IRMI Captive Insurance Issues and Trends 2017

Also in this issue

Captive Insurance: Claims Openingthe Door to the Future 4

Abuse of 831(b): The ERC ImageProblem 10

A Look at RRG FinancialExam Costs 13

Protected Cell Captives and the Pac Re Case 16

Credentialing Captive Managers 20Insurance-Linked Securitiesand Captives 23

Repudiating the OECD’s Challengeto Captives 26

Total Cost of Risk—The Captive Focus

by Hugh RosenbaumHughro Ltd

In March 2016, at the CICA meeting, a panelled by Hugh Rosenbaum explored the subjectof the total cost of risk (TCOR). The questionwas whether, for single-owner captives, properattention is being paid to premiums insured orreinsured by captives and losses retained inthem, and whether the technical aspects ofcaptive insurance accounting are being recog-nized in the TCOR calculation. On the panelwas a risk manager who does include it, an ac-tuary who wasn’t so sure you should, and arepresentative from the annual cost of risk(COR) survey who said that most respondentsdon’t break it out. There were more than 50 inthe audience. When asked whether they (ortheir clients) keep track of the TCOR, only fourraised their hands indicating they did.

Background

To remind readers of the basics, the TCOR in-cludes premiums paid, losses retained, and ad-ministrative and other expenses. Captives areinvolved in all three.

TCOR does not cover these important areas:

• Noninsured exposures, such as the imputedcost of $1 billion excess $1 billion that thebuyer would like to buy but can’t find a seller

• Employee benefits of all kinds

• Other aspects of enterprise risk manage-ment (ERM) such as reputation risk, cyber-risk, loss of market

So the notion of TCOR is restricted to insurableexposures in the property/casualty area only.

Analyst Wayne Wickham of Advisen Ltd., aninformation service company which managesthe annual COR survey, explained that their ba-sic metric was comparing the ratio of TCOR toreported revenues. This, he explained, permit-ted smoothing the irregularities of large versussmall participants and different cohorts ofthose participating from year to year. Heshowed this comparison to the operating ratios

2

Captive Insurance Issues and Trends 2017

of commercial insurers in the United States. Itshows fairly convincingly how the TCOR ratiofollows insurer operating ratios fairly closely, ayear or two later. But from that, he said, oneshould not be tempted to simply use insurancepremiums in the denominator. That’s becausethey are sometimes less than 50 percent of theTCOR for sophisticated retention programs.The main attraction of participation in Ad-visen’s annual TCOR survey is the benchmark itprovides to compare to other risk and insurancemanagement programs.

Dynamic Cost of Risk

The question posed in the right-hand box under“losses retained” in the table on the next pageasks “But what amount?” That has always beena problem for TCOR calculations. How can theTCOR be calculated if the loss amount figurekeeps changing? This panel came up with ananswer, calling a component of the “DynamicCost of Risk” compared to the static one that isreported in things like the annual survey.

The three ways of expressing the loss compo-nent of the TCOR for a given year are the basis

The articles in this special report were firstpublished in Captive Insurance CompanyReports (CICR) or Captive.com. Copyright2015, 2016, 2017.

Opinions in this report on financial, tax, fiscal,and legal matters are those of the editors andothers; you should consult professionalcounsel before taking any action on the basisof this material.

Published by IRMI:International Risk Management Institute, Inc.

12222 Merit Drive, Suite 1600Dallas, TX 75251 • (972) 960–7693

www.IRMI.com • www.Captive.com

for calling the TCOR “dynamic.” They involveconstantly changing amounts for liability re-tained losses as well as some business interrup-tion losses.

• Paid losses, but reallocated to either thepolicy year, the accident year, or the calen-dar year in which the claims arise

• Incurred losses including incurred but notreported (IBNR) claims, with all years re-stated annually—all reflected in this year’sadjusted loss incurred amount

• Incurred losses including IBNR claims withonly this year’s loss figures included—allprior years’ figures are adjusted and restat-ed.

Actuary Joel Chansky reviewed the threetechniques, explaining that IBNR claims ar-en’t the only variable in loss estimations.Confidence levels selected are variables, aswell as “cushions” or risk margins (differentfrom the profit-making risk margins in our ta-ble), as well as discounting are further vari-ables. He gave further details on these threetechniques:

• Method 1: Select loss pick for upcomingaccident year; do not change prior acci-dent years’ retained losses. This is rarelyused, but is a default when historical infor-mation is uncertain or unreliable.

• Method 2: Select loss pick for upcomingaccident year; restate prior accidentyears’ retained losses based on updatedloss estimates. Retained losses used incost of risk calculation are updated (re-stated) each year. This method is oftenused by captive owners because it oftenallows the appearance of “smoothing”over time.

• Method 3: Select loss pick for upcomingaccident year; restate prior accident years’

http://www.IRMI.com

http://www.Captive.com

http://www.captive.com/products/newsletter/captive-insurance-company-reports



http://www.captive.com/

3


CATEGORY COR IN GENERAL CAPTIVE INVOLVEMENT

Premiums Paid To all external insurers If original gross premium (OGP) (the total of what is charged out to operating entities) is the figure reported, and it does not include captive premium retention, this figure should be reduced because the captive is not an external insurer. But if the captive buys reinsurance, it should be increased by the annual reinsurance premiums paid.

Losses Retained Usually the annual aggregate of losses retained under deductible amounts

If OGP charged out includes captive retained losses, they should be added to this figure if it is only entity-retained losses. (But what amount?)

Risk Margins Never included in TCOR calculations

If captive is running an annual surplus, should it be deducted from the TCOR? If so, from which figure? Probably from “below the line.”

Administrative Expenses

Usually departmental and external service charges

Should include captive fees and expenses. Should include cost of fronting, if in reinsurance mode.

Source: Captive Insurance Companies Association (CICA). Used with permission.

TCOR VERSUS INSURER OPERATING RATIOS

Source: Captive Insurance Companies Association (CICA). Used with permission.

4


retained losses but account for the chang-es in current calendar year retained losses.This is usually used by commercial insur-ers but suffers from wide swings wherethere are surprises caused by settlementsof old cases.

One Real Example

The session then included the example ofhow one risk manager uses the TCOR calcu-lation, including the captive figures, in his re-ports to management. James Snell, the di-rector of Risk Management for the Dutchmultinational Ahold NV, reports to the Inter-national CFO. Ahold’s supermarket businessis 60 percent in the United States with some750 locations—with names like Stop & Shopand Giant Food Stores—generate more than$200 million in workers compensation lossesalone. Sales from US operations are some$26 billion estimated for 2016. Annual pre-miums from fronting companies are between$150 and $300 million a year. Ninety per-cent of their TCOR is allocated to US operat-ing companies.

The Vermont captive, Mollyana InsuranceCompany, is a large one with retentions of $5million per loss, lines of business include work-ers compensation, general liability, auto liabili-ty, and property, assets of “many hundreds ofmillions” and net worth (capital and surplus) ofmore than $50 million.

The TCOR he measures uses the second meth-od and includes captive expenses and only ex-ternal insurance premiums. The main compo-nents are:

Retained losses 80 percent

External insurance 10 percent

Administrative expenses,including fronting 10 percent

When asked about profit or risk margins thatmight be retained in the captive, Mr. Snell indi-cated that most of it is returned to the operatingcompanies, prospectively. The annual TCOR,or at least the loss retained component, as apercentage of sales, has stayed constant for thepast few years.

This metric, TCOR as a percentage of sales, isconsidered of great importance to management,especially since the percentage has been hold-ing steady as sales increased. Since the involve-ment of the captive in retained losses is the ma-jor component of the TCOR, Mr. Snell was ableto conclude that the involvement of their cap-tive in the TCOR calculations has had a signifi-cant impact on their TCOR. And managementagrees with him. ❑

Captive Insurance: Claims Opening the Door to the Future

by Michael MaglarasMichael Maglaras & Company

Take a look at the photograph below.

This is a photo of an institutional door handle.The handle is made of copper. You grab thebottom of the latch and pull it up, and the doorto a hospital patient’s room opens. Connectingthis handle, captive insurance companies


underwriting medical professional liability insur-ance, and what happens to you or me when wespend a night in a hospital bed is what this arti-cle is about.

Background

There are two reasons why commercial insur-ance companies exist. The first reason, in ageneral sense, is to protect assets. The secondreason is to pay claims.

What is true for commercial insurance compa-nies is also true for captive insurance compa-nies. Captives are also asset protection mecha-nisms, and they also exist as exceptionalvehicles for the management, reserving, com-promising, and payment of claims.

At captive insurance industry meetings, notenough useful and practical information is dis-cussed and debated on the subject of claimsmanagement and how captives are instrumentalin helping insureds connect the dots between thecausality of loss and the improvement of a busi-ness model. There are some obvious reasons forthis. The whole subject of the adjustment ofclaims has limited sex appeal for most captiveprofessionals. However, when we speak of medi-cal professional liability captives, and we marrythat idea to the important issues arising underaccountable care, the way in which claims arepaid, the way in which we learn from claims withmerit, and the social media and reputational im-pact of claims are all important reasons why, inthis lingering and what may be a “forever” softmarket, captives still prosper.

Debunking Some Myths

Captives underwriting medical professional andgeneral liability for acute care facilities, individualphysician practices, managed care organiza-tions, and other providers of healthcare serviceshave a long history of the management and ad-justment of claims.

