Sunday, April 21, 2024

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Captive feasibility – a Shakespeare drama

This fun ‘Thought Leadership’ article has been submitted by an experienced captive consultant, on an anonymous basis. We have published as an April Fool’s feature.

Few know that the captive concept has actually been in existence for hundreds of years, and the most learned amongst us realise that the origins can be traced back to the times of Shakespeare.

In fact, even fewer know of the long lost play that was retrieved from an ancient, buried library in the far corners of Stratford-upon-Avon.  This was one of Shakespeare’s first works, titled MacCaptive, and clearly demonstrates the frustration of a young English risk manager and his struggles with the concept of captive feasibility.

This is a fundamental and early play, and the phrases used here are also found in many other works that were later authored by Shakespeare. 

The play is lengthy, including many other elements of captive insurance and is a wonderful read. Here, however, we will focus on the beginning of the play, looking at the key elements of determining captive feasibility.

We will humbly provide an analysis of the work and will take you through some portions of the play which have particular relevance to our young man’s struggle to rationalise the process of determining captive feasibility.

The opening scene is in an English Castle boardroom, and our Mr. Lear, CFO for Shakespearea, Inc., or as he refers to himself, King Lear, has asked a very direct question of his risk manager, Thomas Hamlet.

“Thomas, to be or not to be, that is the question, but is it not a foregone conclusion?”

Thomas replies: “Sir, you are exceedingly well read, some way it is a dish fit for the Gods, but all that glitters is not gold.  Let me analyse this green eyed monster.”

AnalysisThe CFO has heard about the benefits of captives in his roundtables with other CFOs and may think that this is a magic solution to his insurance ills, but is still somewhat dubious.  He goes to the risk manager for advice and confirmation. The risk manager knows that there are many captives in existence, and there are many benefits, but also knows that sometimes the captive benefits are not as clear or compelling as provided in the London Quarterly or hyped by purveyors of these entities. Additionally, the benefits to one fiefdom may not hold the same weight or relevance to another. 

Mr. Lear responds, “go find the short and the long of it, and let the truth will out.”

Thomas sets out to determine the key elements of feasibility and provide an analysis and report for his CFO.

Thomas ponders and thinks to himself: “This task should be done at one fell swoop, and I know my findings will be as pure as the driven snow. Perchance I will give the devil his due, a horse, a horse, my kingdom for a horse”. 

Analysis: Thomas has never done a formal analysis and is weary of the Pub talk from liquefied advisors and French captive sales people. He understands that Mr. Lear values the independent analysis of experts that have been there and done that, those with horsepower and experience, and seeks out discussion with his old friend, Romeo.

Thomas:  “O Romeo, Romeo! wherefore art thou Romeo. Surely, there be good men and true, who can help me through this madness. I need the milk of human kindness to navigate these troubled waters. I need someone, his beard was as white as snow.”

AnalysisThe risk manager has deep contacts in the industry and seeks the advice of a longtime friend, Romeo, who has been a captive owner for some time. He knows Romeo is an expert in captive insurance, tax, actuarial, accounting, financial modeling, swordsmanship, etc. 

Thomas asks Romeo for meeting at the Hog Penny pub to determine the process and the key items that need to be evaluated.

Thomas: “This is meat and drink to me, but discretion is the better part of valor.  Perhaps we can conclude in the twinkling of an eye, like the dickens.  What investigation will keep me out of the jaws of death?”

Analysis: Thomas believes a study will be easy, such as a daily meal is consumed, but he wants to be prudent and ensure he analyses every aspect.  Thomas opens the discussion to Romeo to outline what critical areas he believes need to be evaluated.

Romeo: “I am in stitches, but will be fancy free.  There is a method to my madness.  In preparation, I have not slept one wink.”

Analysis: Romeo is concerned that there are many aspects of evaluation that need to be considered and that there is a lot of work to be done, from many angles, to fully evaluate the feasibility of a captive. Romeo states that he will speak his mind. The analysis must be done in a logical order, in light of the specific circumstances of Shakespearea, Inc., i.e. what is most important to Mr. Lear, and what will make the method of analysis successful. 

Romeo continues:  “Surely sir, we must review the beast within, whether it be the eye of newt and toe of frog, wool of bat and tongue of dog.” 

AnalysisThomas must look at the “beast within,” current lines of insurance, deductibles, limits, premium spend, as well as nontraditional company risk to see where a captive could reasonably participate. One must be cautious of insuring risk outside the parental group, and creating a beast that may have adverse losses and cause the castle walls to crumble. 

Romeo next realises that a close review of the numbers is warranted based on the determination above of what the lines of insurance along with what captive limits will be written.

Romeo expounds: “We must use the analysis to date and lay it on with a trowel, but we need experts as but, for my own part, it was Greek to me. As good luck would have it, we have my partner Cleopatra who indeed can read Greek!”

