Pickup Trucks and Captives.

A captive insurance company can be used in different ways to transfer risk.

A captive insurance company, if used effectively, is a useful financial-management vehicle. Unfortunately, though, many languish unused or, at best, underutilized. Arguably, clarification on the tax treatment of premiums paid to a captive over the past decade has made it easier for a corporation to use a captive to improve its balance sheet. There are, however, multiple benefits a captive can provide.

Many years ago, a risk manager compared a captive with a pickup truck. The analogy was confusing at first, but ultimately, it made sense. Consider how many times you have wished you owned a pickup truck. Maybe to move an item for your mother-in-law, if not your mother-in-law herself. How about taking the kids to summer camp with all their gear in tow? Maybe a trip to the nursery for some shrubs or maybe a load of firewood from a roadside vendor. Certainly, a pickup truck--and its virtually unlimited functionality--would be nice to have around.

So what does a pickup truck have to do with a captive? Many captives are formed for a specific purpose--for instance, to access the reinsurance market for liability coverage or as a vehicle to write a contractual-liability policy or a deductible-reimbursement policy. Captives formed and used for such purposes account for a majority of the captives now in existence. Whatever the initial impetus might have been or may be, a captive can be utilized as a multipurpose financial-management vehicle.

The old adage of "a bird in the hand is better than two in the bush" can be applied to current tax deductibility of premium payments to a captive from related insureds. The current value of a tax deduction for a premium payment, as opposed to a similar deduction for losses paid in future years, adds value to the economics of a self-insurance transaction. Certainly, the ability to deduct premiums paid to a captive is more likely today. In cases where taxing authorities have challenged deductions, insureds have successfully defended the deductibility of premium payments to their captives without the assumption of third-party risk.

Where should an insured look to increase the value of its captive? A logical starting point is the balance sheet of the insured. When reviewing such balance sheets, one should ask the question, "Can liabilities that already exist for book purposes be transferred to a related captive in a transaction that results in additional cash flows through accelerated tax deductions?" Typically, such liabilities can be transferred to the captive if the risk represents true insurance risk and not investment risk. Accomplishing such risk transfer is analogous to hauling our initial load in our pickup truck.

Because the captive insurance company is a licensed insurer, it has access to the reinsurance markets. This may afford the company different and typically better pricing and terms as a reinsurer than it had as the insured. While transferring the liability to the captive provides additional cash flows by way of accelerated tax deductions, a further additional cash-flow benefit may be achieved through cost savings by accessing the "wholesale" markets as opposed to the "retail" insurance markets.

Evaluating Risks

Utilizing a captive to its full potential includes evaluating what risks to self-insure, what risks to transfer to another in a commercially acceptable transaction and how to deal with risks that are seemingly uninsurable. (The term uninsurable risk is really a misnomer, since most risks can be insured in some manner if the insured is willing to pay the price.) In making these decisions, the insured should identify and evaluate the impact of high-frequency, low-loss risks; low-frequency, high-loss risks; and all risks in between. Furthermore, the decision to self-insure should consider how the traditional capital markets price such risks.

Finally, public companies, in making self-insurance decisions, should consider the impact of self-insured risks on their long-term stock price. Upon a complete evaluation of these risks, a corporation's management may make the ultimate decision to insure some or all of these risks in a captive. Why? It may be as simple as management wanting to commingle low-frequency, high-loss risks with other more predictable risks. Such risks may be third-party unrelated risks, which in addition to providing predictability, also may enhance the insured's tax position and provide an additional revenue source. A potential downside of using a captive to underwrite these risks is that it must have sufficient capital to do so, not only for regulatory purposes, but also for income-tax deductibility.

Tax deductibility may not be achievable without several parameters being met by the captive. These parameters include, among others:

* having sufficient capital to underwrite the risks;

* having the liquidity to pay a claim, should it be necessary; and

* having little or no financial backing of other companies in the group.

Captive Capitalization

Thus, to underwrite high-loss exposure risks, the captive insurance company must have sufficient capital to do so. The increase in capital may present opportunities for management to appropriately match tax-efficient assets used to increase the capital needed to underwrite the risks. Again, management should look to the balance sheet of the insureds to see what assets are best utilized to fund these risks.

Capitalization of captives is perhaps one of the most difficult issues to solve, especially for captives assuming large risks. Many captive opportunities have "run out of gas" by failing to resolve the funding issue. An insured's financial-management group typically is elated when the analysis demonstrates the benefits of enhanced cash flows resulting from accelerated tax deductions. Elation may turn to gloom when discussing the capital needs of the captive to underwrite these risks. Can this be overcome or can a balance be struck between the two?

