A "captive" is a closely-held insurance company whose insurance business is primarily supplied and controlled by it's owners - in the sense that the owners have and exercise direct involvement and influence over the company's major operations, such as its underwriting, claims management and investment policies - and in which the original insureds are the principal beneficiaries. The "rent-a-captive" represents an evolution of the "captive" insurance company, and has been employed for specialised situations for nearly as long as more standard forms of captives have been operated.
A rent-a-captive programme can be structured so that effectively unrelated parties may participate in the underwriting profits generated by the risks which they insure (or arrange to insure) via the captive. In addition, rent-a-captive policyholders (or owners of such policyholders) may be negotiation secure a significant degree of influence over both the investment of underwriting reserves maintained by the captive in respect of the programmes with which they are associated, and control the rate of the "flow of funds" through the captive (in the sense of the timing of permitted distributions). Such advantages over traditional insurance arrangements have long been the hallmark of the rent-a-captive, and in recent years innovations in Bermuda insurance laws have extended the options for structuring rent-a-captives, leading to a resurgence of interest in their use.
WHAT IS RENT-A-CAPTIVE?
A rent-a-captive is a company, typically established in an off-shore domicile like Bermuda, which "rents" its capital, surplus and legal capacity to engage in underwriting activities (i.e. its insurance licence) to policyholders which are not its voting shareholders. The rent-a-captive will often provide its policyholders ("programme participants") with required administrative services. As such, the term "rent-a-captive" applies to any arrangement where the insured party obtains equivalent benefits to those provided by standard forms of captives without actually participating in ownership or management.
One of the principal characteristics of a rent-a-captive is that the account established for each programme participant is segregated in some manner from accounts established for other programme participants. This is done to achieve a separate accounting basis for the insurance business attributable to each programme participant. Such segregation may be accomplished administratively by the rent-a-captive itself, or there may be a full legal segregation which results in statutory protection from losses attributable to other programme participants.
ADVANTAGES OF A RENT-A-CAPTIVE
Rent-a-captive programmes have long been acknowledged as alternatives to commercial insurance which offer more cost-effective and flexible risk management solutions, particularly with regard to workmen's compensation, but also for general liability programmes.
A rent-a-captive programme offers programme participants many of the advantages of a wholly-owned captive without requiring the insured party (or its owners) to make an equivalent commitment to fund the captive's start-up and ongoing management expenses. These advantages include the facility to customise the insurance programmes and control premiums, pricing and access to re-insurance. Establishment of the rent-a-captive in a select domicile (e.g. Bermuda) results in favourable (yet responsible) governmental regulation. Additionally the rent-a-captive can often secure coverage for specialised risk when this is unavailable in the commercial insurance markets. However, the main advantage of rent-a-captive may lie in enabling the programme participants to obtain a return of underwriting profit and investment income earned on the reserves held in their respective insurance programmes. Such returns will of course depend on the loss experience of the particular case.
Typically, each programme participant will retain a portion of its own risks, insuring the balance with the rent-a-captive. This arrangement creates powerful incentives to programme participants to be proactive with loss control and claims handling measures. Such measures will often be co-ordinated by agreement between the programme participant and the rent-a-captive, and perhaps with professional claims handling service providers.
OWNERSHIP AND CORPORATE STRUCTURE
There are various ways to own and structure a rent-a-captive, depending on whether the proposed programme participants are single corporations or a group or association. There may be tax and other factors to consider, from the standpoint of both the proposed programme participants and the sponsors of the rent-a-captive.
One of the more common rent-a-captive structures involves the sponsors forming a Holding Company which owns 100% of the voting shares of a Re-insurance Subsidiary. The Re-insurance Subsidiary in turn re-insures each programme participant., in association with an Issuing Carrier which issues the policies of insurance to the programme participants. The Issuing Carrier will usually be an insurance company which is licensed in the jurisdiction(s) in which the programme participants are resident. The programme participant will be afforded access to the rent-a-captive programme when it arranges for a policy to be issued by the Issuing Carrier and, in association with this, it will purchase one or more preferred non-voting shares in the Holding Company. Such shares will be purchased pursuant to the provisions of a shareholder agreement wherein the rent-a-captive agrees to cause a dividend to be declares to the owner of record of the preferred shares. Dividend payments will also be controlled by the shareholder agreement, e.g. on a date indicated on the appendix, being an annual payment date or the termination date of the particular programme. Dividends will be calculated according to a specific formula involving investment income earned and underwriting gain r loss. Payment of dividends will be subject to the availability of surplus funds (i.e. surplus of the statutory reserve requirements) in the related account.
