Captive Structures

Common Characteristics

Regardless of the structure chosen, there are some basics common to all captive structures. One of these is the participation of a risk sharing partner, or traditional insurer. Risk sharing partners provide such necessary and desirable services as certification of coverage and limits; reinsurance; loss control and mitigation; claims reserving, adjustment, and oversight; risk management; underwriting and regulatory response and assistance. This often-overlooked service has become one of the most valuable services offered by insurers to captives today. We will have more to say about this service on another day.

The insured that decides to establish a captive must carefully choose a risk sharing partner as providing certificates to outside parties is often a material service. The risk sharing partner must carry an A.M. Best's rating as required by regulators and mortgage holders and lenders in order for the certificate to be accepted. The risk sharing partner must be involved from the inception of discussions and will have a say in the ultimate structure chosen. There is little point in choosing a structure and then learning that no one will partner with you.

Single Parent Captive

The single parent captive is still the most prevalent structure in use today. This is an insurance company owned by one company, usually the insured. It's usual purpose is to provide some risk transfer or financing for a corporation on a specific line of coverage. It is not usually admitted to write insurance in a domicile, other than it's own risks.

This form has been in use for over 50 years, and has stood the test of time and challenge. It is an effective alternative to traditional insurance when organizing the financial risks of a commercial business. This structure is welcomed in all domiciles by all partners.

A single parent captive is most often used to provide coverage either directly, where permitted, or as reinsurance of a traditional primary insurer. Frequently this captive provides reinsurance on workers compensation programs. Increasingly we see them used for property insurance, directors and officers liability, terrorism, and toxic mold.

Recent developments have opened the door for writing certain employee benefits programs in captives. The single parent structure would work well for this exposure, and I expect to see a tremendous increase in this use for captives.

The single parent captive structure is a corporation, therefore some thought must be given to who will serve as owners, directors, and officers. In most captive domiciles the standard C type corporation is the form allowed. Few domiciles allow limited liability forms, although some will allow a structure somewhat akin to an S corporation. Often, the parent corporation is the owner of the shares.

The single parent captive was often used for tax issues, but is now used more for coverage or limits otherwise unavailable. It is sometimes seen as a new profit center for the parent firm. All captives should be initiated with a serious commitment of time and financing, and this form is often a new venture within a larger firm in which the risk management department is planned to generate profits and contribute to the parent companies' bottom line.

The offshore domiciles have been addressing criticisms of the Organization for Economic Cooperation and Development and the Financial Action Task Force in terms of knowing their customers. Many new procedures have been introduced in the past few months that may surprise some who have knowledge of captives. Most of the procedures are reasonable and not burdensome, but they should be reviewed with care before the owners, directors, and officers are selected. There may be issues to address that will slow down formation or even preclude the participation of key organizers.

It may seem obvious that the insured corporation would be the owner, since the form is a single parent captive, but in the case of a private or closely held business, there may be multiple shareholders, and the captive will still be referred to as a single parent. There may be a family trust as owner. The essential element for being called a single parent is that it really insures a single insured, does not entertain risks outside its business enterprise, and the ownership is tightly related.

All regularly recognized domiciles and risk sharing partners welcome single parent captives. The choice of partners is then determined by the other goals of the owner, in terms of obtaining coverage not otherwise available, creating a profit center, or smoothing out the future costs of risk finance. By increasing and diminishing the amount of risk held by the captive, the parent company can smooth its risk costs over time. This is viewed very favorably by many CFOs and treasurers.

Seeking a tax advantage is a bit more challenging with single parent captives, and the use and advice of qualified counsel is strongly recommended. Indeed, there may be no tax advantage at all under this structure. While the current operating philosophy of the Internal Revenue Service (IRS) is fairly accommodating to captives, it is widely acknowledged that what the IRS giveth, the IRS taketh away.

Group or Association Captive

The group or association captive is a structure in which multiple businesses join together either through a formal association or an informal relationship to use a captive to obtain coverage or limits otherwise unavailable. This form has become a source of revenues and industry cohesion for many trade groups.

These groups can be artificial in the sense that an entrepreneur forms the captive and offers coverage to otherwise unrelated insureds, and the insured group can be either heterogeneous or homogeneous in nature.

This structure usually involves a corporate structure with more than one class of share. These different share classes can enable the group to use a dividend policy to reflect the actual claims profile of each separate member of the group or association.

