UK: Captives – The Search for Finality - Insurance Market Update - June 2005

Captives provide a perfect financing solution for many firms. But when the need for them has passed, or circumstances change, run off is not the only option. We examine the advantages and risks associated with alternative exit strategies.

Captives are for many companies an important component of their risk management and financing strategy. In fact, most jurisdictions across the world are experiencing strong growth in new captive formations. However as a result of strategic change in their organisation or due to external developments, there are some owners who may wish to rationalise their insurance operations. Equally, there are those who have maintained such subsidiaries because, quite frankly, they are unsure of how to dispose of them. This article considers the factors that may lead a company to re- evaluate its insurance operations and explores the mechanisms that are open to a company seeking finality.

There has been a growth in the use of captives over the last decade or so, with almost 5000 captive insurers established across 50 jurisdictions. Whilst a significant number of new captives have been established, particularly in popular jurisdictions such as Cayman Islands, there have also been a number of captives closed across various jurisdictions with both Bermuda and Luxembourg having more captives closed than new captives created.

There are various issues on the horizon that could cause firms to reassess their use of captives.

Recent focus in the US has been on finite reinsurance, broker compensation and potential conflicts of interest. Any concerns that may affect the insurance market in the US should not be taken lightly by other jurisdictions.

In the last soft underwriting cycle, a significant driver of the poor underwriting results was the expectation of high levels of investment income that could be earned on invested premiums thus allowing under-pricing of business. As the current market softens, with interest rates at a historical low, significant increases are not expected for the foreseeable future. Therefore, low investment returns render it more risky to maintain a captive to meet future claims based on the expectation that investment profits will be strong.

Currently, capacity in the market is buoyant, with limits available in excess of most insureds’ needs. However, as we enter a softer market, rate reductions may occur in certain classes of business. Therefore, unless a captive owner belongs to a particularly troubled sector, rates may begin to be less expensive in the open market than those that can be provided by the captive itself. This could render it unviable for the parent to pay premiums to its captive, thereby minimising the captive’s use and merely tying up much needed capital. 

Finally, pressure on parent companies to adopt sound corporate governance standards may cause corporates to reconsider their use of captives. Over the past few years, there has been an ever-increasing level of responsibility placed on directors, requiring them to understand the operations of their businesses in greater depth including any offshore captive subsidiaries. This may cause some organisations to consider exiting those captives that demand a disproportionate amount of management time, particularly where shareholders and regulators are seeking transparency on all group activities.

There are a number of situations in which an organisation may decide that, as a result of changes in its business strategy or operating structure, its approach to using captives may no longer be appropriate. Corporate divestments or acquisitions can mean that the use of a captive no longer fits with its desired group risk strategy. A divestment, for example, can mean that the captive can be retaining risks that are no longer related to the group’s business. Also following an acquisition, the group can find itself owning a surplus of captives that are not actually required.

Furthermore, changes in the financial position of the company may no longer justify the use of capital to support the captive. The parent may have alternative uses for its capital within its core business that is currently tied up in supporting captive solvency requirements. Captives that have been in existence for many years may also be overcapitalised, due to a build up of premiums and investment return and good claims experience. Captives have faced collateral and security issues for non-EU fronting arrangements. Conversely, volatility and/or deterioration in claims experience can highlight the continuing cost, uncertainty and risk of a captive to a discerning group board.

In addition, the cost of ongoing management of a captive may cease to be justifiable on a value for money basis for some of the following reasons:

• tax treatment – changes in tax rules, particularly in relation to Controlled Foreign Company (CFC) legislation have eroded many of the benefits the captive was originally established to capture;

• associated management costs – can also be a drain on profits if the captive has ceased to participate in underwriting group risks;

• insurance premium tax – payable on captive premium for UK domiciled risks, presents an additional cost as opposed to the no-cost option of retaining deductibles on the parent’s balance sheet;

• costs associated with fronting – these include both the fronting fee payable in respect of statutory classes of insurance as well as the cost of letters of credit or parental guarantees which many fronting insurers will require. These can tie up capital that the group may be able to use more efficiently elsewhere.

