Virtual Captives - A Real Solution?


1 August 2006 Alan Burton


How can virtual captives be used to offset risk in line with IFRS12 and IAS37? Risk experts David Hertzell and Alan Burton investigate.


Outside the US and associated captive domiciles such as the Cayman Islands, growth in the formation of new captives slowed to less than 4% in the major centres during 2005. This is partly in response to a kinder insurance environment, but also perhaps in reaction to the increased costs of operating, including more complex regulation and accounting.

The tax advantages of a traditional captive have been so eroded that for some companies the virtual captive concept may be the right risk retention solution, combining many of the advantages of a conventional captive with lower cost and greater flexibility.

A RISK RETENTION VEHICLE

A captive has conventionally been defined as a subsidiary company set up to write off the risks of its parent or owner. In reality, a captive is not a conventional insurance company as it does not spread the losses of the few amongst the many. It is rather a risk-retention vehicle, spreading the cost of losses over time.

This is equally true of a virtual captive, which is fundamentally a centrally managed retention within the parent company; a self-contained accounting unit but, unlike a captive, not a separate legal entity.

However, before considering any risk retention solution, it is necessary to develop a risk retention strategy. It is important to have a clear idea of risk tolerance and risk appetite, to have undertaken all the necessary risk modelling and to have commissioned the appropriate feasibility studies to cost and support the chosen strategy, whatever that might be.

CAPTIVE COSTS AND BENEFITS

The benefits of a traditional captive insurance company have been well rehearsed and are long established. A traditional captive:

  • Insulates risk-financing from market swings
  • Facilitates large retentions
  • Provides access to reinsurance markets
  • Charges intragroup premiums / allocations
  • Smoothes operational budgets
  • Provides certificates of insurance
  • Facilitates good risk management
  • Meets statutory requirements for insurance
  • Provides control over claims-handling
  • Underpins sound data collection
  • Ensures appropriate accounting
  • Is tax-effective
  • Is cost-effective

The big query is the question of costs. Regulatory and operating costs have risen over the last few years and accounting has become more complex. Interest rates have fallen. Insurance Premium Tax (IPT) increases are a real possibility for any cash hungry government and current UK rates in particular are below the European average.

Captive operating costs include:

  • Management services and directors' fees
  • Employees, premises, travel
  • IPT, licences and premium levies
  • Accounting / actuarial advice and audit fees

TAX ADVANTAGES LESSEN

Tax was traditionally a factor in establishing a captive and it is no coincidence that the main captive centres are located off shore.

"A captive is a risk-retention vehicle, spreading the cost of losses over time."

However, tax advantages have largely disappeared with controlled foreign company legislation in force across Europe. This is particularly the case for mainstream, non-catastrophe risks.

Another tax issue for captives is transfer pricing. This requires that the premiums paid to a captive are market-based and priced on an arm's length basis. It is no longer possible to build in a substantial profit element. This would apply particularly to conventional mainstream risks where market prices are easily available.

There is a greater element of subjectivity in catastrophe risk-pricing. In addition to losing a possible tax advantage, the captive could potentially be exposed to underpriced risks if the commercial market is particularly soft.

VIRTUAL CAPTIVE PROVISIONS

Post-1999, the accounting requirements for provisions have been significantly tightened by IFRS12 and subsequently IAS37. Essentially, provisions are allowed only for events that have occurred and can be quantified. Statistical quantification, however, is acceptable. It is, therefore, very difficult to carry reserves against contingencies.

However, if it is possible to demonstrate that a loss pattern is likely, based on past experience, and that loss pattern can be statistically quantified, then IFRS12 (IAS 37) provisions are automatically fully deductible.

It is possible, therefore, to achieve accelerated tax deductibility in mainstream accounts, previously only achievable via a captive. Organisations with sufficient data flow and a history to support provision within IFRS can create an accounting unit which can operate much like a conventional insurer within the accounts of the 'parent' company.

So who could benefit from virtual captives?

  • Large companies with good actuarial expertise
  • Companies with excellent data records

Virtual captives could also be useful for companies requiring:

  • High-frequency, low-benefit covers
  • Covers without external certification
  • Low-margin employee benefits

USE OF A VIRTUAL CAPTIVE

If a virtual captive sounds like it might be a solution, then what can be done with it? The virtual captive accounts for provisions in accordance with IFRS12/IAS37, using external actuarial estimates, discounted.

It can buy in claims handling and adjusting services. It can buy catastrophe insurance. It can charge subsidiary divisions for premiums, claims handling, reinsurance and administrative costs and its accounts can be consolidated with an offshore captive assisting the smoothing of insurance costs. In short, the virtual captive can be used in much the same way as a wholly owned captive subsidiary.

The benefits are that the virtual captive is extremely flexible; for one thing, it is easy to set up and would not generally be a regulated insurance entity. There are significant costs savings – in particular IPT, levies and fees, travel, captive management charges, regulatory costs and accounting and audit costs, with no restatement costs on consolidation of accounts.

A virtual captive is ideal for use with high-frequency, low-severity covers or covers where external certification is not required. Low-margin employee benefits are also a possibility.

"Large companies with good actuarial expertise and companies with excellent data records will benefit from virtual captives."

Actual use of virtual captives by UK plcs includes motor accident damage, employers' liability, motor third party (with a front), travel and ex-pat health, personal accident, healthcare via a trust, and the possibility of writing legal expense insurance.

The conventional captive is probably better for catastrophe covers, insurance where certification is required and for profitable customer insurance such as extended warranty.

FINANCIAL DISCIPLINE NECESSARY

The disadvantages of a virtual captive to some extent mirror its advantages. As the virtual captive is very flexible, its funds could be raided for other purposes, leaving the parent company exposed to unreserved losses.

As with all risk retention concepts, it is worth bearing in mind that insurance is an easy industry to enter but very hard to exit. A virtual captive will only succeed as a risk retention vehicle if it is used in the same way as a traditional captive and not as a rainy day piggybank.

It is also not possible to access the reinsurance markets directly from the virtual captive; neither is it possible to issue insurance documentation where that is required for regulatory or other purposes. A comparison between the advantages and disadvantages of a captive, a self-insured retention (deductible) and a virtual captive are set out in the table opposite.

RESOURCES REQUIRED

Although a virtual captive can give a great deal of control, it has to be properly resourced. Operational requirements may not be outsourced to the same extent as with a conventional captive.

In order to set up and run the virtual captive, the finance team must have tax, treasury, legal, accounting and actuarial skills. Although the virtual captive will need dedicated accounting support, it makes sense to outsource claims management and set up a standard process for claims reporting and actuarial reporting to support the IFRS/IAS provisions.

A virtual captive is certainly not for everyone. It is one of several possible solutions to a risk-retention strategy, which now include wholly owned captives, protected cells, risk retention groups and a straightforward retention.

Experience to date shows that it is most attractive for large companies who are able to provide good actuarial support to confirm their IFRS/IAS provisions. However, as with conventional captives, the concept is likely to evolve, particularly if there is a substantial increase in IPT.