Construction Insurance and UK Construction Contracts
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CHAPTER 29
Captives
Introduction
29.1 An alternative to traditional insurance is available to those involved in the construction industry by captive insurance company (“captive”) arrangements. 29.2 There are two categories of captive: first, the wholly-owned subsidiary that only insures and manages all or part of the risks of its parent (known as a “pure” or “classical” captive); and secondly, the captive that is owned by several unrelated shareholders, for example, a sponsoring organisation, group or association, primarily for the benefit of its parent or sponsor (“partial” captive). It is known as a captive because it is not free to transact business independently. Examples of partial captives include group-owned mutuals and pools. An example of a mutual captive in the construction context is the Wren for major UK design firms, and some well-known contractors have a mutual captive. 29.3 Many captives are situated offshore to benefit from ease of establishment and lower rates of taxation. Specialist management companies are usually established in the offshore location to enable the parent company’s professional adviser to maintain close contact with its clients. The principal locations of captives include various states in the USA, provinces in Canada, Luxembourg and several offshore locations including the Bahamas, Cayman Islands, Bermuda, Barbados, Guernsey, Dublin and the Isle of Man.Advantages of captive formation
Reinsurance
29.4 Reinsurers provide services at a relatively low cost, and this is one of the most important features of the captive operation. The captive concept allows the owner access to this market. The parent can decide how many low-level claims it will retain within its own operation and take out reinsurance cover above this level. Thus the parent can avoid mark-up on many premium payments.Risk selection
29.5 The parent has the advantage of choosing what type of risk it wishes to retain. This obviously offers many different advantages. The parent can choose to retain all of one type of risk or different risks within a certain class, with the advantage that the less attractive risks are left to the general insurance market. As with allPage 383
Taxation
29.6 Taxation issues are not dealt with in this book but the reader should be aware that a captive represents a tax-effective way to refund retentions, enabling it to build up reserve funds without the usual tax penalty on internal funds held by corporations. This is achieved by ensuring premium payments from the parent that are tax deductible.Multinationals
29.7 The captive offers certain advantages to the multinational, including assisting it to obtain greater control of its risk financing on a global scale by gaining a far wider coverage of the insurance expenditure, whilst reducing it as described below. Another way in which the captive aids the insurance company is in centralising the worldwide risk-financing policy, as it can obtain business from all of the company’s various subsidiaries, enabling the profits from these various transactions all to accrue to the captive. This centralisation can be improved by developing global insurance policies, which has the added advantage of allowing many local technical difficulties to be effectively side-stepped, for example local capacity problems, strict regulation of policy wordings and premium control.Expansion
29.8 If the captive is properly established, well managed and financed, then it should expand and develop its reserves. As this happens the captive can take on new risks, extending the proportion of the company’s risks that it controls or moving into new types of risk. At the same time it can reduce the reinsurance protection it needs, provided that its loss experience does not deteriorate by any significant amount. Once the captive has reached its optimum with regard to reinsurance pricing and retention of its own risk, it can then use its financial position to move into other areas of insurance and grow as an important profit centre for the company. 29.9 Taxation incorporating captives offshore with a tax-sheltered environment can give rise to lower costs, and significant tax allowance, tax savings from claim reserve funds, and tax deductions.Disadvantages of captive formation
Cost
29.10 Capitalisation of the captive will be influenced by local requirements, the amount needed to run the business at a satisfactory solvency level and the amount needed to ensure quality business is written. This will be important when reinsurersPage 384
Beating the market
29.12 One common use of the captive is to provide cover for risks that have no cover in the conventional market. Although this can be an advantage initially, the captive may have problems putting together statistics that can justify the premium. It is probably necessary to establish that the premium charged bears some relationship either to the loss history or to a likely market premium, particularly if tax deductibility of the premium is to be allowed by the authorities. The captive must also issue a proper policy document, to emphasise that this is a fully incorporated insurance operation.Funding low-level losses
29.13 If the captive is being used to fund low-level losses the company may well have to provide its own services, which may prove difficult to provide on an economic basis in relation to the captive’s size.Before forming
29.14 When companies are on the borderline of captive formation they are required to comply with relevant regulations concerning capitalisation requirements or expenses for high-level exposures. Furthermore, there can be initial difficulties in entering the reinsurance market. Cost in this area tends to be experience rated, so it is therefore essential that the company has a sound loss-control capability, otherwise it may find itself faced with soaring reinsurance costs.Business plan
29.15 A business plan will be required to enable a comparison of the captive’s projected results with the financial effect of maintaining correct risk management plans. The financial aspects of running a captive will need to be carefully planned in order to establish an appropriate level of capitalisation. 29.16 The business plan should deal with:- (1) premium volume;
- (2) estimated maximum loss;
- (3) claims;
- (4) reinsurance;
- (5) investment income;
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(6) commission;Page 385
- (7) management charges.