The shareholder agreement will provide for indemnification of both the Holding Company and Re-insurance Subsidiary by the programme participant, the indemnity being designed to protect these entities in respect of any net underwriting losses, loss expenses and collateralisation expenses arising from the related insurance programme. As collateral for this indemnity, the programme participant will usually agree to provide the Re-insurance Subsidiary with a letter of credit (or substitute cash collateral).
The shareholder agreement will also provide for the payment by the programme participant of all premiums due to the rent-a-captive. Failure will constitute a material breach of the agreement. The amount of any such non-payment, together with interest, may be deducted from any surplus reserves held for the account of the particular programme, or any dividend due to the programme participant.
Dividends on the preferred shares issued to each programme participant will be declared and paid separately, i.e. as a separate class or series. Such shares will also be redeemable at face value upon the termination of a programme. However, where the capital required for the particular programme has been "rented" from the rent-a-captive, the shares will be redeemed less financing costs.
In other cases, the structure may not involve a holding company, leaving a re-insurance company which stands alone as the rent-a-captive. In such an arrangement, it will be this stand-alone re-insurance company which issues the preferred shares and enters into the shareholder agreement with the programme participant.
A growing number of rent-a-captives utilise a private Act of the Bermuda legislature, so that they may achieve legal segregation of the assets and liabilities of each insurance programme which they underwrite, so that there is no potential for "cross-liability" of one such programme resulting from the experience of another. Where the rent-a-captive is so structured (and depending upon the precise language of the private Act), the complete segregation of each programme participant's account can be achieved, the assets for each programme participant being isolated and protected from the liabilities of other programme participants and the failure of the rent-a-captive itself.
The advantages of such a structure will be clear. Pursuant to the typical provisions of such a private Act, a liquidator is as a matter of law bound to recognise the separate nature of the segregated account established for each programme, and may not apply assets of any one programme to pay claims of insureds under other policies issued by the rent-a-captive's non-insurance creditors. In addition, the liquidator typically has no power to void or cancel the terms of any policy, deed or contract issued in respect of any programme.
Not all rent-a-captives will be structured to take the benefits afforded by a private Act of this kind. Some rent-a-captive owners take the view that their programme participants may not be able to deduct premiums for tax purposes if there is demonstrably less risk-sharing among programme participants.
HOW DOES THE RENT-A-CAPTIVE WORK?
In the typical scenario, the programme participant (either on its own or with the assistance of a broker or the rent-a-captive or both) will negotiate with the Issuing Carrier, which will be an admitted insurance company (or "fronting" company) for the provision of policy-issuing and related services. The fronting company will then issue policy and cede the working layer to the rent-a-captive. For this service, the fronting company charges a fee, which may range anywhere from 5%-14% of gross premium. The fronting company will also be required to deduct certain federal and/or state taxes. As a matter of law, the fronting company will be primarily liable for the risk. However, the re-insurance agreement with the rent-a-captive will invariably require the latter to provide the fronting company with a clean, irrevocable letter of credit. The letter of credit is ultimately paid for and backed by the programme participant., typically as a one-time charge of 0.5% of premium, or as an annual fee of 0.375% of the premium deducted from the dividend. The guarantee for the letter of credit is the programme participant's own funds held by the rent-a-captive. In addition, the rent-a-captive itself will charge an underwriting fee of perhaps 2%-3.5% of premium.
CAPITAL REQUIREMENTS
In order to meet the Bermuda premium underwriting requirements (i.e. the ratio of premium to capital and surplus), a programme participant must itself either provide or "rent" the necessary capital. If the programme participant elects to rent, the rent-a-captive will often supply such funds from its own common share capital (usually for a fee of 1%).
Where capital is provided by the programme participant, this is generally accomplished through the purchase of the rent-a-captive's preferred non-voting shares, in an amount equal to 1/5th of the first year's net premium.
