{"id":38,"date":"2015-02-06T01:29:25","date_gmt":"2015-02-06T01:29:25","guid":{"rendered":"http:\/\/mesquitecaptive.com\/wordpress\/?page_id=38"},"modified":"2015-07-07T03:47:15","modified_gmt":"2015-07-07T03:47:15","slug":"faqs","status":"publish","type":"page","link":"https:\/\/mesquitecaptive.com\/wordpress\/faqs\/","title":{"rendered":"FAQs"},"content":{"rendered":"

1. What is a captive insurance company?<\/strong><\/p>\n

A captive insurer (or \u201ccaptive\u201d) is a closely-held insurance company formed primarily to underwrite the risks of its parent or affiliated groups. It is similar to a traditional, commercial insurance company because it:<\/p>\n

\u2022 is licensed as an insurance company;
\n\u2022 sets insurance-premium rates for the risks it chooses to underwrite;
\n\u2022 writes policies for the risks it insures;
\n\u2022 collects premiums;
\n\u2022 pays out claims made against those policies; and
\n\u2022 proper accounting for reserves and surplus.<\/p>\n

The biggest difference between a captive insurer and a commercial insurance company is that a captive cannot sell insurance to the general public. It can only underwrite the risks of its parent organization, related entities, and chosen unrelated parties. Another key difference is that captives are regulated under special captive legislation that is typically less onerous than those regulations governing traditional commercial carriers.<\/p>\n

2. What are the benefits of a captive insurance company?<\/strong><\/p>\n

Premium Stability.<\/em><\/p>\n

The insurance marketplace commonly goes through its “hard and soft” cycles where premium fluctuations have little relation to individual loss experience. By pooling your resources and creating your own captive reinsurance company, these swings can be avoided, making your costs more predictable.<\/p>\n

Lower Insurance Costs<\/em><\/p>\n

A. Retain the profit otherwise earned by a third-party insurer<\/p>\n

Commercial market insurance premiums must be adequate to meet the cost of claims, overhead, and profit for the insurance company. By establishing a Captive, the parent\/owner seeks to retain the profit within the business family, rather than see it go to an outside party. Specifically, bypassing traditional insurance can often lead to a cost savings through the elimination or reduction of profit loads, broker commissions and administrative costs.<\/p>\n

B. Pay premiums that better reflect your loss experience<\/p>\n

A Captive may also reduce insurance costs by charging a premium that more accurately reflects the parent’s loss experience. Specifically, premiums are based on your individual loss history, not grouped together with your industry’s
\npoor performers, as the traditional markets do. You keep unused premiums and earn return from the investment of those dollars.<\/p>\n

C. More flexibility in tailoring policies lowers cost<\/p>\n

Buying insurance is similar to buying clothing. In a highly simplified analogy, we say buying from a commercial carrier is like buying clothes off the rack and having the choice of small, medium or large; whereas, buying through a Captive is like buying clothes through a tailor who custom makes the clothes for one individual to achieve a perfect fit. A captive simply provides an organization with more risk financing options to create the best fit, thereby lower to total cost of insurance.<\/p>\n

D. Access to Reinsurance markets lowers costs<\/p>\n

Re-insurers are able to provide coverage at advantageous rates by operating on a lower cost structure than direct insurers. By forming a Captive, the business owner is given access to the reinsurance markets. By using a Captive to access the reinsurance market, the parent\/owner can more easily determine its own retention levels and structure its program with greater flexibility, thereby “laying
\noff” some of its risk to a third-party company and a less expense rate than through traditional insurers.<\/p>\n

Increased cash flow \/ Investment returns<\/em><\/p>\n

Apart from pure underwriting profit, commercial insurers rely heavily on investment income. Premiums are typically paid in advance, while claims are paid out over a longer period. Until claims become payable, the premium is available for investment. By using a Captive, premiums and investment income are retained by the owner. Additionally, the Captive may be able to offer a more flexible premium payment
\nplan, thereby offering a direct cash flow advantage to the parent.<\/p>\n

