Trend towards captives due to hardening of the market
This trend is supported by a study conducted by the global reinsurer SCOR, focusing on captives domiciled within the European Union.
The study quotes:
“A growing number of corporate groups in Europe believe that captives have a key role to play in their risk management strategies” and “as a result, we have seen a rise in the number of captives in Europe over the past two years, which is mostly driven by increasing (re)insurance premiums, higher retentions, and the capacity constraints on the market for emerging risk as cyber.”
What key decisions clarify whether captives are appropriate for your risk management programme?
We’re seeing more organizations consider captives as part of their risk management programmes driven by a variety of factors; providing coverage for risks markets don’t want to cover or are too expensive to obtain, assist in better risk management, reducing overall insurance costs and increasing retention levels to access to markets that would be otherwise inaccessible. But captive solutions can appear complex and require careful consideration of their likely efficiency, ongoing costs and governance. Therefore, we present five questions that clarify the path to using a captive for your organization and provide more insight, highlighting some key considerations and opportunities.
Q1: Do you want to retain risk?
There are critical decisions to make when structuring a cost-effective risk financing program: to retain risk or not, how much risk to retain, to pre-fund the cost of risk and finally, deciding the most suitable financing mechanism for the organization.
A captive is one option. These specifically established insurance or reinsurance companies are primarily aimed at insuring or reinsuring the risks of the owner(s) of the captive. Captives are risk-bearing entities specifically set up to insure or reinsure the risks of the parent company or related third parties.
Captives function as a facilitating mechanism for organizations seeking more direct involvement in the risk transfer market and aiming to take a position on their own risk. Typically, the "parent company" pays premiums to the 'front' (or fronting company), the fronting company issues the policy and handles claims, reinsuring the program to the captive with the portion that the parent company wishes to retain.
A common captive structure usually involves a captive manager—an organization responsible for the daily operations of the captive—performing functions such as accounting, treasury, administration, regulatory interaction, governance and compliance, and acting on behalf of and in the name of the captive owner.
You can use a captive for a range of purposes:
Q2: What type of captive will meet your needs?
There are a range of different captive structures:
Q3: What costs can you expect with a captive?
The captive owner will pay both fronting fees and claims. Additional expenses arise in establishing and operating a captive, along with the financial commitment it requires. The key components of these may include premiums and insurance premium taxes, excess insurance/reinsurance, claims administration and general administrative costs of the captive.
You can also expect ongoing expenses for managing your captive, including actuarial and audit fees, legal, tax, and domicile costs.
In terms of capital, this will depend on the minimum required by jurisdictions and can take the form of cash or a line of credit (LOC) or other forms.
A captive feasibility study will help provide certainty on the projected costs and capital requirements. The study will also clarify further key decisions, including the most appropriate domicile, which is the state, territory, or country that will license your captive and has regulatory oversight.
Q4: Which domicile for your captive?
The already mentioned SCOR study shows interesting facts regarding captive domiciles. For example, 80% of the captives are domiciled in Luxembourg or Ireland. Other captives considered in the study are domiciled in Denmark, Germany, Gibraltar, Malta, the Netherlands, Norway and Sweden. The headquarters of the captive owners were mostly based in western European countries, primarily France, Germany and Belgium. All of the US-based groups in the sample domiciled their captives in Ireland. Furthermore, if we look at the insurance lines which are written by captives, the SCOR study mentions that property was the most common line written (76% of the captives), while Liability business is the second most frequent line (written by 67% of the captives). A quarter of the European captives (23%) in the SCOR sample write only one line of business. A third (34%) of the captives in the sample write direct business, while more than half (59%) of the captives were utilized for reinsurance.
In general, there are around 71 captive domiciles globally, including European, U.S. and Canada, off-shore and Asia-Pacific options, with each location having different regulatory and fiscal advantages. While professional tax advice should be sought before making the decision to form a captive, there may be certain tax advantages associated with such a decision. These might include the tax-favored accumulation of underwriting and investment income (which may depend on, among other factors, the domicile of the captive, the residence or citizenship of the captive's owners, or the source of its income). Another advantage may be the deductibility of premiums paid for by the insured for tax purposes (as the premium expense of the insured). Also, if a captive qualifies as a true insurance company for tax purposes, then unlike other corporations, it can deduct currently a "reasonable and fair" loss reserve for unpaid actual losses incurred. Although tax advantages may be of significance in the decision to form a captive, they should never be the prime motivating factor.
We can therefore focus the attention on those real key factors on the most appropriate domicile for your captive:
A captive feasibility study can provide answers on the most appropriate and efficient domicile for your captive.
Q5: What are the ideal conditions that suggest a captive is appropriate?
We suggest there are number of indications that suggest ideal conditions for a captive to be an efficient and effective part of your risk and insurance program, including:
Recent trends indicate that some captives are moving towards the country of the parent company, even if it might not be financially optimal due to the absence of captive legislation. Furthermore, more advanced captives have been exploring ways to enhance their return on capital for some time. By utilizing ALM (Asset-Liability Modeling), they are considering alternative investment strategies to optimize returns for a certain level of risk. In recent years, captives have been scrutinized by internal financial stakeholders, leading to more targeted financial management. Additionally, an unprecedented dual impact of COVID-19 and the hard market has compelled captives and their parent companies to retain more risk at a time when their capacity to do so might have decreased. Consequently, captives are adopting a more analytical approach to determine their strategy: analysis is becoming increasingly common to support and improve captive utilization within the context of the overall group risk financing strategy, and includes:
Recent European Union directives on minimum taxation, related to the OECD BEPS project, are relevant to captives as they impact economic justification, substance, and transfer pricing. For specialized global support in exploring the role a captive could play in your risk management programme, please contact us.
