Rent-A-Captive Insurance Company Development

A Critical Analysis of the Benefits, Risks and Implications of Creating an Off-shore Rent-a-Captive Insurance Company in Bermuda.
Contents (Jump to)
Abstract
Chapter 1 –  Methodology
Chapter 2 –  Research Process
Chapter 3 – Findings and Evaluation of Findings
3.1 Captive
3.2  Analysis of Benefits, Risks and Implications
3.3 Rent-A-Captive
3.4 Pestle Analysis
3.5 Porter’s Five Forces
 
Abstract
The potential for utilizing a rent-a-captive facility in Bermuda represents a method that is a business proposition to examination the risks, benefits and implications of utilizing this as a viable strategy. Inherent in equating any strategy are its suitability, ease of entry and exit as well as costs and weighing these against the learning curve and relative benefits that will accrue in best and worst case scenarios. To reach such a determination, the examination will employ a number of strategic as well as financial tools, along with the advantages and disadvantages of the methodology to determine its viability in a general, specific and overall sense. The use of any business strategy has either direct and or indirect implications which represent variables that must prove their worth in their ability to further the overall aims, objectives and purpose of the entity and to be particularly of benefit in adverse economic conditions and or unforeseen occurances.
The preceding tough evaluative climate represents the acid test via which to effectively prove or disprove its potential worth to the enterprise.
A ‘captive insurance company’ represents an entity that is set up for the limited purpose by parent insurance companies to finance risks from the main organization and or its subsidiaries (Bawcutt, 1997, pp. 8-9). Rather than representing a new concept, captive insurance companies have been around since the mid 1870s, borne out of ‘protection and indemnity’ clubs of that period which offered marine insurance in coverage of third party liabilities as well as expenses emanating from either operating or owning ships as a principle (Braithwaite and Drahos, 2000, p. 157). The preceding was a result of the passage of the Lord Campbell Act of 1846 (Alabama Law Review, 2004, p. 884), which “… was enacted by the English Parliament …” and titled the ‘Fatal Accidents Act of 1846’ whose purpose was “… to alleviate the harsh results …” from either serious injury or death on ships during that period (Alabama Law Review, 2004, p. 884). Claim liability potential was increased as a result of the flood of immigrants traveling to the United States as well as the higher value of cargos and injuries to crew members. The Protection and Liability Clubs pooled resources to cover claims arising from the passage of the act and minimize exposure for the primary insurance carriers such as Lloyd’s of London (Alabama Law Review, 2004, p. 884).