Analysis: Romeo is clearly making a joke in that he does not understand actuarial science and what they do is foreign to him, but he knows the actuarial expertise of Cleopatra (formally of Marc Anthony Actuarial, Inc.) is needed to determine the requirements. Losses should be actuarially predicted, given credible data, and drive premium levels. The premium written also should be comparable to what you would find in the commercial marketplace. Premium written and expected losses also often dictate initial capital requirements.  Caution here in that CFO, like Mr. Lear, needs every Pence for things like the West Indies spice trade.

“Oh, that way madness lies, a plague on both your houses, but do not let this green eyed monster get in thy way.”

AnalysisRomeo is plainly talking about the philosophical approach to the cost of capital, which can be a maddening affair for the purveyors of captives.  As captives require premium, capital, and loss reserves, an analysis of how Mr. Lear views the cost of that funding is critical:

  1. Internal rate of return: The return on funds used in operations, such as a capital investment, can be as high as 30%+ (can be expressed as hurdle rate, the minimum investment return to justify a capital expenditure)
  2. Borrowing rate: the rate that a corporation could borrow funds to invest in the captive
  3. Equality: no cost of funds as cash in the captive is viewed the same as if it was at parent – there are always liquid funds to back risk concerns

If the company uses the internal rate of return, then a captive is very difficult to financially justify and there will be a quick death to the project. Also, the green eyed monster is the capital required, which may be seen very negatively by the CFO if the rate of return is not achieved and should be minimized. 

Romeo continues: “The taxation regime is brutal, but this is the stuff as dreams are made on. Surely, the complexities will make your hair stand on end, but I bear a charmed life, and I will wear my heart upon my sleeve.”

Analysis: The reference to the taxation regime is a parallel to the IRS, their changing rules and regulations, when they do provide guidance, on captive taxation. The complexities of tax and captives are varied, and would make the novice weary. If the captive is properly structured, the main drivers of benefits are:

  1. Tax deduction acceleration. The current tax deduction for reserves in a captive versus taking the deductions when the claims are actually paid.  This is an advantage the longer the tail (loss payment pattern) of claims. 
  2. State tax deduction: Both from the acceleration standpoint mentioned above, as well as the benefit that often there is no state taxation on underwriting or investment income in the captive. (Captives are generally taxed on premium, not income, at the state level)
  3. Foreign tax arbitrage: Companies may benefit from taking a deduction for premium paid in high taxation countries and the offsetting income tax in lower captive domiciles.

The reference to a charmed life is the fact that Romeo’s company has argued captive taxation before the IRS regime and won on all occasions. He understands the potential difficulty with the tax collectors and will put his heart into providing the best advice to his friend on proper structure to avoid complications.

Romeo: “Perhaps it is much ado about nothing, but the form of this beast needs to be closely reviewed. Should we rent from our local brethren, form this on our own, or borrow a cell from the host. There may be no rhyme nor reason, and the comparisons can be odorous, but the finest will prevail.”

AnalysisThe structure of the captive drives capital, taxation, capacity, costs, risk sharing, flexibility, etc. Pros and cons of each structure need to be evaluated. The primary choices for a large corporation typically are:

Wholly owned: Also known as ‘single parent’ or ‘pure’ captive. An  insurance company owned by its parent, usually the insured, mostly insuring the risk of the parental group.

Group or association: Multiple businesses join together either through a formal association or an informal relationship.  Alliances between city states, if you will.

Rent-a-captive: The usage of another owner’s captive, potential sharing of liability.

Cell Company participation: The usage of another owner’s captive, without the sharing of liability.

“Next we must consider the kingdom of residency, should you stay or go bag and baggage?  You can reside in all corners of the world, indeed, all the world’s a stage, and all men and women merely players.  You may sun, be fair, or blow, winds, and crack your cheeks.”

Analysis: The domicile of choice is a consideration that can also affect capital, types of insurance that can be written, federal excise taxes, regulatory flexibility, etc. There are over 100 domiciles in the world, the most prevalent being Bermuda, Cayman, and Vermont. Most all domiciles have managers capable of overseeing the captive, or it can be outsourced to a major domicile in a back-office arrangement. Additionally, regulatory sophistication, experience, and flexibility may vary greatly so a detailed review is warranted.

Thomas is a bit cautious, and states: “Something is rotten in the state of Denmark”

Analysis: This undoubtedly does not refer to Denmark, but the perception that some domiciles are new and may not have the regulatory regime and financial acumen of more established domiciles. Also, there may be a perception that some offshore captive domiciles have the misnomer of being a place where one goes to “hide” money or evade taxes.

Romeo naturally responds, “This is the short and the long of it, perhaps a beast with two backs.”

