Special Section—2007 CICA International Conference
Slow but steady
The reinsuring of employee benefits in captives is showing some growth
Captive insurance companies have been a fixture in the risk financing landscape for more than 30 years. Originally, captives were viewed primarily in a limited role for a Fortune 500 corporation’s overall risk financing programs. Despite this limited view, captive growth continued, frequently being pressed into service as a stopgap measure that would be implemented during hard market underwriting cycles. But as time went on, people found more and more opportunities to utilize captives in a variety of risk management situations.
Much of the optimism regarding today’s view of an expanded captive insurance industry comes thanks in large part to the potential offered by using captives in conjunction with reinsuring some of a company’s employee benefit programs. There are numerous reasons why employee benefits may well fuel the continued, long-term viability of the captive insurance movement. Many of those reasons revolve around costs, coverage, and control—the same reasons that justified the formation of captives originally.
Frequently cited advantages for including employee benefits in an organization’s captive include the following:
• Reduced administrative expenses—Expenses such as insurance company overhead, profit loading and other marketing costs can be reduced through the use of a captive.
• Recognition of good loss experience—There is frequently an inappropriate recognition of good loss experience in the conventional insurance market rating structure. As a result, over time, good accounts end up subsidizing bad accounts. Movement to a captive can better match an organization’s good loss experience with its actual costs.
• Earnings from investment income—Historically, this has been one of the primary rationales for forming a captive in the first place. Having the ability to hold on to reserves for long-tail coverages such as workers compensation, professional liability or product liability, thus earning significant investment income, led many risk managers to form captives years ago. The same is true for long-tail employee benefit coverages such as long-term disability and term life insurance. Both of these coverages offer the opportunity to generate significant investment income from holding the reserves.
• Direct access to the reinsurance market—One of the most cited reasons to justify forming a captive has been the ability to gain direct access to the reinsurance market. And while some employee benefit underwriters are not as accustomed to this aspect of the captive operations, savings via reinsurance transactions can provide meaningful cost reductions. It also allows for greater flexibility in program structure than the conventional markets allow.
• Potential additional tax advantages—Depending on the particular situation, the captive owner may be able to gain a minor tax advantage by including employee benefits within the captive. However, a much larger potential tax advantage may be available because the inclusion of employee benefits in the captive could allow the captive’s property and casualty insurance premiums to become a deductible expense to the owner. This is due to the fact that frequently the employee benefits premiums going into the captive are considered as third-party business by the Internal Revenue Service.
• Maintain control over risk management program—As corporations begin moving to a more enterprise-wide view of risk management, moving employee benefits into a captive insurance company can provide maximum flexibility for the captive owner. Additionally, the inclusion of employee benefits allows the captive to diversify its portfolio of risks and provides a better spread of risk for the captive. These all speak well for the long-term success of this risk financing mechanism.
Each of these advantages can provide savings for the captive owner. While each situation is unique, most consultants agree that potential savings on the employee benefit side of the transaction can frequently range from 20% to 25%.
Facts of life
Moving employee benefits to the captive can be a long and winding road. The first corporations to do so successfully had to obtain approval from the U.S. Department of Labor (DoL) before they were allowed to do so. The original captive owners, Columbia Energy Group and Archer Daniels Midland, both had to invest significant time and financial resources in securing the DoL approval. However, once they completed their separate transactions, the DoL’s regulations allowed for a more streamlined approval process. The process, called “ExPro,” requires that the DoL either approve or deny approval within several months of application.
At the time of the movement to ExPro, late 2002, many in the captive movement predicted that captives would be routinely placing their employee benefits into their captives. And while some corporations have followed subsequent to the ExPro regula-tions, still less that a dozen have completed this process. The majority of the companies that have completed this process have used their existing Vermont captive. Derrick White, director of captive insurance for the State of Vermont, confirms that the state currently has seven captives that include employee benefits. He also says that Vermont has an additional three or four deals in the pipeline. White indicates that he is aware of only two other companies that have included employee benefits in their captives.
However, White notes an important point when reviewing the captive/employee benefit issue. He says that, “Vermont’s seven captives are reinsuring ERISA-regulated employee benefits.” These are the only ones that typically require the DoL approval. And he says that non-ERISA related employee benefits continue to move into captives as well. Consultants confirm that there is additional movement of non-ERISA regulated employee benefits flowing into captives, since these transactions require little or no DoL review.
Holding back the flood
To say that the current situation has many people scratching their heads is a major understatement. White echoes the feeling of many in the captive movement when he asks, “What are people waiting for?” With the numerous advantages noted earlier, the expedited procedures in place at the DoL, and the movement to an enterprise-wide view of risk management, why have we not seen the steady stream of business many predicted? That’s the $64,000 question.
White points to several issues that may have limited the movement to reinsuring employee benefits. “Certainly there are turf issues in many companies considering this option,” notes White. And it is quite visible from the start, according to White. He says that of all the discussions he has had with captive owners on this subject, “only one exploratory meeting had representatives from both risk management and human resources.” And, as most experts will attest, it is vitally important to have both departments represented in order to gain corporate approval. This may well be the one key success factor in moving employee benefits into the captive.
Despite the expedited process at the DoL, there is still a significant amount of detail involved with gaining approval. And, as White states, “it has only been recently that the property and casualty side of the house has not had a crisis in one or more lines of coverage.” For the most part, the past five or six years has seen significant pricing pressure on many lines of coverage, everything from professional liability coverage to property coverage. White believes that these “insurance crises have not allowed sufficient time for the risk manager to develop a strategic plan for including employee benefits in captives.”
Long term, there can be little doubt that many existing captive owners will begin to reinsure their employee benefits in their captives. Additionally, potential captive owners will also begin to incorporate employee benefits into their captive feasibility studies. As a result of the inclusion of employee benefits, many more companies may begin to obtain favorable captive feasibility study results. This will result in more mid-sized companies being able to justify the establishment of captives as an integral part of their overall risk management program.
The real questions for agents and brokers are: When will your clients start to take advantage of this movement? And will you—or your competition—be helping them do so? *