Creative Captives

For many Canadian corporations, insurance purchasing decisions are dictated by laws, regulations, bank covenants and other stakeholder requirements. Also, many choose to purchase insurance to cover potential catastrophic losses from natural disasters and material litigation and liabilities because it is a sound business decision.

However, such risk-financing decisions should not be made without an objective evaluation of options. Decisions about whether to transfer or retain risk on the corporate balance sheet should be made with the goal of reducing financial volatility by protecting the company’s earnings and/or cash flow.

Additionally, as with other risk finance decisions – which address, for example, currency and interest rate fluctuations and commodity price volatility – it is essential to evaluate risk-financing decisions relative to a corporation’s defined risk appetite.

If a company is willing and financially capable of retaining the risk on its own balance sheet, then decisions need to be made as to how to optimally fund for the retained risks.

In considering these issues, Canadian companies frequently overlook or undervalue one viable, longstanding, self-financing option: forming a captive insurance company. A captive insurance company is a legal entity formed by a company primarily to insure the risks of that company, a number of affiliated entities or controlled third parties.

What Captives Offer

Captives offer a number of financial, insurance and risk management advantages.

Financially, captives help reduce insurance costs, improve cash flow, match revenue and expense (especially for longer-tail liabilities), generate tax efficiencies and can also provide a source of additional revenue.

Insurance advantages include securing coverage for risks typically not insurable, reducing the need for commercial insurance, improving a company’s negotiating position with insurers, creating flexibility in insurance program design and developing broader, simpler contract wordings.

Captives also facilitate risk management benefits through the design of cost allocation systems, the accumulation of loss data, the design of more effective claims handling and loss control programs and the development of uniform expectations and standards for risk management across divisions or subsidiaries.

For these reasons, corporations around the world have created captive insurance companies to finance risks both at home and abroad. Today there are approximately 5,400 captive insurance companies.

Captives in Canada

According to the ratings agency A.M. Best, Canadian companies or associations owned approximately 145 operating captives as of 2007. This is in addition to numerous registered but no longer active captives. The vast majority of these captives are domiciled in Barbados, due primarily to the tax treaty in place between Barbados and Canada. For some organizations, especially Canadian companies with no foreign risks, it makes sense to maintain their captives locally within Canada. According to the Canadian Captive Insurance Association, 21 captives are currently domiciled in British Columbia, the only province with captive legislation in place.

Canadian companies continue to explore new and innovative uses for their captives. Traditionally, captives have been used exclusively for deductibles of property, casualty and workers’ compensation programs. More recently captives have assisted companies in financing environmental liability, product recall, weather risk, intellectual property infringement risks and other business risks. Organizations also have begun evaluating financing portions of their employee benefits programs through their captives.

There are few limits on the types of risks a captive can finance, provided the risks are evaluated, priced and capitalized properly. Beyond insurance, captives also can serve as viable alternatives to other financial instruments, including letters of credit or other guarantees.

Not every company is an ideal candidate to form a captive, however. In addition to having a healthy risk appetite, companies also need to be in a strong financial position in order to meet capital and surplus requirements. In Canada, strong commodity pricing and efficient production have led to strong financial results for many companies in such industries as mining, energy and agriculture. These companies, which tend to have global operations, are ideal candidates to explore a captive program.

Global Trends

Canadian companies with captive operations or those interested in forming new captives should be aware of several regulatory and legislative trends that might affect their decisions.

Barbados has been the domicile of choice for most Canadian companies, but recent changes in tax agreements between Canada and other domiciles are likely to level the economic playing field. Tax Information Exchange Agreements (TIEAs) have been signed between Canada and several countries, including Bermuda and the Cayman Islands, the world’s largest captive domiciles. The Canadian Parliament is expected to ratify these agreements in early 2011. Once ratified, dividends paid to Canadian parent companies out of the active business income earned by their foreign affiliates in Bermuda and Cayman will be exempt from Canadian taxation.

Certain provisions of the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 will affect Canadian captive owners with U.S. risks. Although its specific impact remains unknown, the act is likely to affect state premium tax obligations from premium payments on U. S. risks made to a captive.

In the United States, the Terrorism Risk Insurance Act and Terrorism Risk Insurance Program Reauthorization Act (TRIA and TRIPRA) provide a reinsurance backstop for U.S. terrorism losses insured by captives and traditional insurers. The act is set to expire on Dec. 31, 2014.

Uncertainty about the impact of Solvency II on captives domiciled in the European Union may also affect companies’ decisions on captive formation. Solvency II will establish strong capital and solvency requirements for insurers.

Looking forward

Soft market conditions are expected to continue in 2011, and so Marsh expects companies will continue to assess the feasibility of new captives for value-added cost savings and further business and risk management objectives. Current captive owners will continue to evaluate their captives for efficiencies, enhancements and cash-access strategies.

Although insurance is often a financially efficient method of managing risk, in today’s environment, in which every dollar counts, companies should evaluate their risk financing strategies to ensure efficient combinations of risk retention and risk transfer. With both financial and risk management benefits, captives have proven to be an effective solution for many companies.