Keeping benefit risks captive
Corporate pressures to improve cash flow and profitability, initially responsible for substantial growth in the multinational pooling of insured employee benefit risks, have inevitably led to an increase in the financing of these risks through employer-owned captive insurance companies.
While both multinational pooling and captive employee benefit risk financing programmes are a reflection of the corporate need to reduce the cost of insured benefits, the latter received an added impetus from what might be termed the self-insurance imperative".
The first objective of employee benefit risk financing is to minimise the net cost of benefits. This is consistent with the overall strategic aim of a business to determine the lowest cost of risk in relation to any kind of corporate exposure. The feasibility of self-insuring all, or part, of the benefits should therefore generally be considered before insurance. Self-insurance is immediately beneficial to cash flow, and avoids unnecessary costs such as insurers' expenses and profits. Capacity for absorbing losses internally will depend on:
q an acceptable degree of variation in benefit claims - the larger the "life exposure" and/or the more frequent the payments (ie, income benefits as opposed to lump sums) the lower the variation in claims, and
q the availability of tax-efficient "in- house" corporate risk-funding vehicles such as corporate-sponsored pension funds and captive insurance companies wholly owned and controlled by the corporate group.
The uses of a pension fund for financing employee benefit exposures are more limited than might be thought. The main exposures are in respect of mortality, longevity, morbidity, medical and accident risks. All these risks are "pure" risks, not speculative ones. The investment risks in respect of retirement benefits are not normally included. The exposures relate to what are usually termed "risk benefits", the most common of which are those payable in respect of death in service, short-term sickness and long-term disability, medical and hospital expenses and personal accident.
Of these, only the death benefits are suitable for self-financing in a pension fund, and then only if the fund is of the defined benefit type ie, with "free reserves". Pension funds operated on defined contribution principles do not normally have "free" (or "unallocated") reserves which can be used to finance death benefits. Although there is nothing in principle to prevent the establishment of a death-in-service benefit reserve in such a fund, this is not likely to be practical. Similar problems arise in the case of newly established pension funds providing defined benefits (particularly "unapproved" retirement benefits schemes), which often have no reserves at the outset. Also, a considerable number of UK companies do not have a pension fund, preferring to provide personal pension arrangements as the only form of retirement savings for their employees.
In most of these cases, a captive insurer (usually, for reasons of tax-efficiency, situated offshore) is likely to be the appropriate corporate risk funding vehicle provided there is sufficient exposure to loss to make self-insurance feasible.
As previously mentioned, the investment risk in respect of pension reserves is normally carried by a pension fund and reinsurance of any part of this risk to a captive insurer has probably been rarely attempted. Nevertheless there is no reason in principle which precludes such a reinsurance. The only obstacles are the practical ones of restrictive tax and insurance regulatory regimes, and the possible conflict of interest between sponsoring employers and their pension trusts or foundations. However, with the increased "globalisation" of national economies and the further liberalisation of tax and insurance regulatory regimes, it is quite conceivable that captive insurance companies, situated in a tax-efficient offshore jurisdiction, could become global pensions asset management vehicles of great strategic value to multinational corporations.
Underwriting risk though a captive is one of several options for the retention of risk. Others include the payment of losses from a revenue budget (normally only appropriate for small predictable losses) or the establishment of a balance sheet reserve or internal fund. These methods, however, may not be tax-efficient, since sums transferred to reserves in anticipation of future losses are not normally tax-deductible in the same way as insurance premiums. By contrast, premiums paid to a captive insurer will qualify for tax relief in most jurisdictions (being paid, if necessary through a fronting insurer).
The cost-effectiveness of self-financing through a captive insurer, compared with retention through a revenue account, balance sheet reserve or internal fund, can be gauged from a straightforward analysis of cash flows under each option. This would compare corporate internal rates of return and loss payments (net of tax relief) under the internal funding option with capital and premiums (net of tax relief) and returns (after tax) under the captive option.
The principal ways in which a captive can reduce the cost of risk can be summarised as follows:
q lower risk premiums, as captives operate with lower margins (ie, contingency, expense and profit loadings) than commercial insurers;
q enhanced cash flow, since premiums stay within the corporate group until paid out as claims;
q tax-efficient investment of reserves;
q direct access to the reinsurance market, which provides cover at a lower cost than most primary insurance markets;
q financing capacity for risks for which cover is not available in the local insurance market, and
q co-ordination of corporate risk treatment strategy, including the establishment of formal strategies for risk reduction and control.
The first five items have a direct effect on the cost of risk, being immediately beneficial to cash flow. The final item is primarily organisational and confers a financial benefit which indirectly feeds into cash flow.
Employee benefit risk financing through a captive is usually a corporate strategic decision, the main advantages for the captive being:
q diversification of its risk portfolio;
q increased capitalisation of the captive due to the addition to its funds of employee benefit risk reserves, and
q involvement of the corporate risk management function in the treatment of employee benefit risks.
The transfer of employee benefit risk premiums/reserves should contribute to the efficient resourcing of the risk financing needs of the corporate group as a whole.
The kinds of arrangement established to enable captives to participate in risk-benefit financing fall into two broad categories:
q reinsurance to a captive of part of the risks of a multinational pool, and
q reinsurance to a captive (either directly or through a fronting insurer) of risks under a company's death, disability or medical plans.
Virtually all forms of reinsurance transacted in the commercial reinsurance market (whether proportional or non-proportional) can also be applied in cases where a captive reinsures part of a multinational pool, or where it reinsures a benefit plan on a "stand alone" basis.
The table illustrates the insurance to a captive (on a 100% quota share basis) of a 1,200-member death-in-service benefit plan. The analysis of premiums, expenses and claims over a five-year period shows how the strategy benefited cash flow.
Premiums were payable to a fronting insurer annually in advance and were remitted to the captive, situated in an offshore jurisdiction, within 24 hours of receipt. Claims were reimbursed to the fronting insurer within 24 hours. The stop-loss insurance covered aggregate claims in each policy year exceeding the captive's self-retention limit of 110% of total expected claims.
Through the captive reinsurance arrangement the corporate group was able to achieve an improvement in cash flow and a saving in insurance costs of just under £2m over the five-year period.
The statistical evidence1 shows that, despite soft insurance markets and hostile action from tax authorities and insurance regulators, the number of corporate-owned captives continues to increase. The captive insurance company has proved to be a corporate risk management tool of great flexibility and subtlety.
Tony Salter is a consultant in the pay and benefit division of Bacon & Woodrow, part of Woodrow Milliman
1 Captive Insurance Company Reports, January 1997, Tillinghast Towers Perrin."