When considering the option of exiting a captive, organisations should also consider the associated implications and risks which include:

• need to manage deductibles in-house – activities currently being undertaken by captive managers, such as the payment of claims and allocation of deductibles will need to be undertaken by the parent;

• removal of alternative to the insurance market – a captive provides an alternative option which can be a useful risk financing tool to manage the cost of premiums throughout the insurance cycle. Captives can offer wider contractual terms and provide insurance for risks viewed as expensive to insure in the open market;

• less direct control of claims – a captive allows the group the ability to control low level claims which may otherwise go straight to the insurer;

• potential for higher premium costs – in the event that the parent is no longer able to access reinsurance markets directly through its captive;

• perception – insurance markets may take a more conservative view of the parent’s risks if the captive is no longer in place.

The decision to exit and how this can be best achieved should be assessed against a number of criteria including:

• cost of implementing the solution;

• the ease of implementation;

• the risk appetite of the parent; and

• the attitude of external parties who have an interest in the captive such as any fronting insurer or reinsurers.

The appropriateness of each option will depend on:

• the classes and jurisdiction of business;

• the nature and value of outstanding claims;

• the terms of insurance and reinsurance contracts in place; and

• the domicile.

There are four key exit options. Most captives belonging to UK parents will be classified as CFCs, and therefore, captive profits will be taxed in the hands of the UK parent. Whilst the UK corporate tax and VAT implications of each of the options are unlikely to drive the decision as to which options is most attractive, the corporate tax and VAT position should be fully reviewed once the preferred option has been finalised.

Historically, many companies chose to run-off their captive to the natural expiry of its liabilities, and followed by its eventual liquidation. This was normally caused by difficulties in negotiating an exit from existing policies, in the form of a commutation with the insured (ie parent) or a novation with a third party insurer.

Running a captive off to expiry does not require the parent to undertake any additional risks on its balance sheet although, it does leave the group exposed to the risk of claims deterioration. Furthermore, the captive will require continuous financial commitment, including capital support and ongoing administrative expenses. If a captive contains long tail liabilities the run-off could take a significant time depending on the type of liabilities which have been underwritten.

A reduction in the share capital and repatriation to the parent may be possible if the captive is overcapitalised and can continue to meet its statutory solvency requirements. This would however, be dependent on agreement from the regulator.

This option is often the least satisfactory for the parent as it requires continued investment of financial and management resources in overseeing the run-off of the captive, runs the risk of potential deterioration of liabilities and does not provide finality. However as this is the default "do nothing" option, it is a common fallback for many companies.

This option would involve the sale of the captive in its entirety to a third party purchaser. The key advantage of a sale is that it will achieve finality and allow the release of assets back onto the parent balance sheet within a relatively short time frame. The key limitation to an outright sale of a captive is generally the lack of interested buyers. Those that are active in the market are generally only interested in making sizeable acquisitions. Over the last few years, several buyers have emerged who specialise in acquiring unwanted captives and are willing to consider smaller companies, but the market is still relatively limited.

The drawback of the sale option is the "cost" of the transaction in terms of the discount to net assets that the purchaser will require in order to make the deal mutually attractive, as well as the time and cost of the due diligence process. Furthermore, if the sale affects claims that are still related to group trading activities, the parent may have concerns in respect of how the claims are managed. The purchaser could set precedents in its dealings with third parties that may not sit comfortably with the group’s approach to handling its risk and therefore the parent itself may want to undertake a degree of diligence into the purchasing party. Purchasers will require a detailed sale purchase agreement that incorporates warranties and indemnities to be executed by the seller.

Purchasers that are actively acquiring unwanted captives are typically formed by private investors, interested in consolidating UK and European insurance companies and portfolios. A typical purchase is likely to be based on the following principles:

• payment for the release of share capital;

• payment for distributable reserves;

• risk premium on the actuarial assessed insurance liabilities.

