Captive insurance companies have long offered significant insurance cost savings for certain types of risk. But complicated Department of Labor (DOL) rules and a rigorous approval pro­cess have meant that, until recently, few companies have used captives to finance employee benefits plans such as disability coverage and life insurance. A series of green lights from the DOL, however, has established a regulatory "express lane" for employee benefits and captives.

Captives are insurance companies established by a parent company, or group of companies, that allow the parent to finance, manage, and insure/reinsure some or all of its own risk rather than limit itself to plans offered by third-party carriers. Traditionally, captives have made sense for risks like property damage, product liability, workers' compensation, and directors and officers coverage. With employee benefits plans, the Employee Retirement Income Security Act (ERISA) prohibits the sponsor (the employer) from having a financial stake in the plans, but exemptions exist if the proper protections and oversight are established.

In 2000, Columbia Energy (now NiSource) became the first employer to receive DOL approval to use its captive to reinsure a portion of its employee benefits plan. Archer Daniels Midland received approval two years later and, since then, an additional 12 employers have received exemptions from the DOL allowing them to reinsure employee benefits via captives. We are aware of several others who have recently filed or plan to file an application for exemption.

Why use a captive to reinsure employee benefits plans?

The main benefit of reinsuring an employee benefits plan with a captive closely resembles the advantages that make captives effective for other types of risk: reduced insurance expenses in the long run. In this economy, strategies to reduce employee benefits expenses are increasingly important. Employer resources for funding employee benefits are caught in a squeeze between stagnating revenues (and benefits budgets) and double-digit healthcare cost increases. Captives can help reduce expenses by providing more control over the risk profile, improved cash flow, more efficient use of capital, some limited tax benefits, and greater stability in the cost of insurance.

More control of risk is achieved by appropriately balancing the employer's unique risk profile between its captive and a third-party insurer. Broadly, life insurance and disability claims fall into three risk categories:

1. The first group includes a stable flow of claims that an employer can be reasonably certain of having to pay out each year. By buying a plan on the market, the employer is paying a premium to a third party when it could afford to budget for this expense itself at a lower cost.
2. The second group is a middle-ground, medium-risk group presenting a greater chance of claim variability, as well as an opportunity for the employer to take a risk on covering these claims at a potentially lower cost than the market premium.
3. The third group includes the most unpredictable claims risks.

Employers that buy employee benefits plans on the market may pay premiums that cover 100% of the risk presented by all three groups, when they could retain the risk for the first two at a lower cost. The approach for putting an employee benefits plan in a captive is to purchase a third-party insurance plan that will cover all three groups, and use the captive as a reinsurer to recapture and manage the risk of the first and second groups. By more effectively balancing premiums with claims, captives can lead to better cash-flow management in addition to better control of risk. Even if employers currently self-insure some or all of the first and second groups, thereby already enjoying the enhanced cash-flow and/or control of risk, transferring these risks into a captive may provide further benefits, such as more efficient use of capital.

Which employers should reinsure their employee benefits in a captive?

For employers with an existing captive, adding an employee benefits plan allows capital in the captive to be used more efficiently by diversifying the risk portfolio. This reduces the marginal capital required to add the employee benefits plan to the captive.

Suppose an employer has a captive that covers workers' compensation and product liability and wants to add life insurance and disability from its employee benefits plan. The existing captive will already be capitalized at a level that meets regulatory requirements and covers claims, with a reasonable cushion. Employee benefits risks tend to be uncorrelated with other risks covered by captives, so the likelihood of facing simultaneous claims is small; a bad year with employee benefits claims is just as likely to be a good year with other risks. By diversifying the captive’s risk portfolio and leveraging its existing capital, setting up the employee benefits plan may require relatively little additional capital, especially compared to launching a new captive from scratch.