To begin, cash-flow enhancements are the result of income-tax savings through accelerated tax deductions from premium payments. Direct loans, on an unsecured basis, from the captive may be difficult to defend against a challenge by the taxing authorities. The insured would be vulnerable to circular cash-flow arguments. But properly matching the captive's assets with its obligations may present opportunities for the captive to invest its assets in a manner similar to how the assets would have been invested had they remained with the insured. The keys to success in investing such assets may be in securitization, liquidity to meet insurance obligations and asset/liability matching.

In determining the investment strategy of a captive, perhaps it makes sense to look at how noncaptive insurance companies invest premium dollars as well as paid-in-capital. A noncaptive insurance company typically would not make large amounts of uncollaterized investments, other than to invest in certain highly rated commercial paper offerings.

Would or should a captive's investment strategy be any different? The investment strategy of the captive should ultimately reflect the overall strategy of the larger group in which it coexists. Thus, in investing the captive's assets, management should do so in a manner that meets the cash-flow needs of the captive yet and is compatible with the overall investment needs of all the companies in the group. Given this, it seems reasonable to do so by becoming a securitized investor in its brother/sister company's assets. Securitized investments should be viewed as prudent if management is able to demonstrate a higher return on equity by investing the assets in the group.

In structuring captive transactions, it may take a combination of some or all of the strategies discussed above, plus others more fully discussed below, for management to agree that sufficient reasons exist to move forward. Conversely, an unmet insurance need could make cost justifications irrelevant if the only way to access an insurance market is as a purchaser of reinsurance. Many captive insurance companies in the 1980s were formed for just that reason. These companies are the typical underutilized captives that may be the best candidates to "tune up" to make them more useful financial vehicles or resources.

Other financial strategies to consider in tuning up a captive include efficiently utilizing the treatment of captives under state insurance laws. For example, a captive that is treated as an insurance company for federal income-tax purposes should under most circumstances be treated as an insurance company for state income-tax purposes. From a tax-efficiency perspective, the captive's earnings, both underwriting and investment generated, should enjoy a lower effective tax rate because most states do not tax the operating income (underwriting and investment income combined) of insurance companies. Thus, state tax benefits should be added to the list of captive financial-enhancement opportunities. For the states that do not assess an income tax on insurance companies, other taxes may be assessed in lieu of income taxes. Premium taxes are the primary example of such in-lieu-of taxes. Proper planning takes on a great deal of importance in these matters.

Producer-Owned Reinsurers

Remember the commercial, "Where's the Beef?" With regard to a captive, we ask, "Where's the PORC?"

PORC is an acronym for producer-owned reinsurance company. A PORC has historically defined a captive that reinsures risk of another insurance company with the owner of the PORC producing the insurance risk that is reinsured into its captive. PORC and third-party risk captives have been used somewhat interchangeably, but they are not synonymous. Third-party risk captives exist where the owner did not generate the business that is reinsured, which is the opposite for a PORC. It should be noted that most PORC business is a source of third-party risk.

A typical PORC reinsures credit insurance and/or warranty/extended-service-contract risk. Another example of a PORC would be an "agency-owned captive" reinsuring risk generated by the producing agent. How does a PORC fit within this discussion of using a captive as an enhanced financial vehicle? Simply put, without an insurance company, it may be legally impossible to share in any underwriting profits or losses. With the amount of commissions limiting the amount of upfront profits a producer may generate off the sale of an insurance product, a sometimes more tax-efficient substitute for a retrospectively rated commission program is a reinsurance agreement.

It is impossible to have a reinsurance agreement without an insurance

company. Accordingly, PORC business can add additional profits at perhaps a lower effective tax rate. It should be remembered that participating as a reinsurer exposes the producer to underwriting risk that would not exist without an insurance company, captive or PORC to reinsure the risk.

If the old pickup truck is not running like it used to, then it may be time for a tune-up. The captive tune-up process may include an analysis of insurance risks of insureds to determine if those risks can be rearranged to create tax efficiencies and/or create additional profit streams. If the insured has a captive within its group, then it may be possible to use some ideas listed above to more effectively use the captive. If no captive exists, then the management of the insured might look at ways to more efficiently and effectively utilize their self-insured risks by forming a captive.

Mark E. Anderson is a partner with KPMG LLP, where he is Risk Financing leader in the Stratecon practice.