In many states, given individual jurisdictionalconcerns and the claims history of the parentorganization, captives regularly investigate, re-serve, defend, and adjust claims of significantsize for medical professional, general, and um-brella liability. My firm has no clients who arenovices in this regard.

In many acute care facilities, it’s not uncommonto find medical professional liability limits totaling$50 million or more, where the first $3 million to$5 million is retained as net in a captive on a perclaim basis, with a multiple of four times thatamount on an aggregate basis. This means thatcomplex and sophisticated claims managementprocesses are in place and have been for de-cades. There is no lack of experience in the cap-tive market in this regard.

Some less enlightened commercial markets,led by mutuals and others devoted primarily tothe insuring of what is, alas, a shrinking physi-cian personal asset protection market, stillhold the view that captive insureds are not thebest gatekeepers of the claims managementand defense process. All the evidence is to thecontrary.

In fact, the Lloyd’s market, representing long-standing syndicate and London companyplayers with significant multidecade U.S.healthcare liability captive experience, sub-scribe to the view that the best insured (or re-insured) is the self-administered-claim in-sured. I have been to many meetings inLondon over the last 30 years, and while theLondon market is supportive of many soundstrategies to manage captive risk, the leadingunderwriters in the hospital and physicianmedical professional liability marketplace areunanimous in their view that a well-conceivedand well-established internal captive claimsmanagement process yields the best resultswith regard to net retained losses, and in turnkeeps them out of harm’s way with regard toexcess claims.

5

6


CAex19befo

The idea that risk management staff in the acutecare setting or in a large super-group physicianpractice setting cannot be trained to manage aninternalized claims process is an idea that hascome and gone. Whether through internal re-sources or through a combination of those re-sources and externalized assistance, such as un-bundled third-party administration intervention,self-insureds and their captives are adjusting andpaying losses successfully every day of the week.What’s more important is that captive owners arevigorously defending and winning on claims filedwithout merit, as all the data clearly shows, in-cluding the paid claim data available as public in-formation in Connecticut, Ohio, and elsewhere,where captive insurers dominate the market.

Defining the Process

The careful management, reserving, and adjust-ment of losses under a captive insurance

aptive Insurance Company Reports must-read by captive practitioners, written by leadingperts in the fi eld, and edited by captive experts. Since 77, Captive Insurance Company Reports (CICR) has en the fi rst and most respected independent periodical to cus on the alternative risk transfer market.

Packed with: • Important news • Commentary on trends and developments • Vignettes from successful captives • Eff ective recommendations for optimizing the benefi ts and performance of captive ownership or participation

Learn more at IRMI.com/go/captivesLearn more at Captive.com.

company architecture is at the heart of any self-insurance program. How a captive handles aclaim involving, for example, as frequent an al-legation as infection due to a retained foreignobject—how counsel is chosen, when counsel isassigned, what the loss run looks like, how rein-surers are placed on notice of a potential lossinvolving them—is the most important functionof a captive. This function is far more import-ant than is generally believed, and not enoughattention is given to both the process and theoutcome at captive board meetings.

With regard to claim reserving and adjustment,and speaking specifically of captives writingmedical professional liability insurance, the pro-cess has become much more complex and de-manding, but ultimately more rewarding,thanks to what we generally refer to as “Ac-countable Care.”

Simply put, providers of health care are not go-ing to be paid in the future for their mistakes.We are moving inexorably in this direction;and, in fact, with respect to the largest singlepayer system in the history of the UnitedStates, otherwise known as Medicare, we arealready there.

So what are the basic elements of a good inter-nalized healthcare provider-owned captiveclaims management process?

1. A way to get information into thehands of the right people: All health-care systems and many larger physicianpractices now use sophisticated electronicincident and claim reporting systems sup-ported by a handful of software vendorswell known to the industry. Many of theseclaims management systems have rolledout only in the past 5 years or so. Gettingan incident report into the hands of a hos-pital or physician practice risk manager,so that it can be triaged, assessed, andacted upon, is a smoother process than it



was a decade ago, and this process hasbeen robustly supported by the healthcareliability captive budgets of captives domi-ciled in Vermont, Grand Cayman, Bermu-da, and elsewhere. The biggest concernhere is speed of information and datatransfer. The second but equally import-ant concern is the protection of personalhealth information at a time and in an agewhen a patient’s private health record is ofincreasing value on the black market. It’snot uncommon for an acute care systemrisk management staff to triage 2,000electronic incident reports in a month,and for that work to result in only 15 orso potentially compensable events, that inthe following quarter show up on a cap-tive’s balance sheet.

2. A reserving policy that makes senseand is consistently applied: Thismeans clearly defining what an “inci-dent” is, what a “potentially compensa-ble event” is, and, finally, what a “claim”is, all consistent with captive policy lan-guage and excess or reinsurance pro-gram terms and conditions. The reserv-ing process is, by definition, dynamic.Claims are a function of the people whocaused them and the people on the re-ceiving end. They are defined by humannature. Therefore, they evolve over theirnatural life, are subject to change, subjectto variability, and subject to surprise.Claim reserves must be assessed on aregular basis, not stair-stepped, andwhere subjective views are tempered by ahard look at judgment value, includingeconomic and noneconomic loss poten-tial, jurisdictional implications, and thecredibility of all witnesses and partici-pants. Defense counsel must be intimate-ly involved in determining the fact sce-nario and helping a captive’s ownersgauge the percentage of success or fail-ure.

3. Managing litigation: Some in thecommercial insurance market still sup-port the view that it is only commercialinsurers that have the experience andcredentials necessary to manage a pro-cess involving complex litigation. Theresults, visible on many captive balancesheets, speak differently to this point,as captive surplus has grown exponen-tially since St. Paul Insurance Companyexited the medical professional liabilityinsurance market in 2001. When theSt. Paul packed up its bags precipitous-ly and exited the market, healthcareproviders with captives had to scram-ble. They had to add surplus to captivebalance sheets. They had to put inplace disciplined claims managementprotocols. They were optionless, andthey have never forgotten the way inwhich the commercial market aban-doned them. The good news is that anumber of enlightened commercial in-surers have come around to the ideathat they can partner with healthcareproviders and their captives. There isstrength to be derived from both sidesof this equation. Self-insureds, and inparticular captive owners, are now veryskilled at setting the framework underwhich matters are litigated, skilled atmonitoring defense counsel costs andstrategy, and skilled at assisting in thescheduling of staff interviews and depo-sitions, and, in general, in guiding theprocess of the kind of litigation thathappens when people’s lives are affect-ed by unintended outcomes.

The Effects of Accountable Care

Lastly, and perhaps most importantly of all,healthcare liability captives now lead efforts, ina very direct sense, at improving the quality ofyour care and mine. In short, we have enteredthe era of the socially responsible captive.

7

8


Captive Claims Flow

Because healthcare liability captives have mul-tidecade experience in the handling and assess-ment of medical professional liability claims,these captives’ healthcare provider parents arenow moving quickly and eagerly into the analy-sis of how the claims paid and the lessonslearned can be translated into increased patientsafety and better reimbursement by payers un-der the revolution mandated by the AffordableCare Act.

It is here where the proverbial rubber hits theroad. It is in fact the reason that, in what hasbeen the longest soft professional liability in-surance market in history, healthcare liabilitycaptives continue to grow and expand theirunderwriting profiles; simply put, when youget in the habit of learning from the losses

you’ve had, you never go back. And by this, Imean that you never go back to the commer-cial insurance market, where the adjustment ofthe loss under a “duty to defend” contract istaken out of your hands and, therefore, out ofyour sight.

Medical professional liability captives containthe seeds of what will now grow into a morevisible focus on patient safety. But there’s more.For a claim that used to be an isolated event isnow recognized as not being that at all. Everyclaim impacting a captive insurance companywriting healthcare liability takes on the aspectsof an octopus. The graphic above shows whatnow happens in the real world when an adverseevent results in a claim with merit made againsta healthcare provider.


and ProceduresHow to structure and operate a successful captive insurance program.

Th is book explains how captive insurance is used and outlines the decisions and actions that must be made to structure and operate a captive insurance program that weathers economic and market cycles.

Learn what it takes to establish a successful captive insurance company that sets the standard and withstands the test of time!

Learn more at IRMI.com/go/captives

Kathryn A. Westover, CPCUAuthor:

How To Structure and Operate a SuccessfulCaptive Insurance Program

Learn more at Captive.com.

That claim now ripples not only through the or-ganization itself and its captive but strikes at thevery heart of the institution’s public face. Claimswith merit regularly (and unfortunately) are dis-cussed and debated on Twitter and Facebook.What happened, when it happened, and why ithappened affect the recruitment of employedand community physicians, the morale of nurs-ing staff, Internet grading, reimbursement frompayers, and of course, finally, reputation. Thereis no greater concern in the competitive health-care market than what people think and sayabout you. And, of course, at a time when ev-eryone is buying everybody else, negative pub-licity related to claim activity may decide wheth-er or not you are a good or not so goodacquisition risk.

So Now Back to the Door Handle …

More than a decade ago, at the board meetingof a captive owned by a major healthcare insti-tution employing thousands of physicians, thecaptive’s directors, many representing the com-munity served by the captive’s parent, went intoa rebellion.

