With an increased focus from both human resources and finance on cost-effective employee benefit programmes, we continue to seek ways to contain cost while maximising benefit attractiveness. Increasingly, companies are resorting to the next level of creativity in order to squeeze the bottom line costs, without neces-sarily taking away from employees’ benefit packages. Factors such as hardening insurance markets, lower interest rates and tough economies are accelerating these activities.
How is it possible to reduce benefit costs further, without taking something away? How much cost reduction can be achieved in this way? What other advantages can be achieved through creative restructuring? What do we do next, we hear you say.
In 2000, we asked international insurance networks about their experience with captives; particularly, the use of captives to reinsure multinational pooling arrangements. We were somewhat surprised to learn that the pooling networks have a lot of experience with captives. In fact, the seven networks that responded to our survey reported 22 pooling arrangements reinsured to captives with annual premiums totaling nearly $70m (E76m). Another 11 pooling arrangements involved the captive in a passive manner by having the pooling agreement issued to the captive without the captive assuming any risk in the pool.
Our own survey of captive owners in 2001 did not reveal this level of activity. The survey asked whether captives are involved or intend to be involved with multinational pooling. Of 112 respondents, only 3% told us they are presently involved with pooling. However, 29% said they were likely to become involved with pooling within the following 24 months.
We have seen varying degrees of interest in the use of captives with employee benefits over the years. There has always been a steady level of interest, but whilst economies were growing, and interest rates and merger activity levels were reasonably high there was less activity using this route as a potential ‘quick win’ on costs. Now, the feeling is changing. Companies are looking to the longer term and at a more strategic level, to examine potential financing structures which will endure for a wider time horizon.
Clearly, there is an interest in using captive insurance companies to reinsure multinational pooling arrangements. Why is this?
Our survey of captive owners told us the number one reason is to achieve cost savings. This was followed in order by the need to improve global management of benefits insurance, to maximise tax effectiveness of the captive, and to stabilise the risk portfolio.
Let’s look at each of these reasons in light of practical realities.
Not surprisingly, the desire to achieve cost savings on benefits insurance aligns with what captive owners told us is their number one business strategy for using a captive: reducing the cost of risk. Captives are in the business of insuring risks of the parent and subsidiary companies as an alternative to traditional insurance markets. Captives assume risks that traditional insurers either will not assume or will charge more for coverage than the insured is willing to pay. Being in the insurance business, captives have direct access to the reinsurance market and can structure the optimum coverage of risk at the lowest cost. They can also structure contracts which may not otherwise be available in the same form and, of course, make them easily accessible to the sponsoring employer.
But pooling is a traditional insurance programme and has been widely used for many years. International insurance networks simply agree to experience rate the losses for each group insurance contract that participates in the pool. The sum of the experience from all participating contracts results in the pooling balance: either a surplus or a deficit. Surplus is payable to the parent, or at the direction of the parent. The network retains the deficit, usually by carrying the losses forward to be recouped from surplus in future years. Nothing new here.
The pool does offer an efficient programme for delivering potential cost reductions on group insurance by spreading risks across a number of contracts and countries, and paying surplus in the form of dividends. In fact, Mercer’s pooling database* indicates an annual pooling dividend of at least 3% of annual pooled premiums. This is an average figure compiled from over 600 pooling accounts. Many pools, however, which are actively managed, pay an average annual dividend of 10 to 15%. Employers may be missing a trick if they simply do not get actively involved in the management of their pools: 10 to 15% of annual insurance premium on employee benefit programmes is simply too good to be ignored.
Where does the captive fit into this equation? This is where we start to break into the next level of creativity. Is it possible the local network insurers are charging more than needed to support claims and expenses? Is this the source of the surplus? Is the network charging the pool higher expenses than needed to cover the cost of administration, risk and profit? Is the rate of interest credited to cash flow and reserves competitive in the market?
A captive that reinsures an existing multinational pool ie, no disruption to existing coverages at all, can reduce the costs of pooling even further, in a number of ways:
o First, reinsuring the pool reduces or eliminates the risk charge that networks impose to protect against termination of the pooling agreement when the pool has a deficit balance. Under what is called a ‘captive retention’, the captive agrees to assume all or a portion of the deficit, typically if and when the pool is terminated. Since the captive has ultimate control over when the pool terminates, there is little or no additional risk involved to the captive, and the captive receives the surplus when the pool has a positive balance.
o Second, a captive can negotiate lower premium rates with the network insurers whose group insurance contracts participate in the pool. For instance, in return for agreeing to reinsure the pool, the captive negotiates a 5% premium reduction for all local insurance contracts. This creates an incentive for local management to insure with the local network insurer, and ensures a high rate of participation from all the parent company’s locations.
o Third, the captive may negotiate to eliminate all incurred but not reported (IBNR) claim reserves, where legally permitted. These reserves are retained by the local network insurers to protect against claims that may become payable after a local group insurance contract is cancelled. Since the captive is assuming the risk from the pool, the local network insurers may continue to charge claims to the pool in the event of cancellation. IBNR reserves typically equate to between 25% to 30% of medical insurance premiums, and 25% to 50% of disability insurance premiums.