Solvent schemes of arrangement have become a popular mechanism in achieving finality for insurance businesses, and can also be applied to captives. A Scheme is a compromise or arrangement under English law (Section 425 of the Companies Act 1985) between a company and its creditors. It becomes legally binding on all creditors if the necessary majority vote in favour of the Scheme and the High Court approves it. Basically, those creditors with a legitimate interest are provided with a wholesale estimation of all present and future claims, based on a selected actuarial methodology. This allows acceleration of the agreement, effecting settlement of claims to policyholders and creditors in order to achieve finality.

Schemes may be most appropriate for those captives that underwrite retail business on behalf of third parties or contain policies related to divested companies. A scheme has the benefit of providing early resolution and finality compared to the natural run-off of the claim. This can avoid some of the costs involved in run-off, such as management and claims handling expenses, which may be otherwise incurred over the course of many years. Equally, a potential benefit to shareholders will be the earlier resolution of shareholder equity. However, schemes cannot be undertaken in respect of compulsory lines of business, and these will need to be commuted separately. A scheme is likely to take a minimum of 15 months to complete.

If a sale or scheme of arrangement is unsuitable or unavailable then a solution could be agreed on a class by class basis via a commutation, novation of policies or transfer of liabilities. This option can involve the transfer of liabilities, either back to the parent, to the fronting insurer or reinsurer, or to an external third party. The attractiveness of these mechanisms will depend on the willingness of one of the parties to take on the additional liabilities at a price acceptable to the other party.

A key consideration as to whether the parent is capable of acquiring the captive’s liabilities is whether there are any regulatory hurdles that prevent a non-insurance entity acquiring insurance liabilities, this will depend on the class and jurisdiction of the portfolio.

The attractiveness of this option is dependent on the risk appetite of the parent and whether it is willing to accept the captive’s liabilities on its own balance sheet, particularly as such liabilities have previously been ring-fenced within the captive. Furthermore, the benefits for the parent, in terms of lower management costs associated with the run-off of its captive, must be assessed against the specialist insurance knowledge and tools that it will no longer have access to, in managing the portfolio.

A commutation is a settlement agreement reached between a reinsured and a reinsurer, in which the reinsurance obligation is terminated. Agreement is reached whereby the reinsurer will pay all funds at present value which are not yet due under the reinsurance agreement. This allows the reinsured to receive cash immediately in order to invest for the payment of claims that will become due in the future.

Agreeing a commutation with fronting insurers may be difficult if the captive’s policy wordings have not been agreed or finalised, as can often occur. The bargaining position of the captive owner will be affected by the strength of their ongoing relationship with the individual insurers/ reinsurers and the brokers of these policies. In practice, the captive’s bargaining position can be significantly reduced if it has been in run-off for a number of years or if the primary policies have been moved to another insurer. In these circumstances it can be difficult to acquire interest from an insurer to agree to a commutation, and if so, this may only be achieved at a significant cost.

If an external third party carrier can be sourced, who is willing to acquire the liabilities, this can be effected by means of a loss portfolio transfer under Part VII of the Financial Services and Markets Act 2000 (FSMA).

The negotiation of a portfolio transfer requires a detailed financial and actuarial analysis of the book of business. Each party must have a clear understanding of both the number and nature of the policies issued, the value and credibility of the reserves established by the reinsured and most importantly, the value of the incurred but not reported losses.

Captives are by definition, a limited purpose insurance company, established with the objective of financing risks emanating from its parent group. The question that many captive owners struggle with, however, is what to do with the captive when its intended purpose comes to an end? It is important that corporate strategy and approach to risk management is aligned with the captive’s strategy. For most organisations, insurance is considered a non-core activity, and therefore issues related to the running of a captive are often given low priority. The perceived cost and uncertainty associated with closing a captive has led many companies to simply place unwanted captives into run-off until all risks have expired. However, there are alternative mechanisms, now well established within the insurance market that can achieve finality for captive owners.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.