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Captive insurance companies can be utilized to provide insurance coverage for commercial purposes, as well as industrial and governmental entities to insure either all or part of the risks facing an organization (Geisel, 2004). Captive insurance companies also can be formed as a result of companies that have similar business risks joining together to pool said risks in a cost effective manner to have the needed insurance coverage for these types of areas (Geisel, 2004). The increased growth in this industry segment is a result of the change in the way businesses and organizations see the way to finance their risks as it represents a more flexible approach against potential losses, augmenting catastrophic risk that is covered via conventional means (Sammer, 2001). Critical to the preceding is understanding that insurance represents “coverage by a contract binding …” one party to “… indemnify another against specified loss …” as a return for premiums paid covering said insurance (Houghton Mifflin, 2006). It, insurance, represents a form of ‘risk management’ that is a hedge against some type of financial loss that has a probable incidence of occurring, thus insurance represents the transfer of this risk from one entity to another as a result of the exchange of premiums calculated based upon the potential of occurrence.
The preceding summary will provide an understanding of the purpose and niche regarding captive insurance companies as well as how they fit into the overall realm of the insurance industry represents important background information that is germane to the topic of ‘a critical analysis of the benefits, risks and implications of creating an off-shore rent-a-captive insurance company in Bermuda’.
Chapter 1 – Methodology
The methodology that will be utilized in this examination will consist of understanding the nuances involved in the process of single parent captives as well as rent-a-captives to determine the subtle and or obvious differences that represent either positive or negative factors which a company would need to be aware of as well as consider to have a full understanding of the process. Inherent in such is the understanding of the legal, business, regulatory, financial, operational and administrative facets of the process and how these impact upon each other in the utilization of a rent-a-captive facility. The preceding represents a broad based understanding as well as in depth with regard to the benefits, risks, implications and related factors. In equating such this examination will employ such tools as Porter’s Five Forces framework, a SWOT analysis, as well as a Pestle Analysis and a discussion of the Balanced Scorecard to aid in reaching a determination of the foregoing.
The limitations to the methodology may be in that the tools of analysis are not directly suitable to analyze the process, and or they may be too many business, operational and or industry variables to enable equating if the process is or will be effective in all or most instances. The methodology is limited by the complexity of the problem in that the decision branch tree factor may be too large to adequately cover all of the potential nuances and aspects which might be important. As the basis for the study is the suitability of a certain structure for potential utilization, the methodology is thus simplified into gathering and comparison as a means to uncover the basics and related detail factors which appear in multiple sources.
Chapter 2 – Research Process
The research process will consist of secondary measures utilizing books, journals and online sources to provide a wide cross section of ideas, viewpoints, concepts, theories and practices to ensure that the salient foundational information is based upon the true and actual conditions present. Through a comparative analysis entailing systematic methodologies of collecting, review and analysis of data, the foregoing will provide for such an outcome. Yin (1994) advises that in conducting research, one should seek to equate the positioning of such against real life phenomenon by virtue of gathering a number of viewpoints to reach a balanced understanding. Yin (1994) also adds that the broader the examination, the better will be the grasp of the information and thus conclusions reached.
Maxwell (1996) supports Yin’s (1994) approach and cautions that quality is more important than quantity, thus the research process will seek to weed out lesser sources in favor of more established ones through a comparative process. The preceding represents the suggested approach as put forth by Lieberson (1991), as well as King et al (1994). As the subject represents a pragmatic consideration whereby theory is less important, the comparative analysis of sources is easier as the base information should be relatively close, if not identical, depending upon the jurisdictional locale. Said variable renders the research process as relatively straight forward.
Chapter 3 – Findings and Evaluation of Findings
In examining the subject matter, background information as well as facts, details and information pertaining to the field of captive insurance companies is an important foundation to understanding the benefits of a rent-a-captive as a comparison. The forgoing includes an understanding of the jurisdiction in which the rent-a-captive is located.
3.1 Captive
3.1.1 Bermuda
Bermuda’s entrance into the international insurance market got its start in 1947 when it was selected by C.V. Starr “… as the location for his American International Company, Limited (Bermuda Market Solutions, 2005, p. 3). The captive concept was promulgated by Fred Reiss in the mid 1960s as “… an insurer owned by a non-insurance parent …” (Bermuda Market Solutions, 2005, p. 3) which was established to finance the insurable exposures of the parent. Bermuda is the global leader in the captive insurance market, growing dramatically during the 1980s as a result of group captives that were created to permit smaller companies to align with those of similar interests to thus gain greater control over their insurance through the pooling of risks (Bermuda Market Solutions, 2005, p. 3). One of the largest of these was the OIL Insurance Ltd. that was formed by petroleum companies in the early 1970’s as a result of difficulties they were facing in the property insurance market.
Table 1 – Total Insurance Assets for all International Insured’s
(in billions)
(Bermuda Market Solutions, 2005, p. 3)

250

 
 
 
 
 
 
 
 
 

200

 
 
 
 
 
 
 

204.3

236.0

150

 
 
 
 
 

131.6

172.6

 
 

125

 
 
 

111.8

116.4

 
 
 
 

100

 

95.0

99.9

 
 
 
 
 
 

75

76.1

 
 
 
 
 
 
 
 

50

 
 
 
 
 
 
 
 
 

0

 
 
 
 
 
 
 
 
 

 

