Multinational companies that want to reduce the costs of their employee benefit programmes – and perhaps enhance the benefits of their employees – are looking with increasing interest at the use of captive insurance companies.
A captive insurance company, or ‘captive’, is a subsidiary company formed to insure or reinsure the risks of its parent. Companies usually set up captives to provide alternative risk management solutions to those offered by the conventional insurance market.
For the past 30 years companies have used captives to underwrite their own insurance or to underwrite specific insurance risks for third parties. However, in the past five years a handful of multinationals have broadened their use to include employee benefits.
The chief attraction of captives is their potential to reduce costs. It has been estimated that a company with a captive can achieve immediate savings of between 10% and 15% on its employee benefits premiums through reduced charges to brokers, economies of scale, and increased cash flow.
Yet the idea of using captives for employee benefits has been slow to catch on. The consulting group Towers Perrin estimates that currently only 25 companies worldwide finance employee benefits through a captive.
Many of these are based in North America. One of the early pioneers was RJ Reynolds – now part of Japan Tobacco. The Toronto-based company , which operates in 170 countries with total risk benefit premiums of $5m (E4m) a year, set up a captive insurance company in Dublin in 1998 to manage the risk of its employee benefits programme.
The company says it chose Dublin as a captive domicile because of its financial services structure, the ability to take advantage of EU regulations on cross-border insurance and proximity to many of the company’s operations.
HJ Heinz, the Pittsburgh-based food processor, is also using Dublin as the domicile for its captive Noble Insurance. Heinz created Noble Insurance in 1996 to handle the company’s property and casualty risks. Noble’s role was expanded two years later as part of the reorganisation of Heinz, which included the consolidation of various employee benefits plans covering 45,000 employees worldwide.
Heinz says it sees its captive as “an emerging business tool” for its employee benefits. Captive managed benefits include a global defined contribution pension plan with Fidelity, and a defined benefit (DB) pension plan for employees who are likely to move frequently between the company’s overseas locations.
Europe-based multinationals have also shown an interest in captive-financed benefits. Last year, Svenska Cellulosa Aktiebolaget (SCA), a Stockholm-based packaging and consumer products company set up a Dublin-based captive, SCAR as part of a programme to cut the costs of employee benefits without reducing their value to its 40,000 employees.
There have been problems, however. Around 5,000 of SCA’s employees are based in the US. Until now, one of the obstacles multinationals have faced when considering financing employee benefits through a captive are the restrictions the US places on the use of captives for employee benefits.
The Employee Retirement Income Security Act (ERISA, the federal law governing employee benefits), prohibits transactions between a subsidiaries of a parent company and its employee benefits plan. This includes using a captive to finance corporate employee benefits. As a result the Department of Labor, which implements ERISA, insists that for employee benefits to become part of a captive insurance programme, 50% of the premiums paid the captive company must come from ‘unrelated’ exposures – in other words business other than a company’s own corporate risk management programme.
However, in 2000, in a breakthrough ruling, the Department of Labor granted Columbia Energy a prohibited transaction exception (PTE) for the use of a captive to finance its employee benefits. A year later, another company, Archer Daniels Midland, obtained a PTE for its plan to fund life insurance plans through its captive. These exemptions have opened the way for US-based multinationals to set up captives for employee benefits in the US.
There are signs that interest in captives may be now quickening worldwide. In Guernsey, one of the leading offshore domiciles for captives, the insurance division of the Guernsey Financial Services Commission (GFSC) has noted an ‘upsurge’ in the number of companies using Guernsey-domiciled captives to manage the risks of their employee benefits programmes and suggests that this is the beginning of a trend.
“The new development of placing employee benefits within captives is expected to be increasingly used by multinational companies employing numerous expatriates whose peripatetic life styles exclude them from their own notional pension and social security schemes or other state schemes operating in territories in which they work,” the GFSC says.
This is borne out by the results a survey by Towers Perrin, ‘Use of captives for employee benefits’ published in February. The survey covered 60 Fortune 500 multinational companies drawn from 10 industries in North America and Europe.
The survey reveals growing interest among multinationals in using captives for employee benefits. Currently 13% of the multinationals who responded to the Towers Perrin survey use a captive for employee benefits. A further 25% are currently in the process of implementing a captive, while 35% say they will consider looking at captive involvement within the next two to five years.
The companies that currently use captives for employee benefits, and companies that are considering doing so in the future, were asked to rank the three most important reasons for using captives for employee benefits. Most ranked ‘cost savings’ and ‘improved cash flow’ first or second. Some US companies rate ‘tax advantages’ as the main reason. Most companies also cite their ability to customise benefits coverage and improve central co-ordination of benefits programmes as important reasons for setting up captives..
One in three companies with captives say that the use of a captive has achieved cost savings of more than 20%. Half of the companies report savings of up to 10%. Six companies report improved central co-ordination and control of life insurance as positive outcomes of using a captive for employee benefits and five report improved cash-flow.
Sofia Tesfazion, a Towers Perrin consultant and former benefits manager for SCA, says that cost savings are achieved by the reduction or elimination of external insurance company risk charges and brokers’ commissions and through economies of scale in group purchasing of administration or service.
“Notably employers that use captives to finance employee benefits enjoy greater control over these programme costs and have direct access to all relevant information that can further enhance cost control”, says Tesfazion. “We expect the interest in captives to grow even more as organisations continue to face cost pressures.”
The reasons why multinationals have been slow to adopt the idea of using captives for their employee benefit programmes are human rather than technical, the survey suggests. Companies that currently use captives for employee benefits, and companies considering doing so in the future, were asked to rank the three greatest challenges they faced – or expect to face – setting up a captive. The greatest reported challenge is the lack of personnel experience within the company.
“Risk management departments don’t usually deal with employee benefits and HR professionals are often not exposed to risk management techniques and captive strategies,” says Tesfazion. “This can lead to internal conflict when pursuing a captive strategy for employee benefits.”
Last year Towers Perrin helped the beverage and confectionery giant Cadbury Schweppes establish a captive for its employee benefit programme. ‘Actually implementing a captive insurance programme can be very challenging, as it usually introduces a whole new way of working together between the centre and the country units, as well as among the risk financing and HR functions,” says Karel Leeflang, Cadbury Schweppes’ international rewards director.
Size is also an issue. A company must be the right size for a captive to be profitable. Towers Perrin says experience suggests a captive arrangement would suit a company with a minimum of 5,000 employees and a sizeable benefits premium. Companies should also have a broad geographical reach to spread the risk.
Among the multinational companies in the Towers Perrin survey, companies that have set up a captive have workforces covered by the captive ranging from 7,600 to 150,000 employees, and premiums ranging from E566,000 to E16m. One company has employees in only one country covered by the captive, while another covers staff in 85 countries.
Captives are not a ‘one-size fits all’ solution for companies’ employee benefits programmes. Pooling, or a combination of captive and pooling, may be more suitable. However, their use is clearly becoming more attractive to an increasing number of multinationals in the US and Europe.