A captive insurance company is a subsidiary of a parent company that is generally restricted to writing insurance coverage for the parent and related companies. The main objective of a captive is to reduce an employer’s cost of managing risks. Traditionally, the cover written by captives has been primarily casualty risks (e.g., auto, fire, general liability, and workers’ compensation). Though using a captive for employee benefits has taken place in several countries, recent activities in the U.S. have increased the interest in using a captive as a vehicle for funding employee benefits for U.S. employees. To date, these transactions have covered life and disability insurance, but other coverages, such as retirement benefits and healthcare, are being considered as well.
The decision to cover employee benefits in a captive insurance company requires coordination between those responsible for employee benefits (typically someone in the Human Resources area) and those responsible for risk or finance. These two areas of an organization often operate independently of one another, and they have different roles and objectives in the organization. The first step in the process is to bring them together to investigate the efficacy of insuring benefits in a captive. An outside consultant can help both HR and risk or finance departments decide whether or not including employee benefits in a captive insurance company is feasible.
Advantages of a captive
The traditional advantages of a captive are usually given as:
- More stable cost of insurance for the parent company
- Greater availability of coverage, especially in "hard" markets
- Reduced operating costs (captives do not have insurance company profit margins and overhead)
- Increased control over cash flows and investment income
- Immediate rewards from controlling risk
- A rating structure that can more closely reflect the experience of the parent
- Direct access to reinsurance markets
- Possible tax advantages
Additional advantages when employee benefits are included in a captive are:
- Diversified risk for the captive
- Potentially reduced cost of benefits for the employer
- Possible additional tax advantages (especially in the U.S.)
Financial analysis
The basic financial analysis involves consistent comparisons of:
- Income and expenditure projections for the company Without With Captive versus Captive and
- Projected balance sheets for the company Without With Captive versus Captive
By creating either a stochastic or deterministic financial model, it is possible to answer a wide range of "What if … ?" questions relating to the feasibility of a captive. Basic assumptions can be varied to test sensitivity.
The basic financial parameters for the captive are:
Model assumptions
Once the specific nature and amount of risks selected for the captive are defined, assumptions are needed in several areas:
- The capital resources of the captive
- Reinsurance costs (or market quotations) for reinsuring layers of risk
- Future dividend policy of the captive
- The effect of taxes on investment income, capital appreciation, withholding taxes, insurance taxes, tax on the captive profits, and the impact (if any) on the multi-national's own taxation status
- The cost of running the captive, the corporate “head office” costs, and commissions, as well as the future inflation rate of expenses
- Projected claims experience, including allowance for settlement delays (e.g., IBNR, litigation), a rate of inflation of claims, and an appropriate rate at which to discount future claims (for determining notional year-by-year claim reserves)
The projection should also consider the investment policy of the captive, including assumptions about currency and asset class/types.
Conclusion
If an employee benefit captive is to be established, it can be on a "stand-alone" basis or as an addition to an existing captive of the employer. In either case, the decision process is aided by modeling the impact of the captive on the company’s financial statements. This process may have other valuable benefits to the employer, such as providing an in-depth examination of the risk management elements of employee benefits.
In the U.S., employers must put careful consideration into the choice of an Independent Fiduciary when covering employee benefits in a captive. The Independent Fiduciary must have strong experience in insurance and employee benefit plan designs, pricing, and reserving. Having an actuary with experience in employee benefits serving as the Independent Fiduciary is the most effective way to fulfill this need.
Many employers in the U.S., Europe, and other jurisdictions have already realized financial and risk management rewards by including employee benefits in a captive insurance company. Employers that are weighing whether or not to include employee benefits in a captive—either a new captive or an existing one—should consider performing a financial analysis and seeking the assistance of qualified advisors.