They received a report about an increase in theparent organization’s nosocomial infection rate.A nosocomial infection is an infection you getwhile you are a patient—you didn’t walk in withit. When you get a bad one, your health is fre-quently compromised, and sometimes your lifeis lost.

The board demanded action. They authorized$500,000 to fund a study involving the analysisof more than a decade’s history of claims paidby this captive to patients and family memberswho had been harmed by hospital-acquired in-fections. A year later, that report was released,and some of us in the industry saw it. It tackledthe subject of these kinds of claims in a candidand revealing way.

As a result of this study, the captive’s parent in-stituted a broad-based effort at reducing its in-fection rates, including using new technologiesto zap bugs with ultraviolet light, as well asmore simple ideas, such as improvements inraising awareness among healthcare profession-als about the importance of washing theirhands.

Buried down inside the depths of the reportwas a recommendation that at first went unno-ticed. That recommendation suggested thatwhen the parent organization built its next newhospital facility, every door handle should bemade of copper. Why? Because the study re-vealed what science had long known: copperhas antimicrobial properties. The bugs thatsicken you or me and that remain on a doorhandle to a patient’s room die faster on a cop-per handle than on a handle made of some oth-er material.

Captive Practices

Captive Practices and Procedures

Second Edition

9

http://www.captive.com/products/books/captive-practices-and-procedures

1


Walk into a private patient room in any hospitalbuilt in the last couple of years. Check the han-dle. A captive made all the difference.

I began and I end with a fundamental idea: in acontinuing soft market, where medical profes-sional liability insurance capacity abounds, andsome, particularly in the commercial market,question why more captives aren’t folding theirtents, the captive claim process becomes a wayin which the door is opened to success underAccountable Care. ❑

(Photo and graphic are by Michael Maglarasand are used here with his permission.)

With more than 35 years of healthcare liabili-ty insurance and consulting experience, Mr.Maglaras is the principal of Michael Maglaras& Company, an international insurance con-sulting firm specializing in providing insur-ance program consulting advice for a varietyof healthcare providers and other businesses.Find out more about the company, and watchMr. Maglaras’s Captive Thought Leadervideos on Captive.com.

0

Abuse of 831(b): The ERC Image Problem

by Jeffrey K. Simpsonand Andrew J. Rennick

Gordon, Fournaris & Mammarella

No segment of the captive insurance market-place is as misunderstood as the segment thattakes the election under Internal Revenue Code(IRC) 831(b). Whether you call them minis, mi-cros, small captives, or enterprise risk captives,and whether you think abuse is rampant or hys-terically overblown, the simple fact is that thissegment has a serious image problem.

For purposes of this article, let’s call them en-terprise risk captives (ERCs). Even though ourfriends at CICR make fun of us for this name,we think it’s important to get away from label-ing these captives by a Code section. We alsothink innocuous labels like micro or small cap-tive don’t do enough to articulate the risk man-agement purpose of these captives. We recog-nize that ERC is not a perfect name, but we dothink it’s better than any of the current alterna-tives.

Problem of Perception

ERCs have an image problem. But the problemis not that the Internal Revenue Service (IRS)doesn’t trust ERCs; the IRS doesn’t trust any-thing about any captive. The problem is thatmuch of the captive industry doesn’t trustERCs. The industry frets that ERCs are a tax-driven sham that will draw the ire of the IRSand others, ultimately ruining captives for usall. To be fair to the industry, ERCs are new,and new is different, and different always takessome getting used to. So, it’s no surprise if theindustry is a little cautious of ERCs.

And ERC practitioners haven’t done much tohelp their own cause. A reader of online fo-rums, blog posts, and other ERC-related

http://www.captive.com/art-market/sponsors/profiles/michael-maglaras-company



http://www.captive.com/captive-videos/thought-leaders/michael-maglaras

http://www.captive.com/captive-videos/thought-leaders/michael-maglaras

www.captive.com


promotional materials could easily concludeevery service provider in the ERC marketseems to think he’s the only one doing it right,and all the others are doomed to prison. To befair, service providers need to distinguishthemselves from one another to compete. Butthe unfortunate result has been ridiculous pub-lic battles that do nothing but diminish thecredibility of all involved. Worse, they rein-force the fears of the industry.

The obvious question, then, is why should theindustry trust and support ERCs in light of theway things have gone so far? The industrycould reasonably argue that ERC service pro-viders have made their own bed and played in-to the hands of the IRS, so ERCs do not meritindustry support. But, the fact is that ERCs ac-tually are important, ERC service providers re-ally are well meaning, ERC abuses really arefew, and marginalizing a material segment ofthe industry is a dangerous idea. ERCs needand deserve industry support, and the route tothat support is interaction and understanding.

The Argument for ERCs

ERCs have become an important captive struc-ture in that they are now a means by whichmiddle market, privately held enterprises arebeing introduced to captives. ERC service pro-viders are helping their privately held businessclients manage risks in new and exciting ways.They help business owners appreciate thatthey can do more to manage risk than just buy-ing workers comp, auto, and general liabilitycoverage. Those business owners are now rec-ognizing a much broader array of risks, consid-ering the financial implications of those risks,funding in advance instead of crossing their fin-gers, and using pools to dilute the impact oflarge losses. All of this is good.

Our experience has been that ERC practi-tioners are competent, professional, and dili-gent insurance professionals, just like the rest of

the captive industry. Actually, many partici-pants in the ERC market are people you haveknown for years as thoughtful, reputable cap-tive practitioners—and they still are. But thevast majority of those who are new to the cap-tive insurance market, having come in throughthe ERC door, are acting responsibly too. Theyjoin the right associations, they attend the rightconferences, and they earn the right creden-tials. They conduct themselves professionallyand competently, earning the confidence andrespect of peers, clients, and regulators.

An example is the ERC community’s thoughtfulresponse to the recent Senate Finance Commit-tee (SFC) proposal to amend 831(b). A group ofERC practitioners, working under the auspicesof the Self-Insurance Institute of America (SIIA),is engaged in a dialogue with the SFC to devel-op an 831(b) amendment that protects the elec-tion and allows for the expansion long soughtby Senator Chzuck Grassley, but eliminatesincentive for certain abuses identified by theIRS. In the interest of full disclosure, JeffSimpson, coauthor of this article, chairs theSIIA committee working on this project. An im-portant feature of the group is that it consists ofERC captive managers from a variety of organi-zations. Some are institutional, some are smallconsultancies, some are from insurance back-grounds, and some are not. But all agree thatthe opportunity to engage responsibly with leg-islators, and maybe the IRS, to untether ERCsfrom perceived abuse is critical for the long-runhealth, not just of ERCs, but of the captive in-surance industry as a whole.

The perceived abuse being addressed by theSFC is estate planning using ERCs. Althoughthe practice is entirely legal, the debate is aboutwhether it should be. Credit the SIIA group forconcluding that the risk management objectivesof ERCs are more than enough without theadded benefit of estate planning and proposingamendment language on that basis to the SFC.It is difficult to believe the group could have

11

1


reached that conclusion if its members weremore interested in the allegedly abusive oppor-tunity. What’s more, the National Association ofInsurance Commissioners (NAIC) has also pro-posed language to the SFC that, with a few mi-nor changes, generally tracks the SIIA proposal.So, the ERC community appears to be on thesame page as the regulators, which ought to bea good sign to the industry.

Meanwhile, actual abusive practices in the ERCspace are considerably less common than mediahype and aggressive IRS scrutiny would leadyou to believe. We have certainly seen a fewabusive structures. But, we declined to be a par-ty to those transactions, and the vast majority ofERC service providers have as well. More im-portantly, wherever possible, we try to educateERC owners and service providers when we seeactually or potentially abusive features in theirtransactions. With only a few exceptions, wehave found them to be responsive. And thosewho are not responsive, we have noticed,whether from ignorance or disposition, are be-ing policed. Peer ERC service providers, otheradvisers, and regulators have all begun to as-sume roles to address abuses.

Cooperation Is Key

While all of this is happening, we believe thecaptive insurance industry is better served bywelcoming ERCs into the mainstream than bymarginalizing them. While the captive industrymight, in order to protect itself from somethingit doesn’t fully understand, be tempted to kickERCs and ERC service providers to the curb,doing so would open the door to the domino ef-fect. It would give the IRS a significant and ma-terial victory in its decades-long quest to con-quer captive insurance. And that big victorywould surely be interpreted as a success for theheavy-handed, scorched-earth tactics they areusing to pursue alleged ERC abusers. Rest as-sured, if the IRS thinks those methods work, itwill use those methods to target other areas of

2

captive insurance, and anyone else working incaptives could find themselves in the crosshairs.

We are all better served by working to under-stand ERC design and application and recog-nizing that ERCs are different, but different isnot necessarily bad. Much of what passes for al-leged abuse, in our view, is just failure to recog-nize differences in application. If ERCs are anovel concept in that they help privately held,middle-market companies cover risks that theyhave not historically covered, is it not reason-able that some of those risks would be differentthan what the industry has traditionally seen?Correspondingly, if these businesses are justbeginning to address these risks, is it a surprisethat they do not always have the necessary in-ternal processes to identify and report lossescovered by their captive policies? Similarly, ifthe pools used for ERC coverages are address-ing risks that have not been pooled before,should we expect that these new pools wouldhave loss ratios that correspond with the lossratios of pools that cover different kinds of risk?We could go on and on.

