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May 28, 2010

Captive insurance companies have been a widely used enterprise risk management tool. Many corporations have used captive insurance companies to manage risks that commercial markets either don’t address cost effectively or may not address at all. Over the past several years, many more companies have incorporated employee benefit plans into their captive insurance platforms, for a variety of reasons:

  • Risk diversification
  • Tax optimization
  • Return on reserves
  • Cost reductions
  • Cash-flow management

ERISA Issues
Before looking at the rationale for migrating employee benefits into a captive insurance platform, issues under the Employee Retirement Income Security Act of 1974 (ERISA) need to be addressed. When incorporating employee benefit risks into a captive insurer, it is very important to assure compliance with both ERISA and Internal Revenue Service (IRS) regulations, as employee benefit issues come under the purview of both the U.S. Department of Labor (DOL) and the IRS. Improperly constructed, captive structures may constitute “prohibited transactions” under ERISA, as amended. ERISA Section 406(a)(1)(D) prohibits the “transfer to, or use by or for the benefit of, a party in interest, of any assets of the plan.” An entity owned by the employer, such as a captive, is considered to be a party in interest with respect to the employee benefit plan under ERISA Sections 3(14)(C) and 3(14)(G).

To manage the party in interest matter, employers should seek a prohibited transaction exemption (PTE) in advance of implementing this type of structure. Responding to the increasing popularity of this strategy, the DOL has created an expedited procedure, or “EXPRO,” to make it easier to implement these programs. The time involved from initial submission to final authorization can be around 90 days. This is dependent upon being prepared to provide all of the necessary notifications and assure that your situation is “substantially similar” to previously approved transactions. Assuring substantial similarity is relatively easily achieved, as prior submissions and approvals are part of the public record and are accessible.

Risk Diversification
For companies that have a history of using captives for managing and funding general liability risks that are too difficult or cost prohibitive in commercial markets, adding employee benefits to the lines of coverage can have beneficial effects on risk diversification. It is often the case that the risks taken into a captive may have a high degree of variability, which has an impact on the reserves necessary to support those risks. The higher the degree of variability, the more reserves must be maintained. Taking uncorrelated risks into a general liability risk captive can have a beneficial impact on reserves and reserve management.

Of the risks that can be taken into a captive insurance company, employee benefit risks tend to have higher frequency and lower severity. This leads to less volatility with these risks and can help mitigate the overall volatility of risks in the captive. Even within the employee benefit area, risk diversification is important — for example, by taking annuity risk (deferred annuities or pensions in payment) against life risk.

Tax Optimization
One of the goals of a captive insurer is to achieve complete deductibility of the premiums paid to the captive. One way to optimize the tax treatment of an existing captive is to introduce unrelated risk to the captive. This will reinforce the captive as a true insurance enterprise. As it pertains to employee benefit risks, the IRS has allowed the full deductibility of employee benefit premiums paid to a captive. Further, it has recognized employee benefit risks as unrelated risk to the captive. The rule of thumb currently observed in the industry is having 30 percent of the premium of the captive relate to employee benefit risks. This will strengthen the position of the captive being treated as a true insurance enterprise under Internal Revenue Code Subchapter L.

Other tax matters need to be considered in the context of the employee benefit captive, especially for multinationals where non-U.S. risks will be introduced as well. The first thing to keep in mind is that non-U.S. risks are not subject to ERISA. A safe position to not have them become subject to ERISA is to segregate them into an offshore entity. When executing this strategy, proper consideration needs to be given to controlled foreign corporation (CFC) rules, especially IRC Section 953(d). Depending on the scale and types of risks, in particular pension risks, passive foreign investment corporation (PFIC) rules should be considered as well.

Return on Reserves
An area where captives can have a positive economic impact on the enterprise is in achieving a better rate of return on reserves. When commercial insurers develop premium rates, one underlying assumption is the investment return they achieve on the reserves they maintain to support that risk. Primary insurers usually assume very conservative (low) rates of return, resulting in higher premium rates. One strategy where this could figure significantly is if a company wished to reinsure bulk pension annuities. In this instance, a company that felt it had a competitive advantage in managing credit-based asset portfolios could build a leveraged spread business (using no credit to generate the leverage) by effectively managing reserve assets and hedging the portfolio properly. It is important to note that these very long-tail risks have significant sensitivity to interest rates and potentially inflation rates (especially for UK-based pension risks). Getting good guidance on asset liability matching (ALM) modeling is very important if you intend to manage pension-related risks on any significant scale.

Cost Reductions
Another advantage to captive funding of employee benefit plans is the ability to take out much of the frictional costs associated with commercial insurance contracts. One frictional cost is the “risk charge” that most insurers use as a cushion that is in addition to the actual risk premium that represents the “pure” actuarial cost associated with a risk. Another cost reduction opportunity is to go direct to the reinsurance markets for any risks not being retained in the captive. Rather than paying “retail rates” on reinsurance that is an embedded cost in the commercial carrier premiums, the company can go directly to the reinsurance market, in effect getting “wholesale rates.” To the extent to which the captive is a direct writer of risk, commissions can be eliminated from the contract. This can be particularly attractive when using a captive-sponsored life insurance contract to fund non-qualified executive compensation plans. These plans have often been “funded” by expensive and underperforming variable life insurance contracts with commissions that can be as much as 90 percent or more of the first year’s premium. Stripping out these costs, as well as expensive administrative, 12(b)1 and management fees charged to the funds inside the contract, can be significant.

Cash-Flow Management
Insurers will often use aggregated data based on industry groups or other indicators to set premiums. They will also determine the timing of premium payments and the release of reserves or dividends. Another important advantage in placing employee benefit risks in a captive is the ability to exert much greater control over cash flow. In particular, the control of premium levels, timing and claims payments can deliver cost savings. Premium levels will be set specifically to the experience levels of the company’s group.

While all of these cost reductions will be offset by set-up costs, administrative costs and annual compliance costs, the benefits can far outweigh the investment.

Alvarez & Marsal Taxand Says:
Any employer that has a captive platform domestically or offshore that has operated in the property and casualty environment, and is seeking ways to optimize its captive performance, should consider introducing employee benefit risks into the platform. Performing a brief analysis of the current structure and modeling the impact of employee benefit introduction may prove to be a valuable investment.

Kevin J. Gregson
Managing Director, New York

For More Information on this Topic, Contact:

Brian Cumberland
Managing Director, Dallas

J.D. Ivy
Managing Director, Dallas

Kandice Bridges
Senior Director, Dallas

Lindsey Miller
Senior Director, New York

Lisa Schlepp
Senior Director, Dallas

Mark Spittell
Senior Director, Dallas


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