The Elements of a Captive Feasibility Study
The first rule to follow in understanding the need for a captive feasibility analysis is the simplest one – if the analysis indicates that your corporate insurance program cannot be deconstructed and then reconstructed using a captive to your advantage inside the reconstructed program…then the feasibility analysis should not move to the implementation phase.
The First Impression
A good captive feasibility study should start with a complete examination of your current insurance and risk financing programs. Any good consultant can look at three things and learn a lot right away. These three things are:
– your last audited financial,
– your current insurance schedule, and
– ten years of incurred claim history in key liability lines.
There is no mystery about this – captives are all about need, premium volume, and the risk/reward of assuming balance sheet liability for insurance exposure you may not have previously assumed. If your business is too small, financially unstable, or your insurance portfolio has insufficient premium volume in general, a good consultant should be able to tell you that fast. This should not be an expensive exercise. The truth is basically only 90 minutes away.
What Lines of Coverage Belong in a Captive?
OK – we’ll cut right through a few things for you – unless your business represents a significant property exposure, property insurance simply doesn’t work in a captive for most moderate-sized commercial accounts. The risk/reward exercise is weighted against success. That is not to say that business interruption risks and certain of the time/element exposures can’t be effectively managed in a captive scenario. The rule of thumb here is not to bite off balance sheet risk without a proportional recapture of premium…which can be hard to do with property insurance in a captive. With respect to tax-exempt health care facilities (so-called “highly protected risks”) it simply doesn’t pay to self-assume hundreds of millions of dollars of all-risk property exposure for a few thousand dollars of captive premium.
Also, let us betray some of our prejudices on this subject. The following types of coverage sometimes work well in a captive program…and sometimes not.
|Type of Coverage||Why Not?|
|· Workers’ Compensation and Employer’s Liability||Stacking letters of credit or other indefinite securitization needs – (always a terrible problem)|
|· Auto physical damage||(Who cares?)|
|· D&O Liability||Unless the entity retention is more than $1 million and you have an active claims history, this usually makes little sense|
|· Primary Fiduciary Liability||(See auto physical damage)|
|· Primary Owned & Non-Owned Aviation||Unless you’ve got an airline, or have a significant owned fleet of aircraft – forget it. This is cheap liability coverage on the open commercial market.|
There are a few lines of coverage that virtually cry out for captive treatment; these are:
|Type of Coverage||Why?|
|· Professional liability||‘Cause that’s where it’s at|
|· General Liability/Products & Completed Operations||‘Cause that’s where it’s at as well|
|· Auto and Fleet Liability||Many times – the best solution for a problem in many states|
|· Employee Benefits||Can be a good idea, but be careful…this is a code phrase many times for “group life insurance”; there is no consistent history of health benefit programs underwritten through captives. The same is true for long and short-term disability. Remember: what motivates the consideration of employee benefit programs in captives can be the creation of an evidentiary case for premium deductibility. If you are a tax-exempt health care system, that problem is not your problem.|
There are other business-specific forms of liability that work very well in a captive, and you should leave your options open to other lines that may be beneficial to your business, and to a potential re-structuring under a captive formula.
Captives thrive on three things – if you remember these three things you will always make the right decision about captive feasibility.
- Claims Volume in Primary or Working Layers of Coverage: captives operate like all insurers. They pay claims. Captives that don’t have an active claims-paying life are essentially investment vehicles, and you can do better in the equities market with your money.
- Premium Volume in Primary or Working Layers of Coverage: if there isn’t enough premium income on the income statement, then reserves and G&A expenses cannot be offset, and it will take entirely too much investment income to offset underwriting losses. Premium volume determines everything in our business.
- Access to Reinsurance: the best captives are the captives that directly access the reinsurance marketplace. Businesses form captives to by-pass the insurance market in key lines of coverage and in difficult market cycles. If you don’t plan to use the reinsurance market, you may have little long-term use for a captive. The most creative, resourceful, and open minds in the insurance business are in the reinsurance market.
Will the feasibility study tell me where to form my captive insurance company?
Any good captive feasibility study will always give you an opinion on the best domicile (location) for your captive insurance formation, given the structure and outline of your feasibility plan.
This is more than just where your boss wants to spend his vacation…domicile considerations are all about:
- how your captive will be organized
- what lines of coverage will your captive be able to underwrite
- how much regulatory scrutiny you can expect from the domicile regulator
- local and federal tax issues
- permissible forms of corporate structure
- whether your program will need fronting by a commercial insurer
Domicile considerations are complex and, contrary to popular belief, should be based on more that input by your actuary or insurance broker, who may be itching to spend more time in his Cayman condo.
A good feasibility study will send you to the right domicile for your particular needs…and always for the right reason. You should beware of anyone who, within the first 30 seconds of a captive feasibility discussion, already has a domicile picked out for you. When this happens, it’s for the convenience of someone else, and not for your convenience.
Whose Help Do I Need to Complete a Captive Feasibility Study?
First, a good actuary is important. You will (if you get beyond the critical first test regarding premium volume) need to provide your actuary with 8 to 10 years of credible claims data in the lines that look like candidates for captive treatment.
You’ll need to provide exposure information as well – and a very good projection of your business’s financial operations in the coming year.
A good risk financing and risk management consultant can inject a sense of reality into this part of the process. Captive consultants devote their professional careers to the testing of captive feasibility, implementing captives, providing on-going management advice concerning operational issues, and have their fingers on the pulse of what is going on in the marketplace.
A good captive consultant will bring the following wisdom to the feasibility process:
- A sense of which domicile will accept your business plan and overall risk financing program based on the facts as presented.
- An understanding of how the claims management process will be handled for the lines of coverage selected.
- An awareness of the legal, tax, administrative, and structural implications of the captive formation.
- How the value of the captive program can be explained (quantified) to your finance committee, CFO, board of directors, etc.
How Long Does It Take?
Always allow 120 to 180 days for true captive feasibility testing…that is, for the creation of pro-forma financials (five years of projected results will be important) and for the written business analysis to be completed and presented.
Always remember, however, that it doesn’t take more than 90 minutes to determine if you are a candidate for a feasibility analysis…don’t let anyone tell you any differently.