A group or association captive can be a management challenge as it can bring risk related, non-group issues to the fore, such as appropriate loss control and the ability of some members to promptly address security against future claims. Playing well together is an important element.

Rental Captives

Rental captives gained popularity over 20 years ago as a reaction to the costs of forming and operating a captive. The potential insured finds an existing captive, often owned by a traditional insurer, which creates a separate set of books within its own structure to reflect the singular risk of the potential insured. Usually this method restricts the choices of risk sharing partners and service providers.

The use of someone else's captive necessarily means that you will be paying increased frictional costs. These may be offset by not having the costs of establishing and operating your own facility. It is important to know these costs, compare and contrast them, and consider the control and partner/provider issues before making a decision on a rental captive.

In recent years, the IRS has had success in challenging the deductibility of premiums paid to some rental facilities based on an apparent lack of real risk transfer. Very careful consideration must be given to this aspect, and the use of qualified tax counsel is again highly recommended.

Some rental facilities have also had difficulty with risk sharing partners due to under-reserving for future losses. Before committing to a rental facility, you should have a discussion with the primary risk sharing partner about their reserving practices, and perhaps even consider an independent actuarial review of the reserves.

Segregated Protected Cells

For the above reasons, plus IRS challenges and reserve inadequacies, several domiciles introduced the Segregated Protected Cell structure. While very similar in approach to a rental facility, there are marked differences that make this structure a very popular choice today.

The segregated protected cell, or sponsored captive, which is not permitted in all domiciles, has a structure in which an existing insurer or "captive," owned by an insurance company or service provider, assists in the creation of cells within itself. These cells must follow similar procedures for establishing a single parent captive, but stop short of ultimate regulatory approval as the regulators look to the sponsor for compliance with their regulations.

All lines of coverage can be underwritten in a cell structure. This is of course subject to the agreement of the sponsor and the risk sharing partners. Indeed, a company could establish a captive and then segregate lines of risk, subsidiaries, or businesses by creating cells within its own captive.

Legislation protects a cell and its owners from claims by creditors of other cells within the sponsored company. To many people, this lack of a "firewall" is a flaw in the typical rental structure. In the typical rental structure, there is no absolute protection from each and every creditor, as at some level the sponsored company has some joint liabilities. With the protected cell approach, however, the firewall is sound and should provide considerable protection against creditors of other cells.

The proposed owner of a cell will be asked to provide information and references similar to what is asked of owners of single parent captives. Indeed, the ownership of an individual cell can take the same variety of forms as a single parent or group captive, or take no structure at all. It may be only a policy of insurance.

Since the cell is within an approved company, with its own already established owners, officers and directors, risk partners, and service providers, it is essentially an approved insurance company. The liabilities and responsibilities fall to its owners in terms of ultimate success or failure. The regulators will want to be knowledgeable of who and what is in each cell, but they will look to the sponsor for assurances of legitimacy and competence.

Each cell will be required to post its own security against future claims on its own risks. This makes it feasible to have more than one risk sharing partner involved with the sponsor. The cell will have to provide an annual audit and actuarial certification of reserve adequacy to the cell's owners, and thus the regulators. The cell may have a different attachment point for reinsurance than other cells within the holding structure. This feature makes the segregated cell structure attractive to heterogeneous groups or groups with members of very different premium sizes. This also greatly complicates the process and adds to frictional costs.

Non-Controlled Foreign Corporations

Non-controlled foreign corporations are more of a tax approach than the other structures. When forming an offshore captive, one of the early decisions is to determine the tax status going forward. Thoughtful consultation with well-qualified tax experts is highly recommended for the decision as to whether or not to take the 953(d) election of the Internal Revenue Code, and be taxed as a U.S. entity, or not. Fines and penalties for doing it the wrong way are formidable.

If the decision is made to not be taxed as a U.S. tax payer, then several "gateways" must be traversed to assure compliance with all regulations. Again, knowledgeable counsel is highly recommended. In general, the participation and rights of U.S. taxpayers are limited, so this structure is most often used where there are more than a dozen unrelated non-U.S. entities involved in ownership of the captive. The tax advantages for the owners, if they establish the captive properly and manage it prudently, can be considerable in some cases.

Conclusion

New captive structures are being created every day, and will be of great benefit to the overall industry. Most will rely in some way on the above general models.