Risk retention<\/em><\/p>\n

A company’s willingness to retain more of its own risk, particularly by increasing deductible or self-insured retention levels, may be frustrated by the inadequate discount offered by insurers to account for the increased deductible\/self-insured retention and by the fact that the company is unable to establish reserves to pay future claims. Establishment of a Captive can help address both these problems.<\/p>\n

Further, where the commercial market is unable or unwilling to provide coverage for certain risks or where the price quoted is unreasonable, a Captive may provide the insurance desired. Specifically, captives can often provide coverage for:
\n\u2022 unique or specific risk that would not otherwise be transferable in the traditional market;
\n\u2022 lines of business that are either difficult to insure in the conventional market or that provide significant cost savings by retaining the risk.<\/p>\n

Reduce Long-term Cost of Risk<\/em><\/p>\n

As a separate business, the Captive has the potential to be a profit-center for the business owner. As such, mitigating losses\u00a0are an incentive to creating a Captive. Commercial insurance does not provide such an incentive \u2013 if a business\u2019 claims are lower than the industry average, the business is not generally rewarded for the lower claim history. With a captive, low claims continues to directly benefit the overall business owner and consequently encourages the implementation of risk mitigation techniques.<\/p>\n

Potential Tax Efficiencies<\/em><\/p>\n

A. Immediate deductibility for self-insured risks<\/p>\n

With traditional self-insurance, companies only receive a an income tax deduction when they make a claims payment (not when a reserve is established). When a Captive is utilized to insure these risks, the company\u2019s premium payments to the Captive are immediately deductible for income tax purposes. Therefore, there is a timing benefit from an income tax perspective from covering self-insured risks through a Captive.<\/p>\n

B. Ordinary deductions vs. capital gains<\/p>\n

Consider the fact that the owners of an operating company are in some way related to the owners of the Captive. Further, when a company makes premium payments to a Captive, it earns an ordinary deduction. However, when a Captive earns profits from its insurance activity and distributes such profits to its owner (i.e., a dividend,) such owners pay tax on such dividends at capital gains rates. Therefore when considering the tax position of the owners of the operating company and the Captive, the portion of premium payments that result in Captive profit received an ordinary deduction, but are taxed as income at capital gains rates.<\/p>\n

C. I.R.C. 831(b)<\/p>\n

Section 831(b) of the Internal Revenue Code states that insurance companies, including captives are exempt from income tax on their insurance-related profits if they collect less than $1.2 million in premiums, annually. Therefore, the profits earned by an 831(b) captive insurer are not taxed at the captive level, but only receive capital gain treatment once distributed to the owners.<\/p>\n

Regulatory benefits of captives<\/em><\/p>\n

\u2022 A captive can start writing business much faster than a traditional insurance company due to a simplified process to
\n   license the captive in a domiciliary state and register it or the Captive in various states.
\n\u2022 There is no requirement for approval from state regulators on rating plans and policy forms.
\n\u2022 There is no requirement to engage licensed agents and brokers to solicit business.
\n\u2022 The reporting requirements to regulators is less demanding than a traditional insurance company.
\n\u2022 With the exception of domicile premium taxes, often there are often no other fee and assessment requirements.<\/p>\n

3. Feasibility Study?<\/strong><\/p>\n

Why conduct a Feasibility Study?<\/em><\/p>\n

A Feasibility Study is undertaken to determine what a Captive can specifically provide for its owners. As Captive\u2019s are often new to companies, this element is very important. Companies will also\u00a0use the feasibility study to satisfy a statutory requirement.<\/p>\n