94

95

96

97

98

99

00

01

02

Bermuda, is the premier domicile for captive insurance companies as well as rent-a-captives with in excess of 1700 insurers (Lowtax.net, 2004). The captive insurance market has slowed over the last couple of years in contrast to its rapid growth pace of the late 1980s and 1990s with other locales offering similar advantages thus effectively bringing its share of the global market down to approximately one third of all captives from a high of 40% in the mid 1990s (Crombie, 2005). Locations such as the Cayman Islands, British Virgin Islands, Hawaii, Guernsey, and Barbados as well as Dublin, along with an addition 45 other jurisdiction as well as a number of states in the U.S. have slowed Bermuda’s growth and market share as a result (Crombie, 2005). Other factors in this trend have been (Crombie, 2005):

the increased popularity of risk retention groups whose small size, in general, does not make them really suitable for location in Bermuda,
increased marketing by new jurisdictions such as Hawaii and Vermont which have the advantage of being American states,
developments in the varied types of corporate vehicles that are available, notably segregated account companies,
and lastly, the ways in which some jurisdictions count their captives, including those that have formed and not removing them once they have been dissolved.

Another important consideration is cost. Bermuda is expensive and thus since cost does matter to smaller captives as well as those operating on slimmer margins, there selection of locale takes this facet into account. Bermuda’s client base primarily consists of large U.S., European and South American companies whose presence has been in that location for some time (Crombie, 2005). The cost is offset by Bermuda’s reputation, quality of professional expertise as well as the ease of access thus minimizing the cost variable over the long term as a result of the foregoing and the locale’s stability. Another factor that must be considered with respect to Bermuda’s global positioning in terms of the attraction of new captives is the limited infrastructure on the island for residences, schools and traffic. Bermuda is basically more of an exclusive club which is based upon quality as opposed to quantity (Crombie, 2005). As the third largest insurance local after New York and London, Bermuda’s new business formations in 2004 saw approximately 50% in the form of captives (Lowtax.net, 2004). The country is the number one location for segregated account companies with 83 that include 6,234 cells within cells as compared to 126 protected cell companies in all other locations as of 2003 (Lowtax.net, 2004).
Table 2 – Captives by Domicile Year End 2002
(Towers Perrin, 2004)

Number

 
 
 
 

5,000

 
 
 

4,897

4,000

 
 

4,276

 

3,000

 

2.891

 
 

2,000

 
 
 
 

1,000

980

 
 
 

 

1980

1990

2000

2002

Table 3 – Leading Captive Domiciles
(Elliott, 2005)

Rank

Country/
State

2003

2002

1

Bermuda

1,150

1,157

2

Cayman Islands

644

600

3

Vermont

507

443

4

Guernsey

383

382

5

British Virgin
Islands

307

282

6

Barbados

248

249

7

Luxembourg

216

213

8

Dublin

205

181

9

Isle of Man

173

167

10

Turks & Caicos

159

143

Total

 

3.992

3,807

The preceding represents data on captives as of year end 2002, thus accounting for the higher figures indicated above, showing captive numbers for domiciles mentioned as a comparison.
3.1.2 Rent-a-Captive Insurance Companies
A rent-a-captive insurance company provides ‘captive’ insurance facilities to other companies for a fee and protects itself from any losses via individual programs that are further isolated from losses via other programs in the same company (Banham, 2001). Banham (2001) provides the analogy of thinking of a rent-a-captive insurance company “… as a mall of stores …” and each store represents “… the self insurance program of a particular company”. The rent-a-captive concept represents the fact that a company does not have to go through the procedures and regulations entailed with incorporating its own captive as it is able to lease one instead. The preceding represents a business rationale for creating an off-shore rent-a-captive insurance company, leasing out its existence.
The concept of the rent-a-captive provides much of the same benefits that corporate owned captives do in that it provides (Banham, 2001):

increased control regarding losses as a result of improved claims management,
the ability to derive a profit from underwriting along with investment income from the funds that are set aside for claim reserves,
various tax benefits, and
avoidance of accounting and audit issues, which are the responsibility of the rent-a-captive sponsor.

The advantages of the establishment of a rent-a-captive insurance company depend upon a number of factors on the part of the interested company. These aspects shall be discussed in the analysis of the benefits, risks, and implications of a rent-a-captive.
3.2 Analysis of Benefits, Risks and Implications
In equating the reasons, as well as benefits, risks and implications of forming a rent-a-captive it is important to have an understanding of the reasons as to why captives are formed, thus providing an understanding of the benefits of a rent-a-captive. The following represent the foregoing (Elliott, 2005):

To reduce and or stabilize cost

Generally, the financing of risk under a captive lowers overall cost and aids in stabilizes costs long term as a result of being less susceptible to changes in the insurance market. Examples of cost savings are represented by the fact there is:

no profit load,
the reduction and or elimination of commissions to brokers,
lower costs for administration,
the owners in a captive share in all of the earnings through policyholder or shareholder dividends,
a captive avoids costly insurance regulations as well as the exclusion of payments into residual market pools and premium taxes,
savings in loss – cost is another area as captives serve to increase the awareness of risk management as well as cost awareness among top management.

