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Growing Our Numbers to Improve Your DecisionsIntroducing the New WERF and the New WERF Newsletter
Numbers are powerful and sometimes surprising. Irrefutable on the one hand, theycan also lead to different conclusions, depending on the skill of people working thenumbers and their ability to accurately interpret results. In a financial services industrylike ours, numbers are crucial, and nowhere are they more important than in the WillisEnterprise & Risk Finance (WERF) practice. We are more than just numbers people, ofcourse – we’re analysts, strategists and tacticians. But numbers are at the heart ofmuch of what we do.
It’s with great pleasure and excitement therefore that we announce that the WERF teamhas been joined recently by the best numbers people at Willis – we think some of the bestnumbers people in the world.We’ve added analysts, strategists and tacticians, as well, withthe inclusion of two great teams within WERF:Willis Actuarial Services and the Willis CaptivePractice. However, this is not just about the efficiencies of joining three practices. Thefundamental synergies between these groups will allow us to raise the bar across the boardin terms of the risk analytics and risk financing techniques Willis can bring to its clients.
What does this mean for you? This means more people working the numbers on yourbehalf and a greater variety of perspectives presented to you in a coordinated fashion.It means more options. It means, in the end, better risk management decisions.
Our solutions can help you objectively measure the value of one risk financing optionversus another, optimize risk capital expenditures or quantify low frequency/high severityrisks that may lack adequate historical data for standard predictive modeling. We canreduce your reliance on benchmarking in favor of risk analytics to guide decisions on limitsand retentions that are appropriate for your individual circumstances.These tools allow youto make risk management decisions that are proactive instead of reactive, which ultimatelywill deliver better results to shareholders and other stakeholders.
The core capabilities of the new WERF team are threefold.
Alternative Risk Financing and Enterprise Risk ManagementAssessment and DesignWe offer new and proprietary methods of risk identification, quantification and riskfinancing that enable you to understand and define the relationship between risk andcapital structure, and, in so doing, help you to implement risk management solutionsthat support more consistent and efficient use of capital. In the ERM space we offera full suite of services from initial risk mapping to program implementation strategy.WERF Associates are strategically positioned in major North American cities.
Willis North America • 10/07
WERF NewsletterNews and Information from the Willis Enterprise & Risk Finance Practice October 2007
Contents
Growing Our Numbers toImprove Your Decisions 1
Recent TaxDevelopments in the UK 2
Captives and Change 3
News Items 6
Contacts 7
Captive Feasibility, Formation and Management Willis has long been a leader in captive management and related services. We service about 300 captive programs around theworld, with premiums totaling over $3.5 billion. Willis’ captive experts are located in all major captive domiciles worldwide. Ourcaptive clients range from family-owned businesses to Fortune 500 corporations. Being at the forefront of the industry in termsof our client retention rate is perhaps the ultimate testament to the quality of our expertise and services and a fact of which weare exceptionally proud.
Actuarial Services The year 2007 has been very significant for our Actuarial operations, including strategic new hires, establishment of a New Yorkbase of operations and several procedural enhancements to assure we continue to offer unparalleled service in the areas of lossprojection, reserve analysis and rate-making. Our skill in actuarial services, however, is not just about crunching numbers. It’s alsoabout effectively communicating results in a manner that is readily understandable. We offer the full range of actuarial services,including specialized actuarial analysis and reports for our captive clients, to every type of organization.
We are also pleased to release the premier issue of our practice newsletter. Readers of The CAPS Newsletter, published by Willis from2004 through 2006, may find this publication familiar – we’ve taken on the look of that publication, just as we’ve taken on muchof the great talent that was part of the Captive, Actuarial and Pooling Solutions practice. We are confident our clients will be betterserved now that the Pooling team has formed its own practice, and the Captive and Actuarial teams have joined us. We think ourclients will share our excitement about these changes and about the increased breadth of expertise, services and synergies that wewill bring to them in the months ahead. We hope you enjoy this inaugural issue, which features, appropriately enough, insights andnews about the captives industry. If you have any issues you would like to see discussed in future issues, please let me know. Ournumber one goal is to help make your numbers the best they can be.