The point is that ERCs are not necessarily bad orabusive because they are different. They are sim-ply different. The challenge is not to try to makeERCs fit the ideal model of some other type ofcaptive. The challenge is to figure out whatshould be the ideal model for an ERC. And figur-ing that out will take time, data, thoughtful policydebate, and engagement between ERC practi-tioners and traditional captive practitioners. Theinfrastructure for this engagement is only now be-ing assembled, and the dialogue is just getting un-derway. The objective should not be to do awaywith ERCs, it should be to recognize the valuethat drives their popularity and understand howthey should be ideally designed and operated.

Conclusion

As Ben Franklin purportedly said, “We mustall hang together or we will surely all hang


Captives and theManagement of RiskUnderstand the pros and consof captives.

Th is book will help you understand what captive insurance is and why it is used in the risk management process.

It reveals: • Th e types of risk that can be handled by captives • Why captives can be eff ective as a risk management tool • Tax and accounting considerations • How to determine if a captive is feasible • How to choose a domicile • How to manage and operate a captive

Your guide to answering the question: “If I have a captive, why? If I don’t have a captive, why not?”

Learn more at IRMI.com/go/captivesLearn more at Captive.com.

separately.” Rather than allowing the ERC im-age problem to fracture the industry, the cap-tive insurance community should welcome andengage ERC owners and service providers.Recognize and support the constructive effortsof the many positive actors in the ERC commu-nity and help them identify and eliminate abu-sive practices and abusive practitioners. Youwill find the ERC community is happy to workwith you as it works out its image problem. ❑

A Look at RRG Financial Exam Costs

by Erich A. Brandt, Greg Fears, and Robert J. Walling III

Pinnacle Actuarial Services

These exams are NOT to be confused with theinitial exams required by a state. These are twodifferent events, and costs. Initial exams are toestablish that the basic financial presentationsare reasonable and appropriate. Usually theseare quick and not particularly expensive. Peri-odic exams are much more intensive and thor-ough.

Some domiciles have actuaries on staff to per-form these duties; others hire outside staff.Sometimes the hiring of an outside firm is donethrough competitive bidding, but not always.There are cost differences with each approach.And, bear in mind, the actual financial costspale in comparison to the cost in staff time,space needs, and upheaval of operations.

As captive growth and domicile expansion con-tinue their strong upward moves, our suspicionis that periodic examinations are an expensenot often discussed in the consideration of for-mation stages. After all, other than the initialexam, the periodic exams may be 3 to 5 yearsaway, and who knows what the landscape willlook like then? So, why cloud consideration for

a captive discussions with these as yet undeter-mined costs? Because the costs will show up. Itis better to understand them beforehand.

“Your Results May Vary”

When presenting domicile options to poten-tial new captive owners, captive managersoften go into great detail highlighting the dif-ferences in application fees, premium taxes,renewal fees, board meeting requirements,and other differentiators. One often neglect-ed detail is the costs associated with financialexaminations. One reason for the frequentexclusion of financial exam costs in domicilecomparisons is that there is typically not afixed cost or formal cost formula for financialexams. So, do financial costs really differ sig-nificantly by captive domicile? The answer re-quires a deeper look into captive financialstatements.

13

http://www.captive.com/products/books/captives-and-the-management-of-risk

1


Risk retention groups (RRGs) have different fi-nancial reporting requirements than most cap-tive insurance companies. In particular, theyare required to file financial statements in theformat mandated by the NAIC. The NAIC for-mat is much more detailed than the financialscommonly used by captive insurers. One ele-ment of this detail is an intricate expensebreakdown, including nearly isolating financialexamination costs. Data for insurance compa-nies filing NAIC annual statements is also avail-able from the NAIC and from the A.M. BestCompany. This is not commonly true of cap-tive financial statements. While this data doesnot provide a comprehensive picture of finan-cial examination costs for captives, the resultsare illustrative and enlightening.

Pinnacle Actuarial Services gathered data fromthe “Total Insurance Department Licenses and

4

# of

RRG

s

$0–10 $10–25 $25–50

Fees” category from Part 3 of the Underwrit-ing and Investment Exhibit, by RRG, alongwith domiciliary state. This expense categoryincludes financial examinations as well assome other smaller expense items, such asagents’ licenses, certificates of authority, com-pliance deposits, and filing fees. Pinnacle ana-lyzed 5 years of financial statement data—2010 through 2014—to isolate the financialexamination costs, which only impact 1 or 2years from the smaller, ongoing annual fees.There were some RRGs that had not had anexam during these years, and some very largeRRGs with understandably larger financial ex-amination costs that were removed to normal-ize the data. There were 149 small to medium-sized RRGs remaining in the final data. As atest of reasonableness, Pinnacle tested the av-erage premium size of the RRGs in the groupand found that 88 percent of those companies

$50–75 $75–100 $100 +


had premium volume of under $25 million in2014.

The average estimated fees associated with thefinancial examinations of the RRGs included inthe analysis were about $35,700, ranging fromabout $3,000 to over $325,000. On average,this represented approximately 0.16 percent ofsurplus and coincidentally 0.16 percent of heldloss and loss adjustment expense (LAE) re-serves. As noted above, there was a significantdispersion in the financial exam costs by RRG.Almost a third of the RRGs had financial examcosts of less than $10,000 and another almost20 percent fell between $10,000 and $25,000.Another third had financial exams costing be-tween $25,000 and $50,000. Twenty-seven of

$

$

$

$

$

$

$

$

$0

the selected RRGs had financial exams costingmore than $50,000. This information is sum-marized on the previous page.

Interestingly, there we are also substantial dif-ferences in average financial examination costsby domicile. The following chart illustrates thevariability in actual exam fees in terms of abso-lute dollars and also as a percentage of bothpolicyholder surplus and held loss and LAE re-serves by state. The state names have been re-moved to allow the domiciles to remain anony-mous. While there is significant volatility in theresults due to sample size in some of the domi-ciles and individual RRG circumstances, someof the differences relate to differences in finan-cial exam cost structures and regulatory

15

1


approaches to RRGs. In addition, the RRGswith financial exam costs in excess of $50,000tended to be concentrated in a few domiciles.Some of the domiciles with the highest averagefinancial examination costs had RRGs withsmaller-than-average premium volumes.

States use a variety of approaches to strike abalance between providing appropriate costcontrols without sacrificing regulatory rigor.These approaches include:

• Allowing actuarial peer reviews, ratherthan full independent actuarial analyses, insome instances.

• Holding competitive bid processes to estab-lish a pool of financial examination serviceproviders, rather than relying on a single pro-vider.

• Using staff examiners versus independentcontractors.

• Establishing financial examination fee pa-rameters and caps prior to the beginningof an examination.

Financial examination fees for RRGs may not beperfectly correlated to costs for captives as somedomiciles use different regulatory processes forcaptives versus RRGs. However, this review ofRRG financial examination costs certainly high-lights that material differences in financial exam-ination costs by domicile may exist and shouldbe considered when choosing a domicile.

There have long been rumors in the captive in-dustry of financial examination costs that wereunreasonable at face value. The data in this anal-ysis suggests that these rumors may have somefactual support. There are 5 RRGs in the datawith financial exams of more than $100,000, de-spite having less than $10 million of annual pre-mium. There are 3 additional RRGs in the datawith financial exam costs in excess of $250,000.

6

Interestingly, these RRGs were not among the largest insurance companies in the database.

One of the important ways a captive insurance company passes savings on to its owners is by controlling expenses. This opportunity can turn into a material risk in domiciles where financial examination fees do not have a clear link to the size and complexity of the captive or RRG. To avoid this risk, captive managers and captive owners should make sure they understand how their selected domicile deals with financial exam-ination costs. Be forewarned, your results may vary. ❑

Protected Cell Captivesand the Pac Re Case

by Jeffrey K. Simpson, Andrew J. Rennick, and Daniel L. Fitzgerald

Gordon, Fournaris & Mammarella

The recently decided case of Pac Re 5-AT v. Amtrust North America, Inc. CV-14-131-BLG-CSO, 2015 WL 2383406, 2015 U.S. Dist. LEXIS 65541 (D. Mont. May 13, 2015), has attracted a great deal of commentary in the captive insurance community. The case in-volves a Montana protected cell structure and considers the judicial status of an individual pro-tected cell and the relationship between the in-dividual protected cell and the company of which it is a part. This article briefly describes the nature of protected cell companies, summa-rizes the Pac Re case, and discusses its import, including a discussion of how sponsors can mit-igate the uncertainty associated with the treat-ment of protected cells.

Protected Cell Structures

Numerous jurisdictions, both onshore and off-shore, have adopted statutory provisions that permit protected cell arrangements. A protect-ed cell captive (PCC) is a segregated account


that exists as a subset of a licensed captive in-surance company. The assets and liabilities ofeach cell are segregated from the assets andliabilities of every other cell and of the compa-ny itself (often called the “core”). Each cell istherefore able to operate as if it were separatefrom the core and the other cells while still be-ing administered and regulated in conjunctionwith the core. As a result, cells can often pro-vide the benefits of a separate captive insur-ance company more quickly and at lower cost.