The savings benefits, in general, exceed the expense of both setting up the captive as well as administering it.

Increase capacity and provide access to reinsurance

A captive can access the capacity of reinsurance markets and might be able to provide more coverage limits than available within the retail market. An example of the preceding is whereby multiple insurers participate in what is termed as a slip to offer millions in added capacity which would not otherwise be available. A ‘slip’ is a binder that often includes more than one insurer. An example of the preceding is provided by Lloyd’s of London whereby the slip is passed from underwriting to underwriter to initial and subscribe to specific parts of a risk (captive.com, 2006).

Control

One of the reasons for the origin of captives is due to insurance buyers that were tired of the vagaries of the market regarding insurance and looked for more control concerning underwriting, rates, investments and claim settlements. Captives provided them with these benefits.

Coverage

An advantage of captives is that they can provide coverage to subsidiaries and other firms that might not otherwise be possible or available for such areas as professional liability, certain business risks and punitive damages.

Rate and form freedom

The benefits of special constructed wording can be written by captives as a guide for reinsurers to follow to thus provide coverage’s for obscure areas.

Establishment of better than average claim experience

As the claim history for a captive insured may be improved or batter than the overall class of business for an insurer in the commercial category, this aspect makes a sound argument for retention of that risk in this framework as opposed to the broader and poorer claims experience as a whole.

Recapture of investment income and to accelerate and or manage cash flow

The investment income derived from a captive may be completely or partially retained by the captive as opposed to staying with commercial insurers thus providing revenues that would otherwise be lost.

Insurance accounting

Special tax treatment accrues to insurance companies, such as tax deductible reserves for claims not paid and in the instance of life insurance reserves no taxes are paid on the internal build up of interest income.

Tax deductibility

Other tax advantages are possible such as in the case of multiple owners or insured as well as in the cases where the insured and shareholders are not the same. Another area is in the deductibility of premiums along with the deferred taxation of insurance income. Careful consideration of tax benefits need to be investigated prior to adding such advantages to the list of benefits.

Perceived safety of formalized services

As the books and records of captives are audited along with the claim reserves being under constant review by actuaries, investments managed by professionals and accounts that are maintained by managers that are independent, these services represent checks and balances with so many differing external factors checking the books and accounts that the system has extra measures of safety that in most cases is superior to other means whereby a number of these functions is performed in-house or by the same company.

Favorable regulations

Many captives are formed offshore to avoid certain unnecessary regulations concerning solvency. However, just as in onshore solvency regulations, offshore captive solvency regulations are designed to protect policyholders. In some instances this regulation is weak in offshore locales, which is not the case for Bermuda as well as the state of Vermont in the United States.

Administrative tool for funding retentions

In many instances, large organizations create captives to fund differences between their large corporate deductibles or retention and smaller deductibles or retention of its individual business units. Under the captive format the main organization is able to offer fixed cost rates that are above the smaller deductibles and balance the equation of as a result overall larger rate, thus spreading the deductible or retention and achieving savings.

Risk management

Captives provide the risk manager with more leverage than the annual cost allocation process.

Innovative deals

Captives can increase the access to certain deals, such as more creative loss portfolio transfers achieved by transferring liabilities from one balance sheet to another.

Warehouse data

Being in a captive can provide a tool for the collection of better as well as more data in support of its cost management efforts. An example of this is that a captive can be the central repository for what is termed common disability cost management for instances when an organization elects to finance certain employee risk benefits as well as worker compensation risks.

Strategic partner support

Coverage can be made available by organizations for their various business partners as represented by key suppliers and or customers, as well as independent contractors, etc. when the normal market pricing and or terms are not favorable. The preceding may very well provide tax management as well as profit advantages.

