Why own when you can rent? If I had a dollar for every time I’ve heard that catchy expression, I’d have at least fifty bucks by now!

And I get confused when people talk about rent-a-captive and segre­gated cell companies in the same breath. Is it the same thing? Seasoned practitioners in the captive world tend to throw jargon around like it’s going out of fashion, and I find that the rent-a-captive arena has more than its fair share. The purpose of this article is to demystify some of this jargon and explore some good reasons for renting a captive instead of owning.

Over the past 10 years, the rent-a-captive concept has entered the mainstream of alternative risk-financing methods and can now stand shoulder to shoulder with any other. The principal reason for this is the widespread use of segregated cell legislation in most captive domiciles, which allows the rent-a-captive facility to legally segregate the assets and liabilities of each insured using the facility.

This wasn’t always the case. Prior to legal segregation, most rent-a-captives operated using contractual segregation and most buyers were perfectly happy with that. By contractual segregation I mean that each program in the facility had a separate reinsurance arrangement, usually providing specific and aggregate protection for the insured’s program. Any policies issued or reinsurance assumed on behalf of the client clearly described the risks being written, and this documentation was referenced in a participation agreement confirming the risks being assumed on behalf of the insured.

Diagram 1 illustrates a typical rent-a-captive operation and the relationship of the parties involved. All of the contracts are tied together through the participation agreement between the insured and the facility. The participation agreement essentially says that the facility will account separately for each client’s premium, losses, and investment income and will also include an indemnity in favor of the facility should losses exceed the amount of funds available in the cell. This indemnity is usually backed by collateral.

Diagram 2 illustrates a typical rent-a-captive operation using segregated cells. As you can see, the transaction is effectively the same, with the obvious important distinction being that the client has rented a specific cell in the facility rather than just “space.”

Once you get over the fact that you don’t own the cell, the benefits of renting a cell versus owning your own captive are pretty significant when weighed against the downsides of renting.

Clients who are considering a captive for the first time should give serious thought to a segregated cell option, for the following reasons:

• The operating costs are significantly less than those involved in forming a captive. A typical single-parent captive owned by a U.S. operation and insuring its three casualty lines will operate with general and administrative expenses in a range from roughly $120,000 to $150,000 per year. This includes management fees, audit fees, legal fees, and domicile fees. For a similar deal, the rent-a-captive will probably cost around $50,000, as the facility itself pays one audit fee, one set of legal fees, and one domicile fee for the entire facility. This is an annual savings of $70,000 to $100,000. That’s every year!

• Capital needed to operate the cell will be roughly the same as required for a single-parent captive. A number of factors influence the amount of capital, not the least of which is the insured’s risk appetite and the need to have a buffer in the event of poor loss experience. Each domicile imposes a technical minimum capital requirement on captives that is around 20% of premium. Domiciles will regulate rent-a-captive facilities as they see fit, with some focusing only on the sponsor while others look at each cell. As most facilities are “pass-through” facilities (i.e., they facilitate someone else taking risk), a number operate on a “risk-free” basis and therefore are exempt from the domicile minimum capital requirement. This is an area to watch closely for potential changes.

• Ease of setup and exit are often touted as advantages of a rent-a-captive compared with an owned captive, and that’s certainly the case as far as setup is concerned. The extent of the benefit, however, will depend on whether the domicile requires the facility owner to have each new cell approved; if so, this process can take time.

• Some privately held companies have difficulty complying with a regulator’s request for confidential financial information when setting up a single-parent captive. As they won’t be a director of the cell or the facility, the same disclosure requirements don’t apply to the users of a rent-a-captive facility.

In addition to the potential cost and capital benefits outlined above, many of the good reasons for forming a captive apply equally to rent-a-captives:

• One P&L is maintained for all retained losses.

• Volatility among subsidiaries or divisions is reduced by having one central funding mechanism.

• It facilitates a reward (and penalty) system for subsidiaries with good/bad loss experience.

• Operating entities will improve loss reporting when they know a recovery is available, which in turn will improve the quality of data available to make management decisions.

• Operating entities will be unlikely to buy down their own deductibles when they know a centralized funding mechanism is available at very cost-effective rates.

• If you cannot buy insurance at the right price or obtain the breadth of coverage you need, or if it’s simply not available, a captive or cell is a good way to recognize the existence of the exposure and pre-fund for it.

• A tax deduction is often available for premiums paid to a cell or captive, assuming the program is structured properly.

When considering a cell or captive, it’s important also to evaluate the broader enterprise risk management benefit of having a structured risk-financing plan in place. Stake­holders develop a greater confidence level in financial statements and data generally, financial reporting risks are mitigated, and internal auditors can look in just one place to find loss information and how it was accounted for.

What questions should you ask before renting a cell? The list below is not exhaustive but should be helpful. It will also draw out some of the negatives of renting that should be considered.

• Who owns the facility, and how long have they been in the business?

• Request a copy of the financials.

• Review the participation agreement in detail.

• What are the facility’s investments, and what control will I have over investment decisions (if any)?

• How is investment income calculated (and allocated if the facility is part of a larger pool)?

• What happens if there is an investment loss?

• Exactly what fees am I being charged?

• How soon can I have my collateral/capital back, together with any distributions for good experience?

• Do I have to take a distribution (can I leave the funds in the cell)?

• On what basis can collateral be drawn?

• What fees are charged during run-off?

• Obtain a sample financial statement for a cell. Will the statements provide the information I need?

• How often will I be provided with financial statements?

• Will the cell be subject to U.S. taxes?

• Is U.S. Federal Excise Tax (FET) applicable to the transaction?

Segregated cell companies are now part of the mainstream when it comes to alternative risk financing mechanisms. This purpose of this article is to introduce a concept that continues to evolve. In the future, look out for the possibility of the IRS treating cells as separate legal entities for U.S. tax purposes and allowing them the ability to make a “D” election. Regulators also are paying more attention to individual cells, rather than the facility sponsor, and this will result in additional regulatory oversight. These are all indicators of the concept’s success and demonstrate that the rent-a-captive option is worthy of serious consideration.

For more information:
Artex Risk Solutions, Inc.
Web site: www.artexrisk.com