A major difference between a Captive insurance strategy and other insurance strategies is the capital investment. Unlike in a commercial insurance situation or a self-insured situation, a company that operates a captive must contribute capital (or at least it must tie up collateral to support a letter of credit). That is, when insurance is purchased from a commercial carrier or a company self-insures its risk, there is no requirement to put capital at risk. In the case of the former commercial carrier, premiums are paid to the insurer and become an expense; in the case of the latter self insured, losses are paid as incurred\u2014again, an expense. Any investor who puts capital at risk will want to make sure that capital is put to good use to benefit the business. Understanding how this investment will be utilized is where the Feasibility Study begins.<\/p>\n

What is a Feasibility Study?<\/em><\/p>\n

The focus of the study will depend on the motivating factors for establishing the Captive.<\/p>\n

Defining the risk<\/em><\/p>\n

Once the objectives for conducting the Feasibility Study are clearly stated,\u00a0an analysis\u00a0begins. The Feasibility Study will identify the specific risks that will be the focus of the Captive. Understanding the risks that the organization is considering assigning to a Captive is critical because a proper and complete risk-management actuarial report can only be completed once the risks are known and clearly identified.<\/p>\n

Measuring the risk<\/em><\/p>\n

Once the objectives of the study are defined and the potential risks to be included in the analysis are identified, the data analysis can begin. The data and financial analysis is the heart of the feasibility study. In the end, this analysis (that includes a competent actuarial study) will likely play the biggest role in determining whether a Captive is going to be an appropriate alternative risk financial solution. Just keep in mind that it is not the only factor in this decision. A good feasibility study will evaluate the myriad of issues that go beyond the pure financial considerations to get the best picture of whether a Captive is an appropriate investment.<\/p>\n

In terms of measuring the pure financial considerations, below are some of the key components:
\nRetained risk and loss projections- The feasibility study will identify which risks the Captive is willing to retain and at what levels.<\/p>\n

Expense budget for the Captive- The Captive Insurance Company is and must be run like a separate, self-sustaining business. Therefore, it must have a clearly defined operating structure with associated expense budget. The Feasibility Study provides the owner the opportunity to fully understand and define this expense structure.<\/p>\n

Tax impact- Tax implications should never be the sole or even predominant reason for forming and running a Captive Insurance Company. In fact, if there is no other compelling reason to form a Captive beyond some tax advantage, you can expect the IRS to challenge the Captive\u2019s existence.<\/p>\n

The taxes that should be addressed include:<\/p>\n

\u2022 U.S. (or other country) income tax
\n\u2022 Excise taxes
\n\u2022 Excess and surplus lines taxes
\n\u2022 Domicile premiums taxes
\n\u2022 Local premium taxes
\n\u2022 Other taxes\/assessments<\/p>\n

Premium strategy- The Captive will need to ensure that it has a clearly established premium rate structure and individual rates for each line of coverage. By presenting these premiums by line-of-coverage, the Captive owner will be able to estimate the total expected premium contribution, which will help determine the overall required capital necessary to support the Captive.<\/p>\n

Capitalization- The reason\u00a0for a capital requirement is to ensure that the Captive can support the risk that it is assuming. It only makes sense for the Captive to be adequately funded but not over-funded. Ultimately, capital requirements will be determined by a combination of captive-funding needs and the domicile\u2019s statutory requirements. The quality of the capital estimate will be based on the quality of the information used to arrive at those estimates. That includes the credibility of loss projections, the quality of the rate-setting process, and the claim-management procedures that will be put in place among with the other processes.<\/p>\n

Pro forma financial statements- Since the Captive will be an independent operating insurance concern, it will need to show profit and loss projections. A five-year horizon for the pro forma financials is appropriate. These financials should include:<\/p>\n

\u2022 Income statements and balance sheets
\n\u2022 Five-year pro forma results
\n\u2022 Presentation of tax consequences
\n\u2022 Financial assumptions (interest rates, growth rates, cost of capital, etc.)<\/p>\n

Structuring strategy<\/em><\/p>\n

The structuring section of the feasibility study will address the various captive-program structure options available to the captive owner.<\/p>\n

