Using captives to manage the risks of employee benefit programmes is becoming increasingly attractive to employers, providing cost savings and greater flexibility. Companies have traditionally used captives to finance a variety of property and casualty risks, underwriting only their parent company’s insurance. Recently, however, there has been a growing trend of companies using captives to fund and manage certain risks associated with their employee benefits programmes.
There are a number of real and perceived reasons why captives have not been used for employee benefits in the past. These include:
q benefits financing decisions were made by human resources (HR) personnel who were, in general, unfamiliar with the idea or workings of captives;
q conversely, risk management personnel were generally unfamiliar with employee benefit obligations;
q insurers have been reluctant to create products to support the inclusion of benefits in captives;
q the volume of employee benefit premiums has been small in comparison to property and casualty premiums; and
q competition in the commercial insurance marketplace has provided relatively inexpensive cover, thereby minimising any significant cost savings in using a captive to fund employee benefits.
In addition, there are various legislative, regulatory and institutional obstacles to the use of captives for employee benefits on both sides of the Atlantic. In the EU, work councils and unions have often negotiated precise requirements regarding the types of benefits employers should provide and how they should provide them. In the US, the Employee Retirement Income Security Act (ERISA), Department of Labour rulings and the Internal Revenue code have limited the extent to which captives could be used.
There have recently been a number of encouraging signals from regulatory agencies, however, indicating that they are now taking a more flexible stance towards employee benefits in captives. This situation has spurred interest, especially among risk managers, in including benefits in captives. Also, trends in the structure and spending patterns of large corporations have begun to make the incentives for using a captive to fund employee benefits much greater. Broadly these trends have been:
q that the amounts of money large corporations spend on pay and benefits has been steadily increasing. The economies of scale involved in bringing employee benefits into captive programmes have consequently improved;
q workforces are becoming increasingly international, particularly the growing number of internationally mobile employees (IMEs). Captives make an ideal funding vehicle for the employee benefits of such a workforce.
The formation or continuation of a captive gives a company, in a range of different ways, greater control and flexibility over the costs and risks associated with its insurance needs. With respect to employee benefits, the most important advantages are discussed below.
Cost savings Depending on various factors, a company may realise immediate savings of 10–15% on its employee benefits premiums on the basis of reduced charges to brokers, consolidation, cash flow and pooling. Where employee benefits are subject to a tariff, the captive can be used to capture, for the benefit of the corporation, the difference between the tariff rate and the economic cost of cover. There may also be present value cost savings on the tax deductibility of benefit premiums. Furthermore, depending on the amount of employee benefits in the captive, a company may also strengthen its case for tax deductibility of property-casualty premiums. It is generally good practice to pass cost savings made through the use of a captive to the participating employers in the programme and their employees.
Risk smoothing The risks associated with employee benefits and property and casualty exposures are, in general, not correlated. Therefore, a captive may be able to smooth its overall risk profile by diversifying its portfolio into employee benefits. This combination of different risk streams may also allow the captive to take on more total risk or reduce its capital requirement.
Increased flexibility Insurance companies to whom benefits insurance is outsourced will normally only pay a claim if the criteria specified in the contract have been strictly met. By using a captive the company has the option of choosing to pay a benefit regardless of whether the claim strictly meets the interpretation laid down in the rules. For example, the captive arrangement can provide useful leeway to the parent company in managing certain death or disability claims, subject to compliance with relevant regulations.
Data stores Captives provide useful “warehouses” within which data about a company’s overall risk exposure can be stored and analysed. This use is particularly pertinent to the employee benefit risks of large multinational organisations, as it enables them to build risk profiles of diverse international workforces. A captive has an advantage over pooling in this regard, because it allows faster access to the data. Often with a pooling arrangement there is a lag of several months before the company receives relevant information. This limits a company’s ability to react to changing circumstances. Funding benefits through a captive provides greater control and access to the data, allowing the company to immediately take necessary corrective action.
Tailored annuities Captives are able to provide retiring employees with annuities at advantageous rates (usually achieved through a fronting insurer), giving higher yields and lower costs than those typically available. These better-than-market rates can be realised by the captive choosing to absorb more risk through reinsurance.
Internationally mobile employees (IMEs) The main advantages in using a captive to fund employee benefits for IMEs include:
q that they allow benefits to be easily transferred between plans held in different countries; and
q the flexibility they offer in terms of the benefits (particularly annuities) that can be provided to members. For example, there are a number of offshore life insurance programmes that can be structured according to an employer’s and employees’ wishes. The captive can either issue a group annuity to a trust formed by the employer, or a deferred annuity directly to the employees.