In addition, captives may also negotiate to hold all reserves for ‘long tail’ claims, such as survivorship and disability income benefits. The local insurance network advises the amount of the contractual claim payment owed to the beneficiary, along with the locally prescribed present value of future payments, and the captive sets up the reserve on its books. The captive then assumes reimbursement to the local network insurer for the claim payment. This has a double advantage: the captive will charge the claim reserve against its income to reduce any tax liability, and can also invest the reserve for a higher rate of return than may be available from the local network insurer. The fact that there is no claim reserve charged to the pool also creates greater potential for additional surplus.
The need to improve global management of benefits – good governance – raises the question about how benefits are actually managed by global companies. This can be answered in two words: not well. In fact, most global companies have little or no idea, or under-standing, of the benefit plans offered to employees outside the home country. Moreover, in spite of the widespread use of multinational pooling, few global companies pay much attention to the benefits insured by the local network insurer. Why is this, particularly in an environment that is becoming more and more open to scrutiny over governance procedures?
Networks offer pooling without charge to their clients. Many pools have been established as a ‘convenience’ to the network and the client. Where group insurance contracts ‘happen’ to be placed with the network insurers in at least two countries, the network will offer to pool. The client need not take any action to initiate the pool; the network does not require consideration from the client to establish the pool. In fact, the client has nothing to lose, since the network agrees to return surplus when the pool has a positive balance and does not require the client to repay a deficit when the pool has a negative balance. Since the client has nothing invested, the client typically pays little attention. As stated earlier in this article, this could mean the difference between the average pooling savings of 3% and the potential pooling savings of 10 to 15%, which we know to be the types of savings to be made in an actively managed scenario.
How could this be improved through involving the captive? When it reinsures the pool, the captive has a vested interest in the pool’s performance. Being an insurance entity, the captive understands the need for large numbers and diversification of risk. The captive will want to look carefully at the benefits being insured, and encourage local management to participate in the pool by contracting with the local network insurer. This can be done by creating incentives through improved underwriting terms and conditions offered by the network, and, as noted, using the network to competitively price the insurance contracts.
The captive can also request more frequent updates from the network on benefits insured, (quarterly rather than annually for example), and share this with human resource management for further understanding of claims experience and action to ensure these programmes align with the company’s HR strategy. Can you imagine how much easier it would be to understand and manage poor claims experience by the simple provision of more regular information? Again, this doesn’t involve changing benefits. What it does provide, however, is another potential cost-saving device with no disruption to the present arrangements.
Many captives view an aggressive tax strategy as essential to their overall business plan. Captives owned by US parent companies for example, are aware of the need for so-called ‘non-related’ business in order to be considered a bona fide insurance company. When a captive has sufficient non-related business, the parent company can deduct from its taxes premium payments to the captive for otherwise self-insured risks, such as workers’ compensation. This can save the parent company considerable money, while also retaining its control over finance of the risk through the captive. The captive can set up reserves for claims, and deduct these reserves against its own taxes to further improve the overall tax situation.
The US Internal Revenue Service (IRS) has ruled that benefits payable to employees (such as disability income) will be considered third-party business. Most insured benefits meet this test. Those insured benefits that do, and participate in multinational pools, qualify for a fairly large chunk of non-related business. Accordingly, captives that have an aggressive tax strategy underlying their business plan will perceive good value from involvement with multinational pooling.
The interest and use of captives in 2002 is growing rapidly in response to the ‘hardening’ of the conventional commercial insurance market. The insurance industry is undergoing radical change, with fewer underwriters offering liability products and steep price increases from those who remain. The reinsurance market is both a cause and effect of these changes. Reinsurers refuse to offer coverage to their insurance clients, causing these insurers to leave the business or increase rates; at the same time, reinsurers are forced to retreat from the market due to losses incurred from their insurance clients. In this situation, captives become a very important alternative for risk transfer.
However, as captives take on more liability risk there is the danger of managing an unbalanced portfolio. With the known difficulties of obtaining reinsurance, captives need to diversify their underwriting portfolios. Employee benefits offer an excellent opportunity to diversify risk in the captive portfolio, particularly mortality-based benefits such as life insurance. Since multinational pooling consists of an existing portfolio of benefit risks, involvement with pooling can bring greater risk stability to the captive.
Caution is needed to ensure that the risks in the pool are diversified and stable before the captive is engaged. Accordingly, the pooling arrangement should be reviewed for performance over several years, and every attempt made to include all eligible locations where the most stable risks are identified.
So, what should we do next? Technology helps us here. Historically, pulling together data on employee benefit programmes around the world could take many months, if not years. Now, at Mercer we have access to web-enabled pooling data gathering tools to make the process short and effective. Only a minimum amount of data is required to assess and predict:
o Potential pooling dividends and savings opportunities;
o Captive feasibility savings to consider as a second layer in the cost effectiveness equation.
It is well worth investigating these possibilities now. The sooner they are quantified, the sooner you can begin to save more on costs and consider how the savings might be applied. A feasibility study can pay for itself in a very short space of time, and the new cost-effective structure is likely to endure for the long term.
*Mercer’s Multinational Pooling Research Study 2001/2002, the second annual global client study of pooling practice, including the results and analysis of multinational pooling arrangements for over 100 multinational companies. The third annual version is currently underway and should be available for publication by June 2002. For further information contact Janet Whyte, Mercer HR Consulting (London) on 020 7963 3301.
Paul Shimer and Yvonne Sonsino are with Mercer Human Resource Consulting in London