Also, if the business within an individual cellconstitutes insurance for tax purposes, thenthe Internal Revenue Service (IRS), pursuant toRev. Rul. 2008–8 and the subsequent pro-posed regulations, will treat the cell as a sepa-rate taxpayer, allowing it to obtain its own fed-eral employer identification number and file itsown tax return as an insurance company. Be-cause they are faster, less expensive, and canbe treated as insurance companies for tax pur-poses, cells have become popular vehicles.

In a protected cell arrangement, a captive in-surance company establishes a number of pro-tected cells by creating segregated accountsfor the benefit of participants in the captiveinsurance program. The applicable captive in-surance statute typically requires that eachprotected cell be governed by a contract be-tween the participant and the company. Thisparticipant contract allocates to the protectedcell certain risk and premiums written by thecompany, while the applicable protected cellstatute provides for segregation of the assetsand liabilities of the protected cell from the as-sets and liabilities of the other protected cellsand the core. Since forming a protected cell isa contractual and regulatory matter which re-quires no filings with the Secretary of Stateand no registered agent or office in the domi-cile, the protected cell structure offers cost ef-ficiencies to the participant, particularly if thecaptive statute allows for reduced capitalrequirements for protected cells. Since the

protected cell is part of the company and op-erates under the company’s license, there may be administrative efficiencies as well.

There are, however, two primary challenges related to protected cells, namely that the segregation of assets and liabilities has not been tested in court, and protected cells gen-erally cannot contract in their own names. First, notwithstanding clear statutory lan-guage supporting the segregation of assets and liabilities in a cell, no known caselaw af-firms that segregation, and, in fact, no case has yet addressed the question. Some practi-tioners interpret the absence of applicable caselaw as indicative of uncertainty over whether the segregation will be respected. Second, protected cells generally lack the statutory authority to contract in their own names. Where a cell cannot contract in its own name, the core generally contracts for and on behalf of the cell. Some practitioners believe that having the core contract for and on behalf of the cell unnecessarily exposes the core. It can also preclude contracts be-tween and among cells because the core can-not contract with itself.

Attempts to address the shortcomings of cell structures have led to the availability of a variety of similar vehicles, including protected cell com-panies, incorporated cell companies, and series limited liability company (LLC) captives, each with unique features and strengths and weak-nesses. However, the absence of applicable caselaw continues to be the Achilles’ heel of protected cell companies, and Pac Re is im-portant because it goes directly to the issue of the separateness of protected cells.

Pac Re

Pac Re is interesting, even exciting, as the first case to directly address the separateness of a protected cell. While the court found that a protected cell is not a separate legal entity and

17

1


cannot be sued apart from the protected cellcompany that houses it, the court also notedthat the assets and liabilities of a protected cellare, in fact, segregated.

The Pac Re case involved a protected cell com-pany domiciled in Montana. Pac Re, Inc. (thecore) established Cell 5-AT (“Cell 5”) to reinsuregeneral liability risks written by a fronting insur-er. Pursuant to the applicable reinsurance con-tracts, Cell 5 was required to maintain a mini-mum level of assets and provide security for itsreinsurance obligations. The fronting insurer al-leged that Cell 5 did not comply with the mini-mum asset and security requirements, and, onthat basis, the fronting insurer demanded arbi-tration. But the fronting insurer did not make itsdemand against Cell 5. Instead, the fronting in-surer sued Pac Re, the core. Pac Re then movedto dismiss the claim, arguing that Pac Re wasthe wrong party, and the suit could only bebrought against Cell 5 itself.

The federal court for the District of Montana de-nied Pac Re’s motion and concluded that Pac Rewas the proper party. In denying Pac Re’s mo-tion, the court distinguished between the segre-gation of assets provided by Montana’s captiveinsurance statute and the separateness of Cell 5’sidentity. The court noted that Cell 5 was not aseparate legal person and could not be sued inde-pendently from Pac Re. The court cited sectionsof the Montana captive statute providing that theformation of a protected cell creates a separatelegal person only if “the protected cell is an incor-porated cell.”

The Montana court concluded, correctly in ouropinion, that Cell 5 could only be sued throughPac Re for and on behalf of Cell 5, in the samemanner that Pac Re entered contracts for and onbehalf of Cell 5. This case stands simply for theproposition that, to sue a cell of a protected cellcompany, one must sue the protected cell com-pany for and on behalf of the cell. Since cells donot exist as separate legal entities, the conclusion

8

makes perfect sense. Frankly, no one should be surprised by this outcome.

This ruling was limited to the procedural matter of how to sue a cell. Accordingly, assertions by some commentators and practitioners that this case in any way implies that Pac Re’s core as-sets are potentially exposed, or that the segre-gation of assets and liabilities will not be re-spected, are both premature and unsupported. This case did not address those issues and can-not reasonably be read to have done so.

While finding that Pac Re was the proper party, the court nevertheless noted that the Montana protected cell statute provides for the segrega-tion of assets and liabilities. If anything, this is an indication by the court that it would respect that segregation.

Importance of Pac Re

The Pac Re court was exactly right. The im-portance of the case is not that it casts doubt on the integrity of protected cell companies or the segregation of assets and liabilities, because it does not. In fact, it suggests that the segregation will be respected. The impor-tance of the case is that it confirms the con-ventional understanding of the structure and operation of protected cell companies—pro-tected cells are not separate legal entities and cannot contract or be sued in their own names, but they nevertheless segregate as-sets and liabilities.

If there is a lesson in Pac Re, it is that protected cell companies should be designed and operat-ed in a manner that maximizes the likelihood that the statutory segregation of assets and lia-bilities will be respected. This includes follow-ing the formalities applicable to cells, contract-ing in a manner that minimizes the likelihood of lawsuits and operating in domiciles that will be inclined to understand and respect the struc-ture.


The first step in getting a court to enforce thesegregation of assets and liabilities is respect-ing the formalities that yield that segregation.Every protected cell statute includes languageabout the formalities applicable to protectedcells. Generally, those formalities are that thecell be formed pursuant to a contract, that theassets and liabilities of the cell be identifiedwith sufficient specificity, and that separatebooks and records be kept for each cell. Com-pliance is relatively simple. First, form eachprotected cell pursuant to a professionally pre-pared contract designed to conform to the re-quirements of the applicable protected cellstatute. Second, although the core must con-tract for the protected cells, it should do so“for and on behalf of” a specific and clearlyidentified protected cell, and maintain sepa-rate bank or other accounts in the same man-ner—“for and on behalf of” a specific andclearly identified protected cell. Finally, thebooks and accounting records of the protectedcell company should include a separate recordexclusively for the financial results of eachprotected cell.

Another step in defending the segregation ofassets and liabilities is not having that segrega-tion challenged in the first place. The ownersof protected cell companies (typically called“sponsors”) should design their protected cellcompanies to minimize the potential for law-suits. While we do not agree that the absenceof applicable caselaw is a reason for not usingprotected cell companies, we do see it as a rea-son to be cautious and not invite challenges.Accordingly, we encourage sponsors to consid-er who might be motivated to sue and whattheir objectives in the suit might be. We suggestthat sponsors avoid allowing or simply prohibitprotected cells from entering the kinds of con-tractual relationships that could result in unre-lated or unknown creditors who might have aninterest in challenging the integrity of the pro-tected cells.

Finally, a third step in protecting the segregationof assets and liabilities is ensuring that any chal-lenge occurs in a jurisdiction that should be in-clined to respect that segregation. Generally, asoccurred in Pac Re, courts in the jurisdictionwhere a captive is formed should understand andbe inclined to enforce the local laws providing forthe captive’s existence. Accordingly, we encour-age sponsors to design their protected cell com-panies to maximize the likelihood that any dis-pute will be addressed in the state of domicile.Contracts should include provisions for exclusivevenue and jurisdiction in the state of domicile,and the captive’s activities should occur entirelyand exclusively within the state of domicile.

Summary

The Pac Re case highlights a disadvantage ofthe protected cell structure—namely, that anycontracting and litigation involving a protectedcell must necessarily implicate the core, as theprotected cell does not have sufficient indicia ofseparateness to contract and litigate on its own.Pac Re did not address the segregation of as-sets and liabilities in protected cell companies.However, the case did not threaten that segre-gation, and it even appears the court signaledthat it would respect the segregation.

While the lack of a court ruling expressly affirm-ing the segregation of assets and liabilities in pro-tected cell companies has some practitioners andcommentators advising against their use, we viewthe absence of applicable caselaw as a businessrisk that should be clearly explained to prospec-tive sponsors and participants, and that can bemitigated. By incorporating appropriate featuresinto a protected cell program, including followingthe formalities applicable to cells, contracting in amanner that minimizes the likelihood of lawsuitsand operating in domiciles that will be inclined tounderstand and respect the structure, sponsorsand participants can minimize the likelihood of anegative outcome. ❑

19

2


Credentialing Captive Managers?by Rod Morris

R&Q Captive Management

At the recent Western Region Captive InsuranceConference in early May 2016, one of the panelswas dedicated to a discussion of “The BiggestThreats Facing Our Industry.” The attendeeswere polled in advance for their own thoughts,and the panelists seemed somewhat surprisedthat the poll indicated more concern about theexpertise and marketing practices (think integri-ty) of captive managers than even federal/stateregulations or the Internal Revenue Service (IRS).And yet, the more the panelists discussed the is-sue, the more they seemed to agree.