Increased efficiency of multinational pooling The efficiency of a company’s multinational pooling arrangements can be greatly enhanced when used in conjunction with a captive. The captive reduces the pool’s costs through the minimisation of administration charges and the removal or reduction of risk and profit charges.
Customised benefits A captive enables a company to finance optional or voluntary employee-paid benefits such as family health and life insurance, spouse’s pensions, long-term care and other lines of personal insurance. Fronted by an insurer and reinsured by a captive, a company can enhance the employee benefits it offers while also enjoying the underwriting and investment profits of the insurance programme.
Employee benefits that are particularly suited for inclusion in a captive insurance programme tend to be long-tailed exposures that are relatively predictable through actuarial analysis. Examples of such benefits include :
q unfunded deferred executive compensation and supplementary executive compensation;
q post-retirement medical insurance;
q personal property/casualty insurance (eg, home and auto coverage for employees);
q group term life insurance;
q group universal life insurance; and
q total health management (integrating disability, workers compensation, health insurance and long-term care).
Using a captive to fund employee benefits will, particularly at the set-up stage, require parts of an organisation that do not typically work with each other to do so. This will include treasury, finance, tax and legal staff but will primarily involve staff from human resources and risk management.
These two groups are typically inclined to have different objectives and different strategies. Human resource managers are traditionally interested in the design; administration and cost of employee benefits whereas risk managers are interested in analysing, controlling and financing the company’s overall risk program.
Risk managers may have other concerns and reservations with regard to extending use of the captive to employee benefits. For example:
q if a company is already successfully running a captive for its property and casualty exposures, the risk manager may not wish to incorporate new and unknown risks.
q the employee benefits premium volume may not be sufficient to include in the captive solely on the grounds of smoothing the overall risk profile. For this to be the case, the risk manager is likely to require benefits premiums to reach 10–15% of the total premium volume before bringing it into the captive.
There may be a need within some organisations to raise awareness of mutual opportunities for risk management and human resources staff, and provide education on the objectives and obligations of the two functional areas of the organisation.
Client case study: RJ Reynolds
RJ Reynolds (now part of Japan Tobacco) is a Toronto-based company operating in 170 countries with over $3bn in revenue and risk benefit premiums totalling around $5m a year. In 1998, management decided to set up a captive insurance company to manage the risk associated with its benefits programme more efficiently.
It was projected that the company would benefit from this strategy by:
q avoiding paying insurance company risk charges;
q negotiating down administration fees; and
q investing reserves and cash flow at a higher rate of return.
Reynolds took the view that none of its local HR managers, who were relying heavily on local brokers and agents, would be forced to join the new arrangement. Instead, the local managers were asked to meet with representatives from the fronting insurance company, AIG/Winterthur, and to satisfy themselves that their price and service needs would be met. They were also assured that all profits would be retained and fed back to the operating entities in the form of lower premiums. In the end, every one of Reynolds’ local HR managers chose voluntarily to join the programme.
The company selected Dublin as the 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. The largest problem faced by the company was actually finding an appropriate reinsurance provider. It found the market to be insufficient for its needs and in the end not able to provide all the cover it wanted.
Two major lessons emerge from Reynolds’ successful experience and quick set-up time (it took the company around seven months to complete the entire project). The first is the importance of communicating with all involved at the earliest opportunity, getting the operating companies on board as quickly as possible. Secondly, success was dependent on creating a co-operative environment. By establishing communication and co-operation early on the company was able to manage an intrinsically diverse project smoothly and efficiently.
Approach and measurement
There are several key points for a company to bear in mind when using a captive to fund employee benefits:
q generally, it is best to operate the captive on a break-even underwriting basis, returning profits back to the participating employers and employees. This may be accomplished through dividends or through reduced premiums;
q the captive must maintain surplus and capital ratios appropriate for the risks and the regulatory requirements of the captive domicile;
q when bringing in employee benefits to an existing property-casualty captive, the company should be careful to moderate its initial risk taking until it is experienced enough to know how these risks will interact with the captive’s existing risks. Underfunding may not be a problem for employee benefits plans (many programmes are already unfunded or underfunded), but it is an issue for insurance regulatory compliance and policyholder financial security.
Captives can increase a company’s flexibility with regard to benefit design and risk management. They can also reduce a company’s risk and benefits costs. This is not to say that a captive is the right solution for every company.
The funding of employee benefits through a captive is likely to involve people from a number of different functional areas through the organisation, particularly human resources and risk management. Experience shows that communication and Cupertino are essential success factors. Ultimately, the inclusion of benefits in a captive should be strategically designed to improve benefits, reduce costs and better align a company’s human resources strategy with its financial goals.
Stephen Mork is a senior consultant in the Employee Benefits International Practice of Towers Perrin in London