Alternative Attractions

The common complaint of many commercial insureds is that their insurance coverage has become too expensive. Alternative risk management structures therefore provide a way to potentially reduce the cost of insurance.

Under the latest hard market cycle, self-insured retention programs gained considerable popularity. Under these types of arrangements, an insurer issues a policy from first dollar to the insured. However, there is normally a deductible reimbursement agreement that indicates that the insured will reimburse the insurance company for a specific amount of each claim. Under a typical arrangement, the insured might agree to reimburse the insurance company for the first $250,000 of every loss. Under such an arrangement, the insured will normally handle its own claims if it is clear that they will be below the deductible reimbursement amount limit.

However, it is necessary for an agreement to be reached with the insurance company as to how claims that have the potential to exceed the deductible reimbursement limit will be handled. It is common for the insurance company to require that its claims department must be involved in claims that have the potential to exceed the deductible reimbursement limit. One of the advantages of self-insured retention and deductible programs is that they reduce the overall amount of premiums paid to the insurance company which also results in a reduction of premium and sales taxes. Another benefit is that the insured gains greater control in the handling of most claims.

Furthermore, the insurer maintains a certain amount of risk in that, if it is unable to recover the amount of the deductible from the insured, it will still be responsible for third-party claims. It is typical under deductible reimbursement arrangements for either a letter of credit or a trust account to be established to provide security to the insurer.

B.C. OPTION

For a number of years, legislation has existed in B.C. allowing the establishment of captive insurance companies to insure the risks of a group of companies. It is not possible for a B.C. captive to insure third-party risks.

A big disadvantage of B.C. captives is that they are not recognized as being eligible for licensing in other provinces. Plus, the underwriting profit and investment income from a B.C. captive is taxable in Canada. As a result, their use has been limited, although there are a number of B.C. captive operations currently active.

FOCUSED ENTITY

An alternative is the establishment of a fully licensed insurance company, either federally or provincially, to insure the risks of a single company or of a group of companies in a similar industry. The advantage of a single purpose insurance company is that it provides maximum flexibility for an insured. There are a number of practical disadvantages to it including the providing of minimum capital of at least $5 million, preparing an acceptable business plan for insurance regulators, and being able to meet the operating costs as well as compliance requirements of a single purpose insurance company.

GOING OFFSHORE

It is possible for a Canadian insured to incorporate a captive insurance company in a jurisdiction such as Barbados. The licensing requirements are relatively easy to meet in such jurisdictions. In Barbados, it is necessary for a captive insurer to have a minimum of US$120,000 in capital. The amount of additional capital required depends on the level of premiums written. It is generally possible for a significantly greater amount of business to be written using the same capital than would be permitted in Canada.

The underwriting profit investment income with respect to a Barbados insurance company that is wholly owned by a Canadian resident would be subject to foreign accrual property income tax (FAPI). However, a Barbados captive would be allowed to establish reserves. In most circumstances, it would possible for taxes to be avoided for the first few years of operation due to the reserves established, including a reserve for incurred but not reported claims (IBNR). Under most circumstances it is possible for a Canadian insurer to deduct the premiums paid to the captive. Under some circumstances, a Canadian licensed insurer can act as a fronting company for the captive – however, this normally requires a trust account to be established.

NON-TAXED

Pursuant to the Canada-Barbados Tax Treaty, it is possible to incorporate a captive insurance company that will create exempt surplus. But, there are certain rules that must be followed for this to occur:

The captive insurance company must be a qualified insurance corporation in Barbados which means that it is subject to local tax at a low rate;

At least 90% of the business must be non-Canadian; and

There must be at least five employees.

A captive that uses an exempt surplus structure will only generally be suitable for risks of a Canadian company operating outside of Canada. However, for those risks, it is a very tax effective risk management structure. The Canada-Barbados Tax Treaty allows the underwriting profit and investment income of the captive to accrue tax free in Barbados and to be repatriated without paying tax.

It is also possible to use a deferral structure with respect to Canadian business. Under such an arrangement, a Canadian company would own greater than 10% but less than 50% of the voting shares of a Barbados captive, or a “rent-a-captive”. The underwriting profit and investment income of the captive would be non-taxable as long as it remained in the captive insurance company in Barbados. At the time that a dividend is declared, or there is a return of capital, the underwriting profit and investment income accumulated are then taxable.

It is important to note that proposed changes to the Income Tax Act may eliminate the possibility of using a deferral structure for Canadian risks. But, the changes were proposed over a year ago and it is possible that they may never be implemented.

PROS & CONS

It is clear that there are a number of different alternative risk management structures available to Canadian insureds. There is no one structure that will fit all circumstances. It is necessary to examine the particular insurance requirements of each insured before determining whether an alternative restructure is appropriate.

However, one of the more important considerations in deciding to enter into an alternative risk management structure is whether it is being done on a long-term basis. Many insureds complain about the cost of their premiums during a hard market and encourage their brokers to find alternatives. When a soft market occurs, they then are happy to return to the normal insurance markets for coverage. There are also a number of set-up costs and tax considerations in establishing an alternative risk management structure. The termination of such a structure may also result in tax consequences.

An important consideration for the use of an alternative risk management structure is whether reinsurance coverage for the captive insurance company will be available. It is important for an insurance broker to provide advice to the insured as to the appropriate amount of risk retention that the alternative risk management structure can assume. It will also be necessary for the insurance broker to be able to place the excess layers of insurance with normal third-party insurance companies at premium rates that will make the overall structure viable.

As such, insureds need to realize that an alternative risk mechanism effectively puts them in the “insurance business”. Many insureds will argue that they understand their risks and can control losses better than an insurer can. They may also argue that they are better equipped to handle their own claims. However, the reality is that all insureds require some degree of third-party insurance coverage on an excess basis regardless of their size.

SPECIFIC NEEDS

As such, alternative risk mechanisms should be viewed as a way to complement and not to replace normal insurance coverages. For instance, in hard market conditions, there are various types of coverage that become difficult to place – which an alternative risk mechanism is well suited to accommodate. Alternative risk management structures can also be effective for associations or groups of insurance that have similar risks. A captive can provide a sufficient spread of risk to effectively be able to assume a significant amount of risk transfer.

Alternative risk management structures are here to stay and will not disappear with the end of the hard market. However, it is important for insureds to realize the limitations of alternative risk management programs.