Risk Management and Captive Insurance - Essay Example

?Executive Summary This report on opening a captive insurance company by an Australian business strives to zero-in the most favourite captive location out of the four provided domiciles. It introduces the topic of captive insurance by referring to the economic ups and downs and increasing premium rates charged by commercial insurance companies as a reason why the trend of captive insurance is catching up. The introduction part defines captive insurance and stresses on its need to cover various business risks. Various types of captive insurance are described along with the kind of insurance business undertaken by them, with different captive roles. As the business group is Australian, the report discusses the impact of Australia’s DOFI legislation on the righteousness of the decision of the business to operate a captive unit for the insurance needs of the company in preferable locations, including Australia, Guernsey, Bermuda, and Singapore. Various related sub-topics are discussed, such as ‘Admitted’ and ‘Non-Admitted’ besides analysing each mentioned domicile destination so that the most preferable domicile is finalised. Starting with Australia, other domiciles are discussed in detail. Guernsey takes the lead as it has maximum favourable points keeping in view the long-term strategic risk-management planning for an Australian conglomerate. The ends by pointing out the difference between a captive and other insurance companies, as a captive insurance can not cover certain insurances. TABLE OF CONTENT Executive Summary...........................................................................................................1 Table of Content................................................................................. ...............................2 Introduction........................................................................................................................3 1.1 Definition of Captive Insurance...................................................................................4 2. Types of Captives............................................................................................................4 3. Captive Roles ..................................................................................................................5 4. Impact of Australia’s DOFI legislation on the company decision..................................6 5. Addressing the ‘Admitted’ vs. ‘Non Admitted’..............................................................7 6. Australia...........................................................................................................................8 7. Guernsey...........................................................................................................................9 7.1 Guernsey Plus-side..........................................................................................................9 7.2 The Non-EU Status of Guernsey...................................................................................10 7.3 The Advantageous Legislative Design..........................................................................10 8. Bermuda...........................................................................................................................11 9. Singapore..........................................................................................................................12 10. Conclusion & Recommendation.....................................................................................13 11. A class of insurance that the captive can’t cover.............................................................13 12. References.......................................................................................................................14 Captive Insurance 1. Introduction Increasing doubts in the world economy and random highs in premiums in the commercial insurance sector have encouraged companies from varied industries to plan their own captive insurance companies. Firms over a varied length of industries are increasingly using captive insurance as part of their risk controlling strategies. These companies are exposed to different risks and unpredictable situations, and it is generally not practical for them to get insurance cover for these risks because of high premiums in the commercial arena and the non-offering of insurance cover for some industry-specific risks. The four major industries globally, in terms of the number of captives established, are financial institutions, healthcare service providers, retail and consumer products companies, and infrastructure companies, majorly building, energy and utilities. In the contexts of the range of captives domiciled on an international level, Bermuda and Guernsey are some of the selected destinations although Singapore has also softened its programs for captive domiciles (Research and Markets, 2013). The leading reason behind financial institutions opening maximum captives across the globe, (nearly 20% captives are opened by financial companies) is due to their risk controlling capacities and the need of fulfilling Basel II/ III standards, compelling them towards the higher use of captives. According to Research and Markets (2013), captive domiciles like Bermuda and Guernsey have agreed not to follow parameters equivalent to Solvency II (Research and Markets, 2013). 1.1 Definition of Captive Insurance In summing up general terms, a captive insurance company can be defined as an entity registered in a specific jurisdiction or domicile mainly to insure or reinsure the risks of the parent conglomerate and /or one or more than one other entities, or even not-related entities. So far as all of a captive’s operations are considered wise and within the limit of the law and routine insurance company practice, it can write nearly any kind of insurance cover for relevant or non-relevant entities and ask a premium that the company and its regulators find agreeable (England et al., 2007). According to Ong Chong Tee, the deputy managing director of the Monetary Authority of Singapore (MAS), as stated by him at the Asia Pacific Rendezvous, “as Asia is poised to embrace more sophisticated risk management solutions, captive insurance will have a role to play”. Incidentally, Singapore captive industry registered gross premiums of near to S$750 million in 2007, which represents 22% of Singapore’s offshore insurance fund business (Marsh, 2008). 