4. What character and types of insurance coverage should be written in a Captive?<\/strong><\/p>\n

A. Character of risks<\/p>\n

I. Low frequency\/low severity risks- Sometimes it doesn\u2019t make sense to carry traditional insurance for claims that rarely occur and even when they do occur they are always of low-severity. Traditional insurance might not be available or it\u00a0may be expensive since the carriers may charge a minimum amount for the coverage. In this case, an appropriate Captive policy can balance the need for coverage and the need for appropriate premium pricing based on the individual organization\u2019s risk profile.<\/p>\n

II. High-frequency\/low severity risks- Some companies experience a high number of low-severity (or low-cost) claims. Purchasing insurance coverage in the
\ntraditional market for this type of claim can be expensive because of the high- frequency nature of the loss history. A Captive can make appropriate adjustments thereby reducing the overall cost of financing the risk.<\/p>\n

III. Low-frequency\/high severity risks coupled with a stop-loss strategy- When claims related to a particular risk occur very infrequently but the potential loss is severe, companies often find themselves paying very high premiums for events that rarely if ever occur. For those companies who have programs or procedures in place to reduce or eliminate the risk of such claims and who wish to reduce the cost of financing whatever underlying risk actually exists, a Captive is often a good alternative. This works, however, only when there is a sound stop-loss strategy in place to ensure that if a severe claim does occur, there is appropriate excess coverage to handle it.<\/p>\n

IV. Risks with large established claims data and existing market of reinsurers- Most Captives rely on reinsurance to handle much of the risk shifting. When there is an existing strong market for the reinsurance sought and there is well-established claims data, there is a good chance that the reinsurance will be very competitively priced and easy to secure. In this case, there is a good chance the overall program to underwrite these risks using a captive will be more financially attractive to the insured than simply buying traditional insurance.<\/p>\n

V. Risks where premiums to policy limits are very close- If you are purchasing coverage from a traditional carrier and the premiums you are paying are not too different than your policy limits, you would likely benefit from having the Captive underwrite that risk. First, the Captive coverage will be less expensive even for the same policy, because the Captive\u2019s overhead is much lower than the traditional carrier. Second, you are getting almost no benefit from the traditional insurance if you are paying out about as much as you would hope to get back in the event of a loss. You are much better off paying the premium to yourself (i.e., to your Captive) taking the deduction and then investing the money according to your Captive\u2019s investment policy.<\/p>\n

VI. Risks that the company manages better than those in its industry- When your company has figured out a way to manage risk significantly better than others in your industry, writing coverage for that risk through a Captive should be a major consideration.<\/p>\n

VII. Currently self-insured risks- There are risks your company is currently self- insuring. Some of these risks are obvious to you; for example, you may decide that for certain risks where you have a history of frequent, small claims, you\u2019d rather pay the claims directly instead of relying on insurance coverage. However, you elect to make sure you are covered in the event one of those small claims becomes a very large claim, you keep traditional coverage but maintain a high deductible. So, effectively, you are self-insuring your claims up to a certain \u201cretention\u201d level. You may even have excess or catastrophic coverage that goes beyond that initial policy limit.<\/p>\n

B. Types of risks<\/p>\n

I. Generally, business owners do not replace their commercially-purchased insurance with self-insurance except in very limited circumstances where the cost of the commercial insurance is drastically too expensive in comparison to a long, established low claim history by the business. The captive can offer policies which protect against the potential to pay the deductibles on the commercial insurance. This will allow the business to increase its deductibles as high as the commercial insurer will allow \u2013 thereby lowering the cost of the commercial insurance.<\/p>\n

II. For instance, most business owners would not transfer all risk property insurance coverage, including fire risk, to a Captive where a catastrophic fire loss could destroy the business and perhaps the Captive. However, it might be wise to transfer the first $500,000 of property loss risk to a Captive and purchase commercial insurance for the coverage above $500,000.<\/p>\n

III. Captives can offer practically all types of insurance with the exceptions of life insurance and workers compensation insurance.<\/p>\n

IV. Casualty Program<\/p>\n