Profit

In some instances captives are created to underwrite the risks of a customer or to provide third party insurance. Such undertakings can provide and or add value to an organization as a result of tying the customer to the owner.
Some of the preceding areas represent clear financial aspects as well as non financial operating areas which can in certain instances turn out to be as important or more important than the financial considerations in creating or utilizing a captive. The understanding of the benefits, advantages and implications of a captive are integral in the discussion of a rent-a-captive in that the reasons and rationales that are found in the former also apply to the latter. As such, a discussion of the structuring of captives is an important aspect to be considered in this context, as such aids in the understanding of a rent-a-captive. There are three primary aspects of captives, the financial, operational and of course personnel. Captive financial resources consist of premiums along with capital and investment income. The premiums and or capital can consist of non-investment instruments such as a letter of credit and these financial resources must be sufficient to accomplish three tasks (Geisel, 2004). First is the facet of financing the legal obligation as part of the insurance and or reinsurance agreements. Secondly, the financial resources must be sufficient to finance a reasonable level attributed to adverse development, and lastly, the financial resources needed to fund the expenses of operating the captive.
It is important to understand that captives, as well as rent-a-captives operate in a somewhat similar fashion as traditional insurers. It, the captive, directly issues policies to insured’s, and or reinsurers via a fronting insurance company (Geisel, 2004). It also collects the premiums and pays claims as well as setting reserves aside to pay for legal obligations stemming from its insurance and or reinsurance agreements, and pay for the captive’s operating expenses, and dividends (Geisel, 2004).
One of the advantages is that captives usually utilize a captive management company to run the day to day operations, maintain books and serve as the liaison with the regulators and Board of Directors (Towers Perrin, 2004). Captives also can and often do utilize specialty service providers, accountants, legal council and actuaries to aid in the operational aspects thus eliminating the need for finding, retaining, and setting up office space to house these aspects, which represent a considerable cost savings in internal administration. In terms of managing costs, captives have the following benefits and or advantages (Elliott, 2005):

Actuarial

Bermuda requires an actuarial analysis as an aspect of the feasibility study concerning the area(s) of insurance and or reinsurance being contemplated for setting up a captive. The premiums as well as losses are thus based upon this information and when the actuarial review has established a level of confidence in these figures, the captive will thus make a better impression on regulators, tax advisors and reinsurers. Bermuda requires ongoing actuarial analysis.

Expenses

In most circumstances a captive should be able to operate in a more efficient manner than commercial insurance companies. The captive’s expenses should be in the area of below twenty percent of premiums, unless loss control dictates a higher ratio.

Investment

It is a general practice among captives to set premiums to reflect the time value of cash in the assumption that the investment returns will closely approximate the amortization of the premium discount over time. The captive investment policy should thus be in keeping with the assumptions that are utilized to set premiums.
3.3 Rent-A-Captive
The foregoing analysis and details concerning captive insurance companies provides the needed foundational and structural information to better understand the nature of the entity and thus the implications, benefits and other facets associated with electing to utilize a rent-a-captive format. Given the preceding, the reasons and rationales for electing to choose a rent-a-captive format takes on increased meaning. Rent-a-captives represent the fastest growing segment of the captive category and the indications are that they will continue this trend and become even more broadly utilized in the future (International Risk Management Institute, 2004). Large corporations usually establish a captive to aid in the underwriting of its risk as well as to assume portions of its losses based upon the prospect of making or deriving a profit from these operations (Elliott, 2005). In essence, the corporation enters the business of insurance in an attempt to gain control over its losses as well as to lower the cost of its insurance as a result of deriving a return of profit from underwriting and or investment income. Smaller companies lacking the financial resources to cover the costs of setting up and meeting requirements for a captive can derive much the same benefits through renting a captive as the alternative to receiving the indicated benefits from their insurance program(s). Rent-a-captive insurance companies are in general funded, created and “… rented by insurers, brokers or groups of affiliated businesses” (International Risk Management Institute, 2004).
The determination as to whether a rent-a-captive represents a viable as well as sound proposition is dependent upon a number of facets that can be summarized as follows (Geisel, 2004):