2. Types of Captives Pure Captive – is totally owned by one parent company. It is designed basically to insure or reinsure the risks of the corporate parent or non-related parties of the choice of the parent corporate entity. Group Captive – is possessed by two or more than two entities, which can be generally trade associations or companies of the same kind. These insurance companies are structured to insure or reinsure the risks of the group. Rent-a-Captive (Cell Captive) -- formed to insure or reinsure the risks of unrelated shareholders; the insureds are "renting" potential of the insurer leveraged by outside sponsors. Risk Retention Group – functions like a group captive but is controlled under federal legislation. It can operate in any state but needs to be licensed in its state of domicile. Insureds and owners must be the same entities. These can write only liability lines of risk and are not capable of offering reinsurance (Wischmeyer et al., 2002). Allowed Business: Pure and group captives can conduct all types of insurance business including: Third-party business Life insurance Joint ventures (Lowe, 2008). 3. Captives’ Roles Based on captives’ roles, they can be categorised as: Sponsor Captive Investors (acts as SPV) Captive able to operate under capital market (ISDA) and insurance validation Third party captive owner Captives situated in all appealing locations and controlled as insurance companies PCC cells provide cost-effective, fast established SPVs > commoditisation Captives can also shift banking risk into insurance Product (Watson, 2008). 4. Impact of Australia’s DOFI legislation on the company decision As stated, the Australian business house has a yearly income of more than $10 billion. Its two leading insurance programmes are costing it $40million in premium. DOFI legislation for proposed exemptions stipulates certain conditions related to high value insureds. One condition out of various others is related to consolidated gross operating income, which must be $200 million. In the case of the Australian business, it fulfils this condition as its annual income is $10billion, as stated above (Robinson, 2007). Another stipulation of the DOFI legislation is related to aggregate level of insurance premium, up to $30 million. This is also clearly met by the Australian company, as already it is paying $40 million in insurance premium per annum. Overall, DOFI legislation does not come in the way of the issue of high value insureds (Robinson, 2007). Regarding insurance of atypical risks, including such risks as kidnapping, malicious product tampering, war, environment, political, nuclear, satellite and asbestos risks, concern has been raised for inadequacy of this list. Further additions of atypical risks under the DOFI legislation have been proposed, including some of the risks related to international P & I Clubs, total public liability and professional indemnity cover, residual value, clinical trials liability, bloodstock, marine, aviation and aerospace and others (Robinson, 2007). The next issue before DOFI legislation is related to various customized exemptions, such as criteria, assessor, and a list of other exemptions for qualifying specific risks to an authorized insurer. Actually, DOFI legislation is yet to address offshore risks and the need of overseas law (Robinson, 2007). 5. Addressing the ‘Admitted’ vs. ‘Non Admitted’ The Australian conglomerate desiring to open a captive company on the selected favourable domicile location would be an ‘admitted’ company, as it would be authorised insurer to represent the standard market. Foreign insurers are admitted by a domicile licensing and registration office by providing them license to operate in the domicile admitted market. The domicile office analyses and agrees on other related transactions that affect the license of foreign insurers. A captive company’s transactions are among the leading functions of a domicile licensing authority for offering related services (Texas Department of Insurance, 2013). On the other hand, non-admitted companies are although registered companies but these insurers represent the non-standard market. When the same type and class of coverage cannot be put in the admitted market with a licensed insurer after a thorough search by a licensed surplus lines agent, as is the case with the Australian conglomerate, it can be put in the non-admitted market with a surplus lines insurer. It is not the scenario with the given Australian company, as it is keen to open a captive unit only and risks are not distinct in kind, not permitting it entry in the admitted market. Generally, the capitalisation parameters for surplus lines foreign insurers are mostly quite higher than the admitted insurers; the regulations are relatively strict (Texas Department of Insurance, 2013). Before deciding from the four domiciles to locate the captive from among Australia, Bermuda, Guernsey, and Singapore for the Australian conglomerate, an analysis of each domicile on certain parameters is necessary. 6. Australia Normally, for Australian companies to use the controlled foreign company (CFC)rules, can at the most make the Australian off-shore functions competitive by offering solace to Australian tax-payers from additional attribution taxes and the burden of adherence but not to the Australian businesses leveraging through CFC captive insurance companies (Willis Australia, 2010). The aim of Australian companies in utilising offshore resident CFC captive insurance companies is primarily to get a competitive edge by purchasing the most cost-efficient insurance programme available. The reason behind opening captives offshore are regulatory (APRA’s changed capital and reporting needs compel Australian companies offshore where regulatory norms are more suitable) and near to global reinsurance centres like Bermuda and Singapore. The main aim of having a CFC captive is to most cost-efficiently finance and shift risk and to operate them near to break-even (surely not with a motive to make bulk profit as insurance is not a basic business for companies using captives) (Willis Australia, 2010). Insurance premiums paid to captive insurers are computed on the basis of a few leading segments: The empirically decided cost of risk to be kept by the business in their owned captive insurance company; the reinsurance premiums payable to shift risk in addition to a business’ kept risk to the international insurance and reinsurance markets; the facilitating costs (actuarial, audit, regulatory and management) to operate the captive