Employers with existing captives are especially well positioned to fold their employee benefits plans into a captive, and for a variety of reasons, not the least of which is firm size. There can be large start-up costs associated with creating or modifying a captive, and companies with captives for any purpose tend to be large. Like any cost-saving investment, the bottom line is that the employee benefits plan must be large enough for the long-run savings to outweigh the start-up costs by a wide enough margin to offer a reasonable return on investment.

The savings available in employee benefits plans are usually not large enough to outweigh the cost of establishing a new captive from the ground up. Having an existing captive in place means the company has already done the work of obtaining a license, setting up the initial capital, hiring a captive manager, and obtaining insurance regulatory approval, all of which can require considerable lead time and up-front investment.

In addition to approval from insurance regulators, employers also require DOL approval before they can put employee benefits plans in a captive, although this process has been streamlined in recent years.

As standalone insurance companies, captives must satisfy insurance regulations that their premiums and capital are sufficient to cover the risks they bear. As subsidiaries that exclusively serve and are wholly owned by their parent company, however, captives must also satisfy ERISA regulations when it comes to employee benefits. ERISA's purpose is to protect employee benefits plans and their beneficiaries. The law has established safeguards to keep employers and plan administrators at arm’s length and prevent employers from profiting from their employees or putting benefits at risk. Under ERISA, using a captive is considered a "prohibited transaction."

In the past eight years, however, firms have increasingly been allowed to negotiate prohibited transaction exemptions (PTEs) for captives. The exemption does not absolve employers and plans of their obligations under ERISA; rather, it requires them to set up their own safeguards and transparent processes to protect beneficiaries, while allowing them to benefit from a captive insurance structure rather than a third-party one.

Most employers buy employee benefits plans from large, well-established firms that the DOL can be confident will meet their obligations. But the DOL needs more assurances that smaller, special-purpose insurance vehicles like captives will protect beneficiaries. So in addition to the captive, employers must also have a third-party "fronting carrier" to provide a backstop for the captive's employee benefits risks. Because the fronting carrier is the primary insurer, it is obligated to cover claims even if the captive is unable to reimburse the insurer for the captive's portion of the claims.

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How do employers apply for approval to use a captive for employee benefits?

Through the process of granting initial PTEs to Columbia Energy and Archer Daniels Midland, a set of rules was established as a precedent for later applicants. These rules include an option for an expedited approval process, or EXPRO, a route that most recent PTEs have taken. If there have been two or more PTEs within five years that your firm can demonstrate are substantially similar to your application, your firm can take advantage of EXPRO and may receive an exemption from DOL within as few as 78 days.

In order to be approved, employers must hire an independent fiduciary to review the plan annually and verify that it continues to meet the PTE stipulations, that rates are set fairly, etc. The change must also enhance the benefits to the employees, rather than merely maintain them. Enhancement options include increasing the minimum benefit an employee could receive on disability, increasing the life insurance benefits, offering free will-preparation services, and other possibilities. Employers must be able to spend the time and effort to engage their employees in the transfer process and provide a disclosure notice with opportunities to send comments to the DOL.

Logistically, employers face a challenge in getting their risk- management and human-resources departments to speak the same language with respect to why and how such a change could work. While the human-resources function must protect the beneficiaries, the risk-management function is focused on making accurate forecasts and cost/benefit calculations. If an employer can get these two groups to work together, there is a potential for significant employee-benefits savings in the long run.

Kathie Ely is an actuary with the Hartford office of Milliman. Kathie's area of expertise is in healthcare, including plan design, pricing, liability estimation, experience analysis, and actuarial projections. Kathie also works with captive and risk-retention-group clients. She has experience with both the independent fiduciary and actuarial services, including feasibility studies and liability estimates, for employers reinsuring their employee-benefits programs in captives.

Andrea Burrell is an actuarial associate with the Health practice in the Hartford, Conn., office of Milliman. She has worked with several employers who have reinsured employee benefits into their captives, primarily related to the responsibility of the independent fiduciary. She has been actively involved in Medicare Part D since its inception, working on pricing of prescription drug plans, employer group waiver plans, and retiree drug subsidy attestations.