization.
The business plan should detail the proposed management of the captive and provide a listing of the proposed service providers, including a description of how they will be compensated. Finally, the business plan should include a narrative summarizing the findings of the feasibility study and the projected financial results.
3. Financial Pro Forma Projections -- The financial pro formas are typically prepared by a third-party actuary or captive manager. These documents consist of standard financial statements (Balance Sheet, Income Statement, Cash Flow Statement, Financial Statements Notes) projected over a period of five years under both expected and adverse scenarios. The loss information presented under both scenarios should be consistent with the underlying feasibility study or actuarial projections.
The pro formas should also present the basis for growth of premiums and operating expenses over time, including inflation factors. Investment income should be calculated using conservative and realistic rates of return for the type of investment vehicles selected and be based on a realistic projection of the assets to be invested.
Once these three key documents are completed, the application is ready for submission to domicile regulators. After approval and the issue of a certificate of authority, any departure from the original business plan must be pre-approved by the domicile regulators.
Free Download: Captive 101 – For a complete guide to the pros and cons of establishing a captive insurance company, download “What to Consider When Establishing and Operating Captives”
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.
Posted by Richard Klumpp on Thu, Feb 16, 2012
The right combination of service providers can greatly expedite the process of filing a captive application with domicile regulators.
Typically, such providers fall into two groups. Required providers are mandated by the domicile where the captive will operate. Suggested providers with special expertise can significantly aid the process. Here is an overview of the roles of both types:
1. Required providers
Most domiciles require captive applicants to retain four core providers: a captive manager, an actuary, a financial auditor, and a bank.
A. Captive manager -- The captive manager, individually or as a firm, typically must be either approved or licensed by the domicile where the captive operates. The captive manager maintains the books and records of the captive, manages the work of the other service providers, and serves as the primary contact for the domicile regulators.
B. Actuary -- Also typically approved by the domicile, the actuary will prepare the annual reserve certification required by the domicile and/or the financial auditors. The actuarial certification of loss reserves is an independent confirmation that the reserves shown in the captive’s financial statements are appropriate. The actuary often prepares an annual report that is used as the basis for the setting of renewal premiums.
C. Financial auditor -- The financial auditor issues an opinion on the adequacy of the financial information issued by the captive under Generally Accepted Accounting Principles or other approved basis of accounting. An annual audit -- with its accompanying audit opinion -- is required by all captive domiciles. Financial auditors also prepare the captive’s income tax returns.
D. Bank -- All domiciles require that the captive’s capital and/or operating funds, if held in the form of cash, be deposited in a bank account in the name of the captive.
2. Suggested providers
Depending upon the type of captive program and the domicile chosen, captive creation could benefit from the services of suggested providers such as:
- A domicile or consulting attorney
- A (re)insurance broker or intermediary
- A third-party administrator (TPA)
- An investment manager
- A tax advisor or other consultants
There is no single “best” combination of required and suggested providers. The cost of retaining such providers can vary widely depending upon the type, size, and complexity of the captive. Often, the number of suggested providers enlisted by a captive is limited only by the associated expense of retaining those experts.
Free Download: Captive 101 – For a complete guide to the pros and cons of establishing a captive insurance company, download “What to Consider When Establishing and Operating Captives"
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.
Posted by Richard Klumpp on Thu, Feb 02, 2012
While a captive insurance entity can provide many benefits, a solid business case must be prepared for owners considering its creation.
To provide the needed answers, an in-depth captive feasibility study must be conducted containing both an Actuarial Analysis and a Financial and Operations Evaluation.
1. Actuarial Analysis – This document quantifies whether the prospective captive owner is being overcharged by the commercial insurance market. Performed by a third party actuary, it consists of a detailed review of the prospective captive owner’s loss exposure information, historical loss patterns, frequency and severity of loss activity, and schedule of large losses. Three to five years of loss information must be analyzed, and complemented with related industry data.
The actuarial report will project both the premium to be charged and estimate the ultimate incurred losses under expected and adverse scenarios. This range of possible outcomes will be used to compute the appropriate amount of capital required for the captive to assume the risk being contemplated.
2. Financial and Operations Evaluation – This document determines whether a captive could best manage potential risk. Performed by a captive manager or consultant, it will review both the financial and industry information of the prospective captive owner. Typically elements include an organization chart, annual report, or financial statements; industry specific regulatory hurdles or barriers; a schedule of anticipated insureds and their current deductible (or self-insured retention levels); the current accounting and tax situation; and program philosophy.
Results should include pro forma financial statements for the captive; a net present value cash flow analysis of the captive compared to alternative options and status quo; a report showing the effects of the captive on consolidated earnings before income tax, interest, depreciation, and amortization (EBITDA); and a schedule of operation and other non-financial benefits or shortcomings of the captive program.
In addition to the above, a captive feasibility study should review one or more proposed captive insurance structures and include a comparison of captive domiciles and available ownership configurations.
