Across Europe, companies have been struggling to contain or reduce costs. As the expense of employee benefits has skyrocketed over the last few years it is not surprising that companies have been taking a long, hard look at how to limit and reduce costs, manage risks and how best to finance benefits.
For most corporates, there are few opportunities to present savings that do not have some adverse effect on customers or employees. But one such opportunity may lie in using a captive insurance company to finance employee benefits. In the right circumstances, captive financing can offer savings in the order of 10-20%. They can also be a useful management tool to improve financial and other controls, cut through governance issues and design more flexible benefits for employees.
A captive is a wholly-owned insurance subsidiary used to insure or reinsure the risks of its parent or group. Captives have long been used in the general insurance area. There are now over five thousand captives worldwide – and the number is growing by several hundred every year. The use of captives to finance employee benefits has built up among European headquartered multinationals over the last decade or so. DHL Express Logistics, (now a division of Germany’s Deutsche Post) was the pioneer of using captives to finance employee benefits programmes, working with our firm from the start. It is still the world’s biggest for employee benefits.
US headquartered multinationals showed limited interest for much of that time due to regulatory issues, but those have lifted and interest has grown rapidly over recent years.
Captives offer a number of advantages. Cost savings are the most obvious attraction, stemming from two main sources:
q Reducing frictional costs: administration costs fall, especially if the captive is part of a global pool, but the big frictional costs that captives avoid are the profit margin that commercial carriers seek and broker commissions. And companies can often improve the investment return on reserves that are built up;
q Reducing the amount of risk coverage that the company pays for – typically companies find they can tolerate more risk than they carry when considered in an aggregate global basis.
The level of saving depends on the type of benefit, but overall companies report savings in the 10% to 20% range. At the same time, captives bring cash-flow benefits, as well as earnings on the investment of reserves accumulate ahead of claims.
From an HR point of view, though, the main advantage is the freedom to tailor the benefits for the company. Employers gain far greater control over what they offer and the quality of service they pay for. Importantly, employers get greater control over claims management and data warehousing, allowing them to react quickly and make changes to benefits plans where necessary, responding to employee preferences from country to country.
For most companies, the main objection to using a captive is their limited internal experience. But, in fact, most corporates have the necessary talent. Successful captives need three functional skill areas to work closely together: specialists in HR tailor the design and monitor the performance of benefits plans; risk managers determine the insurance requirements to fund them; finance manages the cash-flows to and from the captive.
Typically, these functional skill areas have different terminology and focus. The biggest challenge is internal co-operation. Many captive owners initially place responsibility for driving the captive in the hands of the risk management team who are generally nervous about, for example, HR aspects and benefits risk about which they have little knowledge. But, employee benefit risks are often more predictable than the other risks that they manage every day. Increasingly, companies are starting to share the responsibility between risk management, finance and HR people, through a multi-functional team. Furthermore, overseeing the captive’s operations usually requires new corporate and country subsidiary procedures and structures, which puts further pressure on the organisation’s cohesion. But companies are finding it is possible (because they are often globalising many aspects of their business) and the advantages make it worthwhile.
As companies become more familiar with captives as part of their employee benefits financing “toolkit” we are seeing companies considering whether they can help in a growing range of situations. For example, one major UK Plc has used a captive to address issues with relating to its UK disability benefits programme. Another major UK group has been considering whether a captive structure can help it add security to unfunded unapproved pensions for its UK executives. A third major corporation is actively considering whether a captive structure can help improve its financing of funded defined benefit pension plans in a number of European countries. Consideration of a captive alternative has enabled these companies to look away from traditional approaches to their issues and form a new perspective – which in turns helps managers assess and identify the optimal solution, even if it doesn’t involve a captive solution. For example, when one of our clients considered a captive solution the process of assessing the viability of the captive clarified the issues it was trying to address and we were able to point them to an alternative, non-captive solution that meets their objectives better.
There is a commonsense three stage process that corporates should follow:
q Determine which benefit plans are good candidates for financing with captive insurance;
q Develop the business case for captive financing of those benefits;
q Implement the captive while satisfying regulators and insurance partners.
Benefits are not uniformly suited to financing by a captive. Moreover, companies need to consider the mix of risks when designing the risk profile of the captive. For example, the characteristics of group life insurance and long-term disability – high premiums, predictable claim levels and for long-term disability, investment income from long-term reserves – are suited to captives. Medical cover for active employees, with low premiums and frequent claims, may be less attractive. However, this depends a lot on the country you are working on.