Purchasing the shares achieves two purposes. First, it provides the rent-a-captive with adequate capital for regulatory purposes. Second, as ownership of the shares constitutes beneficial ownership of the rent-a-captive, it may provide a basis for the taxable transfer of income back to the programme participant through deemed dividends.
RENT-A-CAPTIVE ACCOUNT EXPENSES
Rent-a-captive account expenses are typically 25%-35% of original gross premium ("OGP"), although they can be higher. These include boards, bureau's, taxes and assessments (3%-4%), claims handling (3%-4%), onshore broker commission (4%-5%), federal excise tax (1%), cost of specific excess (3%-6%), cost of aggregate excess (2.5%-4%), fronting company fees (5%-9%),rent-a-captive's capital and surplus, where applicable (1%).
What is left after fees and commissions (generally 60%-70% of OGP) and loss reserves may be temporarily available to the programme participant. Meanwhile, the rent-a-captive will invest these funds (typically though a professional investment adviser in order to maximise investment portfolio performance) and return investment income to the programme participant through dividends on the preferred shares, less a service income fee to the rent-a-captive (generally 1% of the value of the portfolio).
Provided that the rent-a-captive complies with applicable minimum solvency and liquidity ratio requirements (or, if there are segregated accounts pursuant to a private Act, where each programme for which a separate account is maintained complies with such requirements), Bermuda law permits complete freedom of investment management with regard to selection of asset classes.
PROFILE OF A PROSPECTIVE PROGRAMME PARTICIPANT
A prospective programme participant will generally:
- be too small for, or not interested in, establishing and operating a wholly-owned captive for itself; and
- generate at least $750,000 of annual premium onshore (be it a single-owner or association programme of insurance). (Workers' compensation programmes in California, which may be underwritten with less premium, are an exception to this).
In the case of association programmes (which are thought to account for about one third of total rent-a-captive premium income in the Bermuda market), association members are typically characterised by:
- similar exposures;
- a willingness to share risk within the mutual account;
- a combined loss ratio of 50% or less;
- a single or related exposure such as workers' compensation, general liability or automobile liability; and
- a consensus on the allocation of underwriting profit and investment income.
DOES THE RENT-A-CAPTIVE ITSELF ASSUME RISK?
Many of the rent-a-captives formed in Bermuda do not assume substantial risk in respect to the insurance programmes of their programme participants. Rather, these rent-a-captives view themselves as service companies and in fact require aggregate excess protection in some form as a condition of accepting a particular programme. All financial agreements are typically backed up with letters of credit ultimately guaranteed and paid for by the programme participant.
In recent years, the Registrar of Companies of Bermuda has made it clear that his office is prepared to consider applications to establish rent-a-captive which will accept risk for their own account, subject always to meeting relevant solvency and liquidity requirements.
The insurance team of Appleby, Spurling & Kempe has been actively contributing to the growth of Bermuda's dynamic international insurance industry by our involvement in formulating and recommending changes to relevant legislation and advising on innovative corporate structures. Our Insurance Team is the largest practice area within the firm and comprises ten corporate attorneys practising almost exclusively in the insurance fields and twelve full-time dedicated corporate administrators. Should you wish to find out more about CATEX Bermuda, please contact Warren Cabral, Head of the Insurance Team, using the telephone or facsimile number or e-mail address printed on the first page.
The Insurance Team Attorneys of Appleby, Spurling & Kempe are:
Warren Cabral (Head) F. Chesley White (Deputy) John D. Campbell Q.C. (Senior Partner) Richard D. Spurling Kenneth E.T. Robinson Douglas H. Molyneux Michael J. Burns Timothy C. Faries Gigi Barit Brian J. PattersonThe insurance Team Corporate Administrators of Appleby, Spurling & Kempe and their secretaries are:
Insurance Team I Cheryl S. Harney (Corporate Group Manager) Peggy A. Tucker (Deputy) Nicola J. Backeberg Michelle F. Smith Jill D. Paynter Kevamae Sampson - Team Secretary Tonita S. Eversley - Team Secretary Marcia Gillbert - Team Secretary Insurance Team II Audrey M. Mansell (Corporate Group Manager) Judy Taylor (Deputy) Cilma A. Lamb Shari L. Simons Stacy Grant Dionne G. Hackett - Team Secretary Marcia Gilbert - Team Secretary
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