Brady Young, panelist and president of Strate-gic Risk Solutions, has been advocating for great-er self-policing within the captive industry foryears after witnessing incompetence, conflicts ofinterest, and inappropriate manipulation of cli-ents by less-than-scrupulous managers.

Chuck Cohen, panelist and attorney specializ-ing in insurance and corporate matters, was al-so the Director of Insurance in Arizona from1998 to 2003 during the conception and incep-tion of its captive program. He spoke of an evo-lution in his attitude on the subject. While direc-tor, he strongly believed that the Department ofInsurance should not be in the business of cre-dentialing service providers but, after seeingabuses that came with the exponential growthof captives, he has changed his opinion.

I [author Rod Morris] can identify with Brady’sconcerns and Chuck’s evolution. I was a regula-tor of captives myself a dozen years ago whenthere were only a handful of domestic domicilesand nonbroker-owned captive managers. Every-one in the industry knew each other, and therewasn’t a lot of mystery in what their strengths

0

and weaknesses were. But, at least a couple ofthings changed that altered the captive businessmaterially: the proliferation of domiciles, andthe emergence of small captives with 831(b)federal tax elections.

The proliferation of domiciles created an atmo-sphere encouraging growth in both captivesand in the service providers servicing them.Also, aggressive promoters and facilitatorssprang up to solicit 831(b) eligible captiveswho, it might be fair to say, showed more inter-est in growth and profits than with an entirelyresponsible approach to management. All of usknow that captives have been formed for verysmall owners with very little risk but hungry fortax avoidance or exemption even if based onunjustifiably inflated premiums, questionablecoverages, and even more questionable reinsur-ance pools.

So, do we need some improvements in the in-dustry? Of course. Will credentialing help? May-be. If it will, I’m all for it.

Measuring Knowledge

It seems to me that the purpose(s) of a formalcredentialing process would be to determine acaptive manager’s worthiness to represent notonly the client but also the domicile. After all,regulators should be in the business of protect-ing the public, but they should also be free todifferentiate themselves from other domiciles,including control of who they want to workwith. But how exactly would that be deter-mined, and how might it work?

Is worthiness a function of knowledge? If so,how would a regulator determine who knowswhat and whether what they know is sufficient?After all, who hasn’t known “professionals”with lofty, even multiple academic degrees andcertifications who can’t effectively competewith those who just dig in and learn by doing orsucceed with on-the-job training? Older readers


might remember that, for the first few years af-ter the introduction of the Chartered PropertyCasualty Underwriter (CPCU) designation, thejoke was that it stood for “can’t produce, can’tunderwrite.” I don’t think it was meant to be somuch insulting as much as an expression of awell-entrenched conviction that the best insur-ance professionals come from practical experi-ence rather than “book learning.” That said,how does a third party, such as a regulator,identify or measure practical knowledge andexperience by some objective measurement ifnot by degrees or certifications? So, I don’tthink “knowledge” is sufficient in itself.

Measuring Experience

Is worthiness a function of experience? Whohasn’t seen plenty of examples of someonewith 1 year's worth of experience times 15rather than 15 years of accumulated, deepen-ing expertise? And what kind of experiencewould be necessary—years in the insurance in-dustry, years in captive insurance, number ofcaptives managed, or number of captives man-aged in each type of captive? For instance,does experience in forming or handling 20 (oreven 200) pure, single-parent captives providethe experience necessary to manage a risk re-tention group?

Measuring Reputation

Maybe credentialing should be based on reputa-tion, but reputation with whom—clients, peers,the specific regulator, or other regulators whohave worked with them? I have to admit that Iknow some managers with less than impressivereputations, yet they produce a ton of businessand, remarkably, just keep sailing along eventhough many within the industry know that theirreputations are undeserved. Speaking of whatothers in the industry know about the integrity orresponsibility of managers, what does it say aboutother service providers that feed or deal withthem? Should they be tainted by association?

In my opinion, none of us should tolerate un-ethical, irresponsible, or conflicted practices.I’d rather be out of business than be complicitwith unethical behavior. And why, by the way,should credentialing be a topic of discussion forcaptive managers only? I have had more than afew conversations with lawyers and accoun-tants who are completely clueless.

Solving Problems from Within

I want to work in an industry that is clean, ethi-cal, and fixes its own problems when they’rediscovered. I come at this issue from three per-spectives: as a former captive regulator, as acaptive manager, and as an expert witness oncaptive and industry issues. Actually, I guessthere’s a fourth perspective as a senior officerin the insurance business for over 4 decades. Ifall of that experience has taught me anything,it is that we should never rely on those fromoutside of the industry to fix our problems anddo the right thing for our clients and our indus-try. I neither want nor trust the IRS, attorneygenerals, cops of any description, or even arbi-trators to address our problems fairly, compe-tently or in a timely manner.

As a captive manager and certainly as a regula-tor, I have seen and heard about irresponsibleconduct, but as an expert witness, I have first-hand knowledge of the details of some prettyegregious conduct—the kind of conduct that thecritics of the industry complain about, the kindthat should be punished, the kind that shouldget someone “drummed out of the corps.” Butthey often don’t and, even more astoundingly,I’ve seen them prevail in arbitration brought byaggrieved clients—against all logic, against evi-dence of irresponsible conduct, and in spite ofadmissions of inappropriate conduct and prov-able, blatant perjury.

Arbitration should be one of the mechanismsthat help us identify and punish the bad guys,but if we can’t trust arbitration to arrive at

21

2


logical, informed, and fair judgments, it’sworthless. And if it’s secret, it identifies noone, and it provides no insight into what orwho is right or wrong. The industry learnsnothing, and we repeat the same mistakeswith the same people over and over again.Clients keep getting burned, the critics addmore fuel to the fire, and the bad guys aren’texposed. So, again, we have problems, but is“credentialing” the answer to the ethical prob-lems of the industry?

Self-Policing

I think that regulators should vet, scrutinize,and question captive managers and any otherservice provider with each application. I don’tthink they should “approve” or “credential”them and then publish them on a website im-plying that the approved entities are good forall captives under all circumstances at all times.Captive managers—all service providers—should be viewed as components of each cap-tive application, and the regulator should havethe right, if not obligation, to make a decisionabout the acceptability of each under the spe-cific circumstances at hand, in the same waythat they would question the specific aspects ofthe captive structure, ownership, membership,coverages, rates, etc. Is it subjective? Ofcourse. But how do you force objectivity into aprocess that is inherently subject to judgment—judgment about knowledge, experience, reputa-tion, and whether any of those things havechanged for the better or worse since the lastreview or approval?

Still, the Departments of Insurance (DOIs) can-not be the industry’s sole response to self-policing or ethical, responsible behavior of theindustry’s practitioners. The DOIs cannot ade-quately control tax issues, legal structures, oreven the interdependencies and conflicts of in-terest within the service providers. They don’teven know what is being disclosed, discovered,

2

or adjudicated in arbitration that has direct bear-ing on these issues. Maybe they should.

The bottom line is that we have to develop amethod of holding people accountable in a muchmore comprehensive and transparent way. Theissue is not credentialing. It’s self-policing, andit’s an issue overdue for some formal debate.

Self-policing would be grand in theory, just asmore regulation from above would be grievous,in theory. Unfortunately, more regulation fromabove is the most likely scenario. Regulating iswhat regulators do. Bermuda has announcedplans to put in place for January 1, 2017, rulesfor captive managers and captive boards. Willthe idea spread? You bet. Will some new regu-lations still allow those who we all “know”should be excluded? Yes. Will some new regula-tions hurt some who are doing a good job? Theanswer is also yes.

The qualifications and abilities of some manag-ers and service providers are certainly question-able. Rod’s point about service providers otherthan managers is a great one and should bemore widely discussed. The first point of under-standing should be with the prospective client,but that begs the question of, with whom dothey check?

Going to the well-known domiciles is always agood start but can be limiting. They have ideasthat may conflict with yours; good, bad, or not.Going to a public, “big name” source is also limit-ing as they will likely be self-aggrandizing. “Wecan do it all!” Sure, but how well? It is axiomaticin the world of large entities that revenues mustbe found to pay for the ancillary operations whenthey are not producing self-sustaining revenues.“Use our actuary/accountant/attorney! Please!”

The smaller firms/sources may give good ad-vice but maybe not as much due to their size.Experience in a large firm can be very broaden-ing, if you are paying attention, as you will see


a lot of “things,” probably more than the small-er firms. But people leave large firms to starttheir own firms so that they can offer superiorknowledge with little cost for expensive ancillaryparts in some cases.

At the end of the day, captives are similar to anyother industry. There are good apples and badapples, and it is hard to sort them out. ❑

Insurance-Linked Securities and Captives

by Thomas JohansmeyerISO/Verisk Insurance Solutions

The convergence of the captive market andinsurance-linked securities has begun. Althoughthe early steps have been small and recent, theydo suggest the potential for much more activity.ILS can help companies using captives to fur-ther refine their risk and capital management,taking advantage of both diverse capital sourcesand different structural elements that can pro-vide plenty of flexibility.

Sources: Artemis.bm and Property Claim Services® (PCS®), a uni

Overview of the ILS Market

Last year, the global insurance and reinsur-ance industry raised approximately $6 billionin capital through 24 transactions. While thisfell short of 2014’s record-setting $7.8 billionresult, it still made 2015 one of the most ac-tive issuance years in catastrophe bond markethistory and shows that this form of risk trans-fer provides strategic value to cedents world-wide.

