Creative Use of Captives

Canadian corporations are taking a second look at a captives strategy, and delegates attending the 8th Annual Canadian Captives & Corporate Insurance Strategies Summit, held in Toronto on May 16-17, heard a number of creative ways captives can be used to further business ends.

The 2012 conference had a decidedly practical bent, with speakers sharing insights on how exactly they were able to use captives to advance their organizations’ corporate objectives. The conference opened with a positive outlook for the creation of captives by Canadian companies.

CANADIAN CAPTIVES EXPECTED TO INCREASE

“The reality is that for the vast majority of Canadian companies, their captives are well-capitalized,” Trevor Mapplebeck, managing director of alternative risk solutions for Marsh Canada, said in his opening address to the conference. “They’ve been financially quite strong. Canadian corporates are going to be creating captives as opposed to shutting them down.”

Captives can help provide a cushion in a hardening, firming or tightening marketplace, he suggested. “There’s general appetite for risk, of financial willingness and ability for the organization to accept risk on the balance sheet,” Mapplebeck said. “There’s an opportunity for you to internally insulate the organization from some of the impact of the changing markets.”

In particular, the energy, agriculture and base metals/minerals sectors are expected to generate the most activity in the captives area, given the state of the market and the strength of commodities, Mapplebeck said.

And even though 2011 was a rough year for captives in the financial, construction and real estate sectors, investment returns for captives were about 3% overall. “Captives undoubtedly are a very favourable and effective tool in the risk management arsenal for Canadian corporations,” Mapplebeck said.

Still, he cautioned “the larger the organization or the captive, the more opportunity it has to diversify its investments. A lot of the smaller, less-insured captives will still need to focus on safety and liquidity of the investment.”

Most Canadian companies with captives are multinationals that have operations outside the country, he noted.

CAPTIVES HELPING TO ADVANCE BUSINESS OPPORTUNITIES

Frequently formed to ensure sufficient capital during hard insurance markets, captive insurance companies can also be used creatively to facilitate business opportunities, noted Paula Gentile, senior vice president of risk management and general counsel for MGM Resorts International.

Headquartered in Las Vegas, MGM owns condominium buildings, hotels and 14 casinos. MGM formed its captive in 2001, when hijacked commercial aircraft slammed into the World Trade Center buildings in New York.

At the time, MGM could not find insurers willing to insure its buildings for damage arising from terrorism. Also, domestic insurers were squeamish about underwriting property coverage for MGM, since U.S. legislation required them to insure fire following terrorist acts.

The company’s real estate holdings were worth $10 billion. “At the time, I was just a market saying,‘I need at least $2 billion of all types of coverage in order to sleep at night,’” Gentile said. “I have to be able to replace my property if something catastrophic happens.”

MGM created a captive so that foreign, non-admitted insurance capacity could be used to insure the company’s property holdings without any commitment to terrorism coverage. Once formed, MGM used its captive creatively to promote business opportunities. This included providing surety bonds for the purpose of releasing money held in escrow accounts, thus saving money for MGM.

For example, Gentile cited MGM’s City Center Project, a 76-acre, mixed-use, urban complex in Las Vegas that includes 2,500 condo and condo-hotel units measuring a total of almost 17 million square feet. At the time, real estate values were such that people were paying $1,800 per square foot.

Under contracts with MGM, the condo unit buyers put 10% of their money down in escrow, representing tens of millions of dollars. MGM could not touch the money held in escrow until either: 1) the escrow was fully closed and the money was completely transferred to the seller; or 2) a surety bond was posted with the escrow.

“It occurred to us that it would be a very good idea if the company, the developer, could get the use of that [escrow] money in advance to apply towards the construction costs, which could save money,” Gentile said. “It saves you money on your loans, interest and your carrying costs.”

With the approval of the state insurance regulator, MGM’s captive provided surety bonds for the escrow deposits.

“We saved a few million in fees,” noted Gentile. “We saved a lot more money than that in carrying costs and interest on our construction loans. That proved to be a great, money-generating activity.”

SHORT-TERM BUDGETS, LONG-TERM CAPTIVE PROGRAM

How do you establish and operate a multi-year government captive insurance program within the context of a government’s annual budget appropriation cycle?

This was the biggest challenge in establishing the British Columbia government’s risk-pooling programs through a captive, said Phil Grewar, executive director of the risk management branch and government security office for the provincial government.

B.C. self-insures its entire healthcare sector, the Kindergarten to Grade 12 public school sector, 12 Crown corporations and approximately 10,000 service providers. The province sought to self-insure when healthcare costs began to rise in the 1980s.

One major challenge was the inability to accumulate funds to pay for increasing costs over a multi-year timeframe. Government policy at the time was that unused funds would be appropriated at the end of the fiscal year.

Grewar gave the example of a government department needing insurance to cover a $10-million risk exposure. The captive insurance program would establish a $5-million premium, and find an understanding multinational broker.

At the request of the government captive, the broker agreed to invoice the captive for $5 million. The captive paid the invoice, so the broker received $5 million.

The captive then invoiced the broker for $5 million, which the broker paid back to the government. Since the money from the broker emanated from outside of the government, the $5 million the captive received from the broker entered the government’s books as “deferred revenue,” which is allowed to accumulate beyond fiscal year-end.

To keep the auditor general from being concerned about a long-term increase in deferred revenue, the captive program sought and achieved a longer-term solution — a statutory amendment that allowed the captive to move ahead with self-insurance initiatives.

PLANNING FOR BLACK SWANS

Captives would be wise to plan for “black swan” events, cautioned William Montanez, director of risk management for Ace Hardware Corporation.

These worst-case scenarios are characterized as high-impact, rare and unpredictable events. Taking these into account, and to ensure viable and sustainable captive growth, Montanez said the captive should:

• quantify asset, credit, reserve and underwriting risks;

• determine the overall health of the captive; and

• develop a road map to strategically grow the captive.

At Ace Hardware, it initially appeared the captive had $24 million in capital surplus. “We asked the experts what would happen if everything went south on us on the claims side?” Montanez said.

Based on the answer, Ace Hardware adjusted its total to about $12 million. And then, once an actuary considered other risks as part of the captive’s dynamic risk modelling — underwriting risk, reserve variability, interest rate, credit risk and equity investment volatility — the number fell to about $10 million.

Going through this process allows the captive to determine excess capital available “to grow the business,” Montanez said.With this number,the captive can explore options such as underwriting coastal coverage, providing a rate decrease or underwriting umbrella coverage for retailers.