With a well-prepared captive feasibility study, owners can decide if a captive makes sense for their organization. If a decision is made to move forward, the study will become the basis for the captive’s application with domicile regulators and its eventual formation.
Free Download: Captive 101 – For a complete guide to the pros and cons of establishing a captive insurance company, download “What to Consider When Establishing and Operating Captives”
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.
Posted by Richard Klumpp on Wed, Jan 18, 2012
Although much has been written about creating and launching a mini-captive, there are a number of steps common to all.
A review of these steps can help you determine if a mini-captive is right for your firm and, if so, what needs to be done to make it a reality. These include:
1. Be sure your firm qualifies – In order to successfully form a mini-captive, your firm must meet all of the following requirements:
- Annual revenue of at least $25 million
- EBIT of at least $1.5 million
- Your business(es) must be currently profitable
- Current property/casualty premiums are at least $300,000–400,000
2. Do your homework – It is imperative that you research and compile all of the following documents before engaging professionals:
- All commercial policies currently in effect
- Loss data for past five years
- Corporate organizational chart
- Details of business ownership
- Audited financial statements
3. Do a pre-feasibility study -- Working with an underwriter and a representative of the proposed mini-captive’s management firm, conduct a pre-feasibility study to identify uninsured risks and to determine if a mini-captive would be economical.
4. Verify potential tax savings – Although not mandatory, it is highly useful to obtain a tax status memo on the proposed mini-captive from an experienced CPA or attorney.
5. Complete a full feasibility study – A critical step is a well-thought-out mini-captive feasibility study that engages both the underwriter and the mini-captive manager. This study should include:
- Underwriter’s report of risks to be insured
- Estimated premium
- Mini-captive manager’s business plan
6. Be committed to act – Because of the time and cost required to make a thorough mini-captive feasibility study, it should not be done without a firm commitment to make a go/no go decision.
7. Engage an actuary -- Begin the formation/application stage by engaging an actuary to perform loss reserve analyses and premium forecasts and to develop proformas to be filed with the application.
8. File the formal application – The mini-captive manager finalizes the business plan, completes the application, and communicates with domicile regulators to answer questions.
9. Launch – At this point the mini-captive receives its license, is capitalized, and begins operations.
The benefits of a mini-captive can be substantial, both from savings on insurance costs, as well as from substantial tax and estate planning benefits for its owners. For these reasons, it is important to engage professional assistance early in the process, to save time, money, and provide the best solution for your particular needs.
Free Download: To learn more about the pros and cons of mini-captives, download “The Uses of Captives for Small and Mid-Sized Companies"
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.
Posted by Richard Klumpp on Thu, Jan 05, 2012
When a mini-captive is properly structured, it should have no compliance problems with either the IRS or insurance regulators.
The key phrase here is “properly structured.” There are many examples of questionable practices or even outright scams involving real or supposed mini-captive insurance companies. Most of them involve one or more of the following characteristics:
Inflated Premiums -- As an insurance company, a legitimate mini-captive must rely on an honest and competent actuary to set insurance rates. In some tax-fraud operations, mini-captives have “charged” their clients exorbitant rates, the goal being to allow the parent owners to realize a tax deduction on “premiums paid” while actually transferring large sums of money to the mini-captive.
No Real Shifting of Risk -- One of the key tests of a legitimate mini-captive is whether or not risk is actually transferred to it. If risk is not actually transferred, the mini-captive can be disallowed and all the benefits lost. This can be an issue in particular with some third-party risk pools that are offered to the mini-captive market. Before buying into any pools, it is essential for the mini-captive owner to perform due diligence to ensure that the pool is a legitimate third-party risk transfer pool and not a sham designed for tax evasion purposes.
Secret Return of Asset Control -- In some fraudulent schemes, a firm pays a mini-captive for “insurance,” while the captive secretly remits most of the money back to the parent owners, typically by placing it in an offshore account. The bogus mini-captive, in other words, simply serves as a front for funneling funds to offshore accounts while allowing the U.S. firm to claim a phony tax deduction for premiums paid along the way.
In some versions of this scam, control of the funds is actually relinquished to another owner (typically an offshore entity) for a period of time with the agreement that it will later be returned – perhaps in five years. These often turn out to be true scams: In several documented cases, the offshore entity (or its promoter) has absconded with the clients’ funds and, when threatened with legal action, has threatened to expose the clients to the IRS as tax evaders.
There are two lessons to be learned for any potential mini-captive owner: First, do not be tempted by any type of mini-captive program that is either manifestly illegal or that mysteriously promises significantly greater benefits than a legitimate mini-captive could deliver. Whether resulting from IRS scrutiny or predatory deception, significant risks and penalties are likely to occur.
Second, it is important to have an experienced and reputable manager overseeing a mini-captive’s creation and operation to ensure that it is not caught up in the same nets cast for those committing actual fraud.
Free Download: To learn more about the pros and cons of mini-captives, download “The Uses of Captives for Small and Mid-Sized Companies"
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.