Market cooperation
29.17 The captive owner obviously needs a number of services, such as engineering and claims facilities. He may find it either impossible or prohibitively expensive to secure these services. This will be a particular problem if he is operating in a difficult insurance market environment. Furthermore, if the captive is taking risks that are uninsurable conveniently he may find the necessary reinsurance cover difficult or impossible to purchase.Local company legislation
29.18 The integration within the captive’s business of insurances from overseas subsidiaries is a complex operation. First, the captive may have to contend with the market attitude to overseas insurers. This may make it impossible to secure the necessary fronting facilities. Furthermore, local legislation may also prohibit the payment of adequate cessions or premium amounts to the captive. It may be that the exercise is not economically worthwhile as the premium available may be insufficient, making the administrative effort counterproductive in relation to premium received and the risk taken.Attitudes of authorities
29.19 A possible disadvantage for the multinational in captive formation is unfavourable attitudes from the local authorities, who may not like the idea of a substantial proportion of their insurance leaving the country in the form of reinsurance payments.Government controls and returns
29.20 It is likely that many controls will be imposed – strict solvency requirements, high capitalisation, exchange control restrictions, etc. These are likely to be onerous as most developed countries exercise draconian control over the insurance market. A corollary to this is a potential delay in the formation of the company because there may be a need to supply a considerable amount of information to the authorities prior to establishment on a continuing basis. One possible solution is to establish the captive in an area where it is less difficult to operate.Management time
29.21 One contingency that the owner may fail to take into account is the potential cost of the services. This is also the case with regard to management time. Many companies employ independent management companies to handle the actual captive activity and the establishment of the insurance company. However, the amount of management time actually used in decision-making can be costly and it must bePage 386
Premium payment
29.22 It is important that the premium payment is appropriate in relation to the market. It is also advantageous for the company to pay premiums offshore and develop the captive as a profit centre.Loss control
29.23 Throughout this chapter the need for adequate loss control provisions by the company has been emphasised. If this were to deteriorate then the captive would be likely to suffer in the long term.Managing the captive
29.24 Self-management is neither economic nor advisable for traditional captives. In relation to offshore captives, staff need to be located in the domicile, which would increase costs and would be likely to produce the necessary calibre of underwriting and accounting personnel. If parent company staff were used, the taxation benefits of offshore arrangements would be endangered. Usually, a specialist professional management company is appointed under a management agreement approved by the captive’s board of directors to work within specified guidelines. 29.25 The management company will provide at least the following:- (1) accountancy services;
- (2) underwriting facilities;
- (3) arranging for policy issue and endorsements;
- (4) claims handling facilities;
- (5) reinsurance arrangements;
- (6) investment and accounting;
- (7) compliance with statutory requirements, for example, in relation to monitoring solvency and liquidity requirements.
Selecting the managers
29.26 There are several ways to manage a captive. The first possibility is to manage it “in-house”. This may be by use of an existing organisation within the company, or a separate organisation could be established that will depend very much on the location of the captive. The legislation in some countries forbids the parent company from managing the captive on a direct basis. Severe penalties may be incurred if this is ignored. 29.27 Tax must also be considered. In some areas the residence of a company for tax purposes is related to the location of the management. If this is the situation then the management of the captive should be seen to be separate from the country of the parent company, the parent should not issue any directives to the captive and the boardPage 387
- (1) independent management companies;
- (2) underwriting agents including existing insurance companies;
- (3) management companies owned by brokers;
- (4) others, including lawyers, banks and accountants.
Management agreements
29.32 For the reasons explained above, it is essential that the management agreement is properly constituted. It needs to contain certain principal agreements laying down the responsibility of the managers and the areas where they operate within agreed board decisions. A typical agreement would include:- (1) the official appointment of the manager;
- (2) acceptance that the appointed managers can:
- (a) accept writs on behalf of the captive;
- (b) employ sub-agents to collect premiums;
- (c) pay or settle claims;
- (d) control underwriting;
- (e) issue policies, certificates, endorsements, etc.; and
- (f) maintain bank accounts.
- (1) render statements of premiums and claims within an agreed timetable;
- (2) render final accounts on an annual basis;
- (3) submit the appropriate documents to the authorities in compliance with the requirements laid down.
- (1) the overall investment policy of the captive;
- (2) the policy on funding for claims and the methods used for reserving on outstanding cases;
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(3) the position on errors and omissions of the managers; the position should the managers or the captive or owner become insolvent, are taken over by another company, or decide to close down the captive operation.Page 388
Establishing a captive
Legal
29.37 Legal advice on company formation in the country in which it is to be based will be required. There will inevitably be detailed local procedures for insurance company formation and detailed requirements so far as directors, company name, authorised capital, names of officers, etc. are concerned. After the captive has been established, local legislative controls will also need to be monitored in case there are any specific changes. Further complications may include potential overseas legal problems.Documentation
29.38 As an established insurance company the captive will have to provide evidence of the cover it is supplying in the form of the relevant policies it offers. The production of these documents will also help in tax deductibility. As emphasised throughout this chapter, it is essential that the captive should be a properly constituted insurance company. To this end, the documents provided must be real and properly issued.Accounting
29.39 Insurance accounting is a particularly specialised area and accounting procedures for the captive would have to be considered in detail.Taxation
29.40 In some areas tax matters are deal with separately, depending on whether investment income or underwriting income is involved. Thus tax minimisation has to be considered very carefully. Again, there will be marked differences here between insurance and conventional company accounting, particularly with regard to premium taxes.Underwriting
29.41 The captive must decide on and establish an underwriting policy.
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Claims handling
29.42
An efficient method of handling claims needs to be established at the outset. Complications can arise in claims handling due to currency problems, conflicts of interest and reinsurance problems.