– Steve Saporito, WERF Managing Director
2 Willis North America • 10/07
Recent Tax Developments in the UK
The UK Treasury’s recent discussion document, “Taxationof Foreign Profits of Companies,” issued on June 21,2007, will be of interest to captives and their owners, asit puts forward a broad reform package for largebusinesses. The new “controlled company” regime inparticular may have a significant effect on the captivesector. The next step for the reforms will be the publicationof a consultative document followed by new legislation.The reforms will likely be effective from April 1, 2009.
At present, most UK-owned captives are regulatedby the UK controlled foreign company rules.Although exceptions apply, the profits of thecaptive are taxed in the hands of the UK parent.
The typical exemption relied on by captives is thepayment of a dividend based on 90 percent of theprofits. This gives a marginal tax benefit.
The 2006 Cadbury Schweppes case, held in theEuropean Court of Justice, potentially offered tax
benefits to captives in EU jurisdictions (for example, Dublin, Maltaand Gibraltar). However, the UK government’s interpretation ofthe case in the December 2006 Pre-Budget Report means thatthe benefits for captives are likely to be minimal.
The wider reforms following the consultation process willneed to be compatible with the Cadbury ruling. The reformsenvisaged in the discussion document include an exemptionfor foreign dividends paid to UK companies that own 10percent or more of their captive, together with a newcontrolled company regime.
The focus of the new regime will be on “passiveincome” rather than the status of the company. It is
not certain whether the underwriting income andinvestment income of an insurer and specificallythat of a captive will qualify as passive incomeor active income, the latter falling outside thecontrolled company rules.
While the 90 percent dividend paymentexemption of the existing regime will likely be
removed, overall it remains to be seen whether or notthe new regime will be of benefit to captive owners.
Captives and Change
Experts will tell you that captives should be regarded as a medium-term strategic tool and not a short-term fix in a hard market. They’reright, because in the early stages of captive establishment anddevelopment, costs can outpace benefits. The long term is anothermatter. Especially in a fast-moving global economy, thecircumstances that inspired an organization to form a captive maychange so significantly that a captive as originally conceived may nolonger make sense over time.This does not mean the captive shouldbe abandoned – and the initial investment sacrificed. Captives canchange. Captives must change, in fact, to continue generatingbenefits and to respond to new challenges as they arise. Below, weexamine the changing environment inwhich captives operate and howcaptives can respond to it.
Drivers of ChangeThe Insurance MarketA common misconception is thatcaptives are most cost-effective in hardmarkets – and that interest in captives,therefore, follows the insurance marketcycle with new formations in hardmarkets and with captives being woundup or moth-balled in soft markets. Tosupport this view, people often point tothe significant number of new captivesestablished during the hard market of 2003-2004. It may be thatpeople tend to talk about captives more during a hard market, but acloser examination of the evidence shows that the number of captivesin the world has grown fairly steadily irrespective of market cycles.
We do see something of an increase in formation activity duringhard market cycles, but we suggest that this is a matter of short-termconditions inspiring organizations to push forward their captiveformation plans rather than the reason for forming the captives inthe first place.A hard market provides a useful argument in justifyingthe high front-end costs of establishment.
That being said, the state of the market profoundly affects theways in which a captive is used and the value it creates. In ahard market, several advantages of captives are highlighted,including access to reinsurance markets, and the ability to fillgaps in a program where 100 percent cover is not available,terms vary or cover may be denied for specific risks. In a softmarket, captives have proven to be just as competitive in termsof pricing. The important factor is that captives keep pricesstable, whether the market is hard or soft.
Regulatory and Governance EnvironmentsHardly a week goes by, it seems, without word of some newinternational or domestic initiative that affects the operation ofinsurance companies in general or captives in particular. Thisincludes changes to accounting rules or actions by theInternational Association of Insurance Supervisors, the FSA, taxauthorities, the EU, the IMF, FATF, etc. The list of rules andregulations impacting captives either directly or via their parentgroup often seems endless. Fortunately, much of this activityinvolves little more than the documentation of best practices andcan safely be left to competent insurance managers foradministration and compliance. Changes that directly impact theoperation of the captive, however, need careful consideration.