Nineteen of last year’s catastrophe bonds had atleast some exposure to US risk, which remainsthe most frequently used risk area by a signifi-cant margin. Further, it was a market character-ized by veteran sponsors—only four were debuttransactions.

And that’s the opportunity for captive manag-ers. Bringing original risks to the investorcommunity can unlock new forms of capitalfor captive managers while giving diversifica-tion opportunities to capital providers. Evenfor traditional US property catastrophe risksceded through catastrophe bonds, captiveswould be supplying additional risk to a market

23

t of Verisk Analytics

2


faced with a scarcity of capital deployment op-portunities.

How Catastrophe Bonds Work

A catastrophe bond provides protection to acedent (usually an insurer or reinsurer, but al-so potentially captives and corporates) inexchange for a premium. So far, it’s muchlike any other form of risk transfer. The dif-ference here is that the cedent “sponsors” aspecial purpose insurer (in Bermuda par-lance; in the Cayman Islands, its special pur-pose vehicle) that provides the cedent withprotection and issues notes that are con-sumed by investors. The investors receive aninterest payment on the note in exchange forsupplying the capital to collateralize the cov-er—and pay in the event that the catastrophebond is triggered.

Investment bankers or the investment bankingarms of reinsurance intermediaries tend to leadefforts around planning, structuring, and distri-bution (lining up investors). The investors in ca-tastrophe bonds can vary. ILS fund managersgather assets from end investors—usually pen-sion funds, sovereign wealth funds, traditionalfixed-income investors, and other capital pro-viders interested in the catastrophe bond assetclass but who are not yet ready to invest inthose instruments directly. End investors seekbenefits including very low correlation to theglobal financial market and comparatively highyield relative to other fixed-income opportuni-ties.

For investors, returns can vary with the expect-ed loss of the bond (reflective of the level of riskbeing transferred by the cedent), the structureof the transaction (including the trigger used),and the cedent’s experience in the catastrophebond market. Recently, many of those factorshave been slightly muted, given the vastamounts of capacity already in the ILS market,estimated to be around $70 billion. And it’s

4

been reported that global pension funds have atarget asset allocation of 2 to 3 percent to glob-al reinsurance risk, which could be as high as$900 billion.

Soft market conditions have led to favorablerates and terms for cedents in both the tradi-tional reinsurance market and the ILS space.

Key Considerations forGetting Started

Of course, the decision to enter a new market israrely made lightly. And, while there have beenseveral captive- and corporate-sponsored ca-tastrophe bonds, a learning curve remains. Ifyou’re thinking of dipping your toe into the ILSmarket, here are a few important factors to con-sider.

First, size matters. When you look at the ca-tastrophe bonds sponsored by captives, they allhave one thing in common: size. PennUnion Rewas sponsored by Amtrak, for example, andMetroCat Re came from the Metropolitan Tran-sit Authority—both of which have captives inplace with very significant exposures. To becost-effective, catastrophe bonds generally re-quire at least $100 million in risk to transfer.Last year, the average deal was about $250 mil-lion. Even if you don’t have that much risk totransfer, it’s still possible to access capital mar-kets’ capacity. The vehicles are just a little dif-ferent.

“Cat Bond Lite”

“Cat bond lite” can meet the liquidity mandatesthat many ILS funds have and offer reduced fric-tional costs that support tactical risk manage-ment. The average cat bond lite last year was alittle over $30 million, with the smallest a mere$9.7 million. There’s plenty of flexibility here aswell. The largest cat bond lite of 2015 was $71million, and, over the past 2 years, transactions


Sources: Artemis.bm and Property Claim Services (PCS), a unit ofVerisk Analytics

have come to market with industry loss index(PCS®), parametric, and indemnity triggers.

So, what is cat bond lite? Basically, it’s a risk-transfer agreement, such as an industry loss war-ranty (ILW) or collateralized reinsurance contract,that’s transformed into a security. The cat bondlite structure seeks to offer cedents an approachto securitization that doesn’t include the some-times cumbersome, expensive, and time-consuming overhead of traditional catastrophebonds while still delivering the structural disciplineand potential liquidity that catastrophe bonds pro-vide. Consequently, sponsors have gained theability to complete tactical capital managementactivities faster and with lower frictional costswhile still accessing new sources of capital.

Industry loss index remains the trigger of choicefor the cat bond lite market. Half of last year’scat bond lite transactions (8) and $203 million(41 percent of limit) used the PCS CatastropheLoss Index. There were fewer deals with indem-nity triggers, but they were larger, adding up to$212 million in issuance, with an average sizeof $42.5 million. The average industry lossindex-triggered cat bond lite was $25.4 mil-lion. No publicly revealed cat bond lites used

parametric triggers last year (the approachtaken in PennUnion Re and MetroCat Re),although three transactions did not have theirtriggers revealed, accounting for the remaining$75 million in limit.

Pooling is another way for captives to gain ac-cess to the scale they need for ILS to be cost-effective. Rather than go it alone, several cap-tives could participate in a joint facility thatwould provide reinsurance protection for eachwhile laying off (at least some of) the risk simul-taneously through an ILS transaction. The par-ticipating captives would receive fully collateral-ized reinsurance protection as well as analternative source of capital (that is, the capitalmarkets), which would reduce both counterpar-ty credit risk and systemic risk.

Since most catastrophe bonds come from singlesponsors, pooling would be a novel approach—although one not without precedent. A handfulof multi-sponsor catastrophe bonds have cometo market. In 2012, Combine Re was spon-sored by a reinsurer to provide $200 million inprotection to two of its reinsureds for severalperils. This was the only mainstream catastro-phe bond to protect multiple underlying ce-dents. Somewhat different—but still useful inthis context—is the catastrophe bond from theWorld Bank Caribbean Catastrophe Risk Insur-ance Facility, which provides $30 million inprotection for multiple underlying cedents in aprivate deal (similar to a cat bond lite).

Using a pooled-captive facility would requiresome careful thinking around structuring, par-ticularly for the reinsurance protection providedto the participating captives. However, the ILSportion should be relatively straightforward.

While size and scale are important, the real op-portunity that captives provide for the ILSmarket (which could in turn benefit the captivesthemselves) is diversifying original risk. The ILScommunity has spoken for years about casualty

25

2


risk, specialty lines, terror, and cyber. There’splenty of appetite outside property catastrophe,and for captives that were formed to providecoverage that a traditional insurer wouldn’twrite, the ILS market could become a readysource of protection.

In particular, terror and cyber have come up fre-quently in client conversations, with capital pro-vider appetite suggesting potentially significantnew risk-transfer opportunities for captive spon-sors worldwide. Further, investors have shown aninterest in simplified but unconventional triggertypes that could make it much easier to developclear and effective transactions with the potentialfor fast execution and post-event resolution. Forexample, we’re working on a global terror para-metric index-style trigger with data from VeriskMaplecroft that could be particularly effective onbusiness interruption covers. Similar approachescould be effective for cyber as well.

Creativity will win the day. In addition to provid-ing more original risk to the global ILS commu-nity, it will provide captives with the tools theyneed to manage their risk and capital more ef-fectively, helping them achieve their mission asrisk-financing tools to protect business ownersand their ability to grow value. There’s a newsource of capital available to captives, and itlooks as though the proof of concept has beenachieved. Now, the market needs to see ifthere’s a sustainable advantage to accessing theILS market. ❑

Repudiating the OECD’s Challenge to Captives

by Ian KilpatrickAdvantage Insurance Holdings

In this age of a global economy, more and morecaptives are insuring their parents’ worldwidebusiness risks and, as a result, they face extraor-dinary challenges. Keeping track of the myriad

6

of regulations and tax compliance requirementsin a multitude of countries can give rise to amajor headache for the person responsible formanaging a multinational enterprise’s (MNE’s)captive. Globalization has created substantialproblems for member countries of the Organi-zation for Economic Cooperation and Develop-ment (OECD), which is composed of 34 marketdominant democracies, including all membersof the G–20.

The original mission of the OECD was to pro-mote economic growth, prosperity, and sustain-able development in countries around the worldto improve the economic and social well-being oftheir populaces. While that may have been theoriginal purpose, today it appears that its maingoal is to secure funding for its member states.

While intercompany transactions are an ordi-nary and unremarkable feature of the vast ma-jority of MNEs’ daily operations, OECD mem-ber states have found them challenging toregulate and difficult to tax. The OECD believesthat MNEs strive to avoid paying taxes by mov-ing their profits to no or low tax countries. Inattempts to reduce deficits in their national bud-gets, the OECD has attacked MNEs for struc-turing their operations in a manner to avoid“paying their fair share of taxes.” By targetingthe practice of moving profits from one countryto another by means of transfer pricing, whichthe OECD has given the loftier description of“Base Erosion and Profit Shifting” or BEPS,they believe they will be able to provide mem-ber countries with significant large increases intax revenues.

The OECD admits that, in most cases, thesestrategies are legal, and it is not the MNEs thattake advantage of these opportunities who arein the wrong, but the various countries, includ-ing member states, whose tax laws and regula-tions allow “MNEs to distort the integrity of thetax systems and cause fiscal and social hard-ship.”