As with everything, risk and reward go hand in hand. So, while basic life insurance, long-term disability, accidental death and disability (AD&D) and active medical stop-loss are relatively easy for a captive to handle, they produce cost savings at the lower end of the spectrum. As you go up the scale of difficulty, benefits such as defined benefit pension plans and post-retirement medical could produce significant opportunities to reduce costs.
For most companies planning to introduce a captive, the choice of which benefits to include in the arrangements is usually driven by loss history and the type of benefit. But, with experience of operating a captive, about half of companies are as likely to include all risk-related employee benefits.
A feasibility study helps to identify which captive architecture is most suitable, which risks to carry and assess the merits of the potential captive against chosen measures. Short- and long-term operating profits for the captive and the net present value (NPV) of cash-flows from captive financing are standard benchmarks. These are driven by some critical assumptions including:
q Expected claims and payout patterns;
q Fronting fees to cover service of claims, other administration and commissions;
q Investment returns;
q Discount rates for NPV estimates;
q Operational expenses of the
As part of the financial modelling, a company should carry out a sensitivity analysis before reaching any decision to proceed. It should also take a realistic balanced view as to whether it has - or can develop - the interfunctional and international collaboration to make the captive work effectively. If - and only if - the business case stands up, the corporate can consider how to go about setting up their captive.
Companies can structure their captive in a number of ways, but each situation is unique. Relevant factors include the maturity of the programme, the design of the employee benefits plan(s), the geographical profile of benefits costs, the quality of services required, and the amount of risk retained.
The amount of risk retained is critical, since it determines the gains and exposure of the captive. The level is usually set by the company’s philosophy on risk. Companies tend to cede between 75% and 100% of group life assurance, long-term disability, and AD&D. For medical, organisations are inclined to take an either none or all approach to ceding this risk to the captive. Captives can also be used to address specific challenges (eg disability insurance) or for re-organising pension plan risks to help hedge all or part of the risk.
The most common structure is to use a fronting insurance company (“fronter”) to insure the underlying financial risk at a local level, which then reinsures the risk, transferring it – and the premiums – to the captive. This is a common approach when a company needs a licensed insurer to issue local policies in different countries, or if it needs the expertise and administration of direct insurers.
Another important question for corporates concerns the treatment of monies that are left in the captive after paying out for the year’s claims. Direct or reinsurance captives usually hold claim reserves (in countries where law permits it) rather than having them held by external insurers, or reinvests funds in the parent company.
Where a fronter is required, corporates typically use an insurance network. This is a working arrangement between subsidiaries or affiliated insurers through which a multinational company can obtain various kinds of employee benefit cover on a worldwide basis. But using local, independent insurers as fronters is also an option. However, this is not used often. Administration costs tend to be higher and more complicated, and there is limited negotiating power for the sponsoring multinational if it uses unaffiliated insurers in different countries. When selecting a fronter, companies tend to rank flexibility, quality, reputation and geographical coverage more highly than favourable contract terms or even experience working with captives.
So far the number of companies that have set up a captive to finance employee benefits is small, with 30 or so already operating them. But the figure is set to grow quickly with great interest in both Europe and the US.
Considering an average business case, an organisation with 5,000 or more employees and benefits premiums over €5m seems to be the threshold of viability. The more geographically spread the better, because this reduces exposing the captive to severe losses caused by major events in one location. Experience shows when a company launches a captive for use for employee benefits in one country, it invariably increases the number of countries in the programme subsequently.
It should be re-emphasised that captives will not be suitable for all firms. Nor should it be assumed that companies can only embark along the path of assessing the applicability of using captives if they have perfect knowledge of their benefits programmes, claim histories and have articulated a clear company-wide philosophy of risk appetite. Experienced experts – such as Towers Perrin – can help companies understand quickly and easily the main pillars of data and knowledge with which to assess a possible business case – for captive solutions or other more suitable vehicles. It is possible to begin a feasibility - or even a pre-feasibility study - with only partial knowledge of an organisation’s benefits and only a selection of its risks in the key countries the organisation operates in.
Over time we expect it will become easier to establish captives in Europe to fund employee benefits. It is likely that regulations will be relaxed to allow more risk-based benefits to be included in a captive, in particular concerning the handling of reserves.
While not ideally suited to every company, there are enough advantages for many European corporates to consider assessing the business case. And the assessment process may reveal other ways to address employee benefits challenges.