For instance, recent changes in EUdirectives, particularly when amplified or“gold plated” by local regulatoryauthorities, have seriously affectedcaptives’ access to markets, levels ofcapitalization and operating costs – insome cases, enough to undermine thevalue of the captive and lead to its closureor transfer to a more sympatheticjurisdiction.
One example is the recent EUReinsurance Directive, which mayencourage reinsurance captives to moveoffshore. Similarly, the implementation of
Solvency II will penalize EU captives for their lack of risk spreadand increase their regulatory capital requirement.
Business EnvironmentPerhaps the more important impetus for change comes from captiveowners themselves, as they evolve and respond to their own marketand business environment. Organizational restructuring, mergersand acquisitions, listings, delistings, changes in strategy, newmarkets, new products, new management – all these and more havea direct and often profound impact on the operation and role of thecaptive and on the risks it insures. Keeping the strategy of thecaptive firmly in line with the objectives and strategies of the parentgroup and ensuring that the group derives maximum value from itare perhaps the toughest challenges faced by those responsible forthe management of a captive.
3
The list of rules and regulations impacting captiveseither directly or via their parent group oftenseems endless. Fortunately, much of this activityinvolves little more than the documentation . . .
Willis North America • 10/07
Soft
Har
d
Low
High
Number of Captives
Stat
e o
f th
e M
arke
t False?
True?
The introduction of a joint venture, for instance, leads first to issuesconcerning third-party risks, and second, to the appropriate meansof separating out joint risks and assets from those resting entirelywith the parent. Protected (segregated) cell captives have providedeffective solutions in many such cases.
The basic structure and function of protected cell companies hasnot fundamentally changed since their advent in the 1990s, andtheir value remains the same. Against their advantages must beweighed the possibility of a loss, possibly exacerbated by thelimited spread of risk in most captive programs, and the impactin terms of operational costs, capital and management time.
Sources of Captive ValueStrategic Value• Flexibility and control over the insurance program in terms of
both coverage and claims management• Optimized program design – risk retention/risk transfer at
both business unit and group levels• Supplements conventional markets – specific or unusual
covers including new risks without claims history• An important option to consider in the pursuit of optimal
corporate governance
Operational Value• Reinsurance market access• Holistic risk management control and coordination• Expert advice and access to specialized management
information systems
Financial Value• An alternative to conventional markets can provide market
leverage• Reserving of claims, especially IBNRs and IBNEs• Reduced administration costs through outsourcing to
specialist administrators• Cash flow/investment returns• Efficient capital use
• Tax deductibility of premiums• Other fiscal benefits subject to parental (controlled foreign
company) restrictions
All captives generate value through some combination of theabove. The right combination of location, corporate structure,program management and governance infrastructure allows acaptive to deliver value in line with group priorities and objectives.
How does a captive owner go about achieving the rightcombination and creating an optimal, value-generating captive?
Generating ValueFirst, all parties – the group risk manager, the broker and thecaptive manager – must work together with a clearunderstanding of the organization’s strategy and objectives,which in turn drive the captive’s goals and priorities.
Next, it is important to have an objective means of assessing thebenefits generated, even where this is not measurable infinancial terms. Only by such examination can the overall valueof the captive be determined. Furthermore, not only should thisexamination be undertaken regularly, but to ensure theoptimizing of value, the parent group must constantly challengethe captive to re-evaluate the risks it addresses and the risks itcould address. Many insurable risks are potential sources ofadditional value. The captive should always be considered as analternative to conventional insurance.
While we stress the need for all parties to fully understand therole and potential value of the captive and to work togetheropenly to achieve it, clearly it helps to have brokers experiencedin working with captive programs, and to have insurancemanagers with wide experience and expertise in a range ofcaptive structures, programs and domiciles. Good governanceinfrastructure and, in particular, a strong and competent captiveboard will provide effective scrutiny of proposals and oversightof operations. All too often the value of strong, knowledgeable,non-executive captive directors is overlooked. Communication,among all parties is always critical.