Analysis: Romeo makes note that incorporating a subsidiary in a country that has a public perception of being a tax haven could be viewed negatively by the C-suite. However, while the perception may be one thing, the backside may be the most advantageous for the company.

“Ah, but is this a dagger which I see before me? The gold coins needed will certainly require a pound of flesh, but we can endeavor to make this minimal. Certainly, neither a borrower nor lender be, as the taxation regime will have issue.”

Analysis: Romeo is apparently talking about the capital needs and cash premium generation that a captive insurance company requires. Insurance premium needs to be funded and flow from parent (or subsidiaries) to the captive, where in the past there may not have been premium as amounts resided in retentions. Initial capital is needed depending on the business plan and actuarial analysis and is adjusted based on calculated reserves and premium writings. There are ways to minimise cash outlay, and many domiciles allow for collateral in the form of LOC’s or trusts, which for some may be advantageous. Romeo also indicates that there is a need to analyse ways to minimise the capital draw, such as a loan back of funds to the parent, but he also mentions that the taxation regime may take issue if this is seen as circular or the corporate structure is arranged per safe haven guidelines.

Romeo:  “The decision and comparison must be fair and true. You have a fine arrangement now, and changing must be fully analysed.  Shall I compare thee to a summer’s day?

AnalysisThe captive insurance arrangement benefits should be compared to the current programme. All items should be considered, to include funding, tax deductibility, other taxes (premium, state, federal excise, etc.) premium required, cash flow, capital and frictional costs, etc.

Romeo:  “Next, one must consider, and it is very nearly never done, the high time that this entity will consume. As merry as the day is long, distractions may occur and hinder the reasonableness. So, come what come may, we will quantify.”

Analysis: One of the items that often is not reviewed fully is the time it will take the risk manager and board members to manage the captive. Romeo points out that there will be times when the captive may consume more time that originally anticipated, and he will endeavor to quantify, based on his experience, the hours and time when captive involvement will be heightened.

Romeo continues:  “Fie, foh, and fum, I smell the blood of a British man. Certainly, this beast will allow us to have better relations with our kinsman.”

AnalysisA captive will allow direct access to reinsurance markets including Lloyds syndicates and there may be savings over using an insurance company.  While this may be true, what many feasibility studies are lacking is a direct comparison of insurance and reinsurance costs. In essence, it is difficult to obtain reinsurance quotes until you have already established a captive. It is never sufficient alone to say the captive can access the reinsurance markets and save premium, unless this is tested.

Romeo: “The entity will have its challenges, and we don’t want this to take a King’s ransom. Be careful, you will be eaten out of house and home and that would surely be a sorry sight.”

Analysis: Costs can impede results, federal excise tax, direct placement tax, captive management fees, attorney fees, audit fees, actuarial, domicile fees, etc. The challenge is for the benefits to outweigh the costs. Clearly identifying the costs prior to implementation and basing a decision with that in mind will ensure that there are minimal cost surprises.

Romeo: “You will need a stony-hearted sort, in the place that smooth runs the water where the brook is deep. There would be no short shrift, and we can help identify those men that are good and true.”

Analysis: Romeo intonates that the selection of a captive manager is critical in the smooth running of the captive. The manager must have experience in the domicile, and have accountants and managers that also have deep experience.  One should seek references to identify these good men.

Thomas:  “But let me ask, upon good riddance, will this be the winter of our discontent?  Will we be able to slay this beast? For ever and a day, all’s well that ends well.”

Romeo: “Surely, misery acquaints a man with strange bedfellows, and this can be the Devil incarnate. If we don’t plan, we will find ourselves in a pickle.”

Analysis: The risk manger is worried that once a captive is incorporated, and running for some time, that it will be very difficult to close down and liquidate if the need arises. Indeed, if the captive uses a front company, has reinsurance, or acts as a reinsurer of third-party business, it may be difficult to untangle these arrangements. To close, one must demonstrate to the regulators that all liabilities are extinguished. This is straightforward with short tail converges, but can be problematic with long tail, such as casualty.

Thomas: “OK, I cry havoc and let slip the dogs of war. Indeed then, the game is afoot.  We must ensure the quality of mercy is not strained.”

AnalysisAlas, Thomas realises need for a detailed review, and asks Romeo to help with the review. Thomas will gather his kinsman for this challenge, representatives from risk management, tax, human resources, treasury, etc.  Indeed, these folks are needed to produce an analysis that is qualitative and quantitative, not volume orientated, and includes a combination of insurance, actuarial, tax, and accounting.

Romeo replies, “Once more unto the breach, dear friend, once more.”

Analysis:  Romeo is more than happy to assist his longtime friend, indicating he will help Thomas with an evaluation including hiring those external resources needed to augment the internal team.  As it has been said, “Some are born great, some achieve greatness, and some have greatness thrust upon ’em.”