OECD Speaks Out

The OECD first published a report in 1998,“Harmful Tax Competition—An EmergingGlobal Issue,” in which it expressed a viewthat “preferential regimes” (i.e., countries withlower tax rates than OECD member states)were encouraging MNE’s to participate in a“race to the bottom.” Since the introductionof that report, the OECD issued guidelines, di-rectives, and published papers on harmful taxpractices, which included transfer pricing, cul-minating in its report, “Base Erosion andProfit Shifting,” which was issued in February2013.

That report identified transfer pricing as oneof the major pressure areas, stating “transferpricing, particularly in relation to the shiftingof risks and intangibles, artificial splitting ofownership of assets between legal entities,and transactions between related-party enti-ties that would rarely take place between inde-pendent entities” was “particularly trouble-some.”

Along with transfer pricing, the report listedadditional pressure areas to be addressed, in-cluding “tax treatment of related-party debt fi-nancing, captive insurance, and other intra-group transactions.” The report inferred thatMNEs were using captives as a vehicle of taxavoidance by shifting profits from highly taxedcountries to those with low or no income tax-es, and this required greater transparency andoversight. The report raised the question ofhow risk is actually distributed among MNEscorporate entities and examined the econom-ic substance of transactions. In particular, theOECD questioned the managerial capacity tocontrol risk, the financial capacity of the ar-rangement to bear risk, and whether any in-demnity payment should be made when risk isshifted between group members—all of whichbrings into question the reason for forming acaptive.

Captive Response

The Captive Insurance Companies Association(CICA), together with the European Captive In-surance and Reinsurance Owners Association(ECIROA), responded to the report in a letterdated May 1, 2013, and pointed out many ofthe reasons captives are formed. In conclusion,the letter stated:

[T]he reference to Captives misusing theirstructures for tax circumvention or avoid-ance is misleading and without significantbasis. Captives are extremely valuable riskmanagement instruments which strength-en the market position of their parentcompany or organization during times ofheavy claims and losses by facilitating theestablishment of reserves to meet futurelosses. The most important point is thatcaptive insurance companies are justthat—insurance companies. Like all insur-ance companies, they are highly regulatedby the financial authorities where they areregistered. Captive insurance companiesare a risk financing tool that is essential forstable business operations, not a taxavoidance business.

OECD Action Plan

In August 2013, the OECD followed up on itsBEPS report with an Action Plan. The purposeof this Action Plan was to combat BEPS andrevamp and update its earlier work on harmfultax practices, with a priority on improving ex-change of information with no or low tax coun-tries ensuring that substantial activity takesplace in the MNE’s operation within the domi-cile of the preferential regime.

The Action Plan is based on the premise that“taxation is at the core of a country’s sover-eignty.” When designing their domestic taxrules, sovereign states may not take into ac-count the effect of other countries’ rules.

27

2


While international standards have sought toaddress this issue, gaps remain, causing bothdouble taxation and the opportunity of BEPS.The OECD believes these anomalies must beaddressed to restore both source and residencetaxation where cross-border income wouldotherwise go untaxed, or taxed at very lowrates. In the area of transfer pricing, the OECDactions are specifically designed to providecountries with the opportunity and capabilitiesto better align their rights to tax with economicsubstance and activity. The OECD’s proposedactions seek to put greater emphasis on valuecreation than formulary apportionment ofprofits.

The Action Plan listed 15 actions organizedaround three main pillars:

• The coherence of corporate tax at theinternational level

Meaning, currently not all countries are on thesame playing field, i.e., they have different taxrates and different methods of collecting them.The OECD’s goal is to have all countries adoptsimilar tax laws thus removing any opportunityfor an MNE to take advantage of any particularcountry’s favorable tax laws. To achieve thisone, the Action Plan recommends changes tovarious domestic tax laws and also calls forchanges to the OECD model tax treaty to createa multinational tax convention.

• A realignment of taxation and substance

The goal of the OECD is to realign MNE’s prof-its with the location of “real” activities of theMNE’s. Its BEPS report and Action Plan inferthat captives are used to artificially transfer in-come from MNEs in a taxable jurisdiction. In re-ality, the formation of captives is driven by cor-porate risk management strategies that havesubstantial business purpose and are managedby key personnel who understand all aspects ofeach MNE’s risks. However, in light of the

8

OECD’s demand for senior and experienceddecision makers within the captive itself, it islikely the value added in the captive domicilecompared to the value added by personnel lo-cated onshore, for example in the head office,may need evaluation.

Where it appears nontax benefits to the groupfrom the transfer of risk are limited, or wherethe captive is too heavily dependent on person-nel elsewhere in the group for underwriting,policy documentation, and pricing, challengescan be expected.

• Transparency, coupled with certaintyand predictability

The goal is to require MNEs to report the activi-ties of their various operations in every countrywith the tax authorities of not just the country ofthe operation, but all authorities where they haveoperations. They are setting their sights on oper-ations of MNEs that are not only located in coun-tries perceived as “tax havens,” but any countrythat offers business an incentive to invest there.To assist them in their efforts, the OECD is pro-posing the creation of standardized transfer pric-ing documentation which will result in improvedreporting to tax authorities, thus allowing themto assess the true purpose of MNE’s intercompa-ny transaction.

Complying with OECD’s Action Plan will re-quire complete transparency and coherencebetween countries, which presents many chal-lenges. While the OECD is trying to achievetax harmonization, its member countries arestriving to attract international business totheir shores. It is likely these countries willcontinue to adopt policies to support theirown economic advantage, making it difficult toachieve consensus. However, this lack ofagreement will not deter OECD’s pursuit ofpreferential tax regimes. When creating andmanaging a captive, it is important to clear-ly establish that the reasons for forming the


captive in its chosen domicile should not bebased on tax minimization opportunities.

Summary

Detailed review and gathering of informationfor this article brought to light the following:

• Transfer pricing regulations in the UnitedStates and among OECD member coun-tries already require captive owners todemonstrate that their insurance premiumsare determined in line with the arm’s-length standard and that their transactionsare consistent with third-party activitieswithin the captive insurance industry.

• Captives are an integral part of the “enter-prise risk management” of multinationalenterprises (MNEs). And, captives are theonly tool available to MNEs to manage oth-erwise uninsured risk exposure in a formal-ized and regulated way.

• Captives allow MNEs to reinsure risks di-rectly to the reinsurance market (which isnot possible without captive involvement).This makes it possible for MNEs to accessthe higher level of capacity they need toprotect their risks.

• Captives are managed by personnel withadvanced knowledge, training, and industry-approved certifications. This complies withOECD’s requirements that transactions un-dertaken must be able to establish economicsubstance and that the people who have theknowledge, authority, and ability to controlthe company—and the risks it accepts—areresponsible for the transactions.

• The information that captives are requiredto disclose in regulatory filings upon forma-tion and during their operation, combinedwith their financial and tax compliance re-porting, is substantial. Significant and

consistent documentation standards andpractice could assist a tax administrator inmore efficiently assessing tax complianceand perhaps alleviate some of the poten-tial misunderstandings of the captive’s op-erations.

• Establishing a formal documentation pro-cess will increase transparency. Clearlyoutlining how the captive has consideredthe arm’s-length concept, use of educatedthird-party service providers, sound actu-arial techniques, and significant federaland state regulatory oversight will provenecessary due diligence to comply with In-ternal Revenue Service (IRS), OECD, andother foreign regulatory requirements.

• Many of the issues raised in the OECD re-port related to captives can be correlatedin one way or another to the captive’s in-surance operations. If sufficient and rou-tine consideration is given to the assess-ment of the captive’s tax position, thiscould mitigate or resolve many of theOECD’s concerns. Establishing a formaldocumentation process that addresses thevarious aspects as mentioned in this arti-cle is very important and will result in in-creased transparency.

• Current tax codes in the United States ad-dress concerns related to transactions withforeign entities with ties to US sharehold-ers. Many foreign captives insuring USrisks have (or should) consider the 953(d)election to avoid complexity and costly ex-pense for complying with controlled for-eign corporation rules, which are de-signed to help prevent some of the sameconcerns raised by the OECD.

Documenting all the steps you’ve taken aboutforming your captive and determining yourtransfer pricing will prepare you for the kind ofchallenge the OECD’s BEPS is proposing. ❑

29

• The � rst and most authoritative onlineresource for unbiased information onthe alternative market

• Free access to anyone with no sign-in required

• Captive thought leader videos

• Designed for tablets and smartphones

• New Learning Center: online CE and CPE credit

Captive.com is ...

• NewNew Learning Center: online CE and CPE credit Learning Center: online CE and CPE creditNewNew Learning Center: online CE and CPE creditNewNew

Editors John Salisburyand John Foehl have

more than 50 years ofcombined expertisein the captive arena.in the captive arena

About IRMI

IRMI was the fi rst publisher of reference content coveringthe fi eld of risk fi nance in 1983 with the publicati on ofRisk Financing, a comprehensive reference resource on allaspects of traditi onal and alternati ve market approaches.IRMI also publishes the fi rst newslett er to cover the fi eld of capti ves, Capti ve Insurance Company Reports, as well as two comprehensive books on the subject of capti ve insurance. Learn more at IRMI.com/Go/Capti ves.

Contact Monica Sturgeonfor advertising opportunities at

(800) 827–4242, ext. 379, or [email protected]

A service of IRMI®

Since1995

http://www.captive.com

Data & Analytics

IRMI Captive Insurance Issues and Trends 2017