4 Willis North America • 10/07
For instance, recent changes in EU directives,particularly when amplified or “gold plated” bylocal regulatory authorities, have seriouslyaffected captives’ access to markets, levels ofcapitalization and operating costs – in somecases, enough to undermine the value of thecaptive and lead to its closure or transfer to amore sympathetic jurisdiction.
The introduction of a joint venture, for instance,leads first to issues concerning third-party risks,and second, to the appropriate means ofseparating out joint risks and assets from thoseresting entirely with the parent. Protected(segregated) cell captives have providedeffective solutions in many such cases.
Finally, flexibility should be designed into every aspect of the captive from inception. This should include:
5
• Domicile Selection – Attention should be paidto the style and substance of local regulation(including local laws regarding companymigration, should a change in domicile be soughtlater), market access restrictions, capitalrequirements, and the availability of potentiallyuseful corporate structures such as protected cellcompanies and incorporated cell companies.
• Program Design – Contracts need to reflectthe possibility of change in the underlying risksand enable early cessation throughcommutation and/or cancellation clauses.
• Capital and Structure – Care should betaken to ensure that capital can be increasedand decreased to suit evolving needs.Shareholding should be arranged to providethe least restrictive consolidation for bothaccounting and tax purposes.
Conclusion
A wise person once said, “The only constant is change.” Those most successful at dealing with change are those who plan for it andwho develop the infrastructure to manage the change process.This requires:• Environmental awareness• Knowledge of the sources of captive value• Ongoing assessment of captive performance• High-quality, flexible support infrastructure
Only by responding quickly and positively to change can captives reliably generate net benefits in the medium and long terms.
Lake Champlain
Bermuda Rooftop
Gibraltar City Singapore City
Malta
Guersney, St. Peter Port
News Items
6 Willis North America • 10/07
Arizona: Captive Law Updated
On April 24, 2007,Arizona Governor Janet Napolitano signed HB2294,Captive Insurer Amendments, enacting significant updates to Arizona’scaptive insurance law. The legislation was developed and lobbied for bythe Arizona Captive Insurance Association and will be effective later thisyear, 90 days after the legislation session adjourns.
Below are some notable features of the legislation.
• New provisions allowing the establishment of branch captives toprovide employee benefits
• New provisions defining "deductible reimbursement" business,and clarifying that deductible reimbursement business ispermitted on a direct basis
• Allows group captives (except risk retention groups) to cover"controlled unaffiliated business"
• Eliminates remaining restrictions against writing commercialmotor vehicle business on a direct basis
• Eliminates an Arizona residency requirement for captivemanagers, and requires that captive managers do business at alocation in Arizona
• Reduces the minimum capital requirement for a protected cellcaptive from $1,000,000 to $500,000
• Allows a pure captive to be formed as a limited liability company
Hawaii: A More Competitive Domicile
Legislation efforts during the past session were undertaken to makeHawaii a more competitive captive domicile while maintaining properregulation. The following two bills were passed.
HB1323, S.D.1: Sponsored by the Insurance Division, this billeffectively amends §431:19-116 to establish a premium tax capof $200,000 (equivalent of $250,000,000 of taxable premiums)per annum.
HB272, H.D.1, S.D.1: Sponsored by the Hawaii Captive InsuranceCouncil (HCIC) working in cooperation with the Insurance Division, thisbill allows captives to be formed by limited liability companies (LLC) andformed as an LLC, allowing greater investment flexibility. The bill alsocontained several housekeeping amendments.
7 Willis North America • 10/07
Contacts
WERFSteve SaporitoManaging DirectorWillis Enterprise & Risk Finance Practice+1 617 351 [email protected]
ActuarialEd Davenport, FCAS, MAAA Managing Director+1 615 872 [email protected]
CaptivesMalcolm Cutts-WatsonLeader, Willis European Captive Practice+1 44 (0) 1481 [email protected]
Oliver HeyligerManaging DirectorWillis Management (Bermuda)+1 441 278 [email protected]
James Girardin, CPALeader, Willis NA Captive Practice+1 802 658 [email protected]
Stephen GrayManaging DirectorWillis Management (Cayman)+1 345 949 [email protected]
Jason PalmerManaging DirectorWillis Management (Hawaii)+1 808 521 [email protected]