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Investment
29.43 Two points dealing with investment strategy need to be noted. The first concerns investment of funds for profit. The captive is likely to make a profit for the parent only if funds are properly invested, so an appropriate sensible strategy needs to be designed. Secondly, the captive needs to be able to meet large claims that may arise. This means that care needs to be taken to ensure that adequate funds remain accessible.Administration
29.44 The likely functions of the administrative team will include:- (1) issuing policy documents;
- (2) settling claims, or instructing assessors of claims-handling agents;
- (3) keeping financial statements and accounts;
- (4) issuing statutory returns required;
- (5) setting up and organising ordinary and other meetings that will be necessary in the management of the company.
Loss control
29.45 Good loss-control capability will require separate personnel, or the use of consultants and engineers. The strategy for loss control should also provide one of the foundations of the captive’s activities and thus should be reflected in other areas, such as reinsurance tactics.Captive set-up and operating costs
29.46 A typical list of set-up costs for a captive would be:- (1) paid-up capitalisation;
- (2) registration fee;
- (3) stamp duty on capitalisation;
- (4) application fee;
- (5) advertising of captive in compliance with regulations;
- (6) initial legal fees;
- (7) annual legal fees;
- (8) directors’ fees;
- (9) management fee;
- (10) annual audit fee.
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Consolidation of the captive board
29.47
It is advisable that the majority of the captive board live locally. A typical situation is a board constituted of two directors from the parent company and three local directors. At least one of the latter should have insurance experience and in some areas legislation will demand this. Decisions are generally ratified by:
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- (1) approval of resident board members; or
- (2) through proxies appointed by the parent company; or
- (3) resolutions circulated to the directors of the company.
Alternative solutions
29.48 Whether or not there is an alternative option to creating a captive depends very much on what the company is attempting to achieve. If the chief purpose is to retain more risk within the company’s own operation, then a number of alternatives do exist. The alternative self-insurance options include operating a budget, funding mutual captives and participative insurance. 29.49 These options will require careful consideration of the costs associated with this type of management and dealing with claims.Operating budgets
29.50 With an operating budget, losses will only be paid for as they are incurred, as no premium is available. Although this method does not require capital injection, nor is it regulated, it is only really practical when risks are of low value and high frequency. Any other type of risk is likely to affect performance of the company. 29.51 Losses can be paid for out of operating budgets. This has a number of advantages. The first is the psychological impact of losses appearing in the budget. This can result in a significant attempt to improve the company’s loss control. There is also a financial benefit as losses are paid for as they arise rather than in advance. Profit performance can also be improved as losses that do not occur are not paid for. This can have the added benefit of improving cash flow. If the loss level is satisfactorily low, then losses will remain deductible. 29.52 Problems with this system arise when the losses are of an infrequent and sizeable nature. If the loss is such that it would seriously harm the overall or local management profit performance in that year it could well act negatively in all aspects.Self-insurance and funding
29.53 Funding involves setting up a separate fund in the company with the objective of earning sufficient investment return to fund losses. The disadvantage is that capital will be tied up and withdrawn from use on other ventures and, in addition, the tax benefits of most offshore captives will not be available. 29.54 If losses are larger than those referred to above, then a similar system can develop funds to pay for losses that would occur beyond a financial year. The same benefits would accrue, but without the disadvantages. The disadvantage is that in most countries it is not possible to develop funds in such a beneficial way becausePage 391
Mutual captives
29.55 A mutual captive is jointly owned by several organisations with complementary risk profiles. Examples include the Wren (for architects), the P&I clubs (Britannia, Steamship, etc.), Griffin (for medium-sized brokers) and SIMIA (for solicitors). This may be appropriate where the methods described above are impractical, e.g. due to the pattern of losses, where it is uneconomic to set up a captive or where risk exposure is high. Another advantage of mutuals is their potential for lower costs because of the ability to spread the burden between a number of owners. This should also encourage lower reinsurance costs owing to the greater spread of risk and premium volume. 29.56 The main disadvantage of a mutual is that different loss profiles of its members may result in those members with better loss records subsidising the others.Participative insurance
29.57 The methods of participative insurance that provide alternatives to the captive fall into five categories:- (1) deductibles;
- (2) co-insurance;
- (3) retrospective rating plans;
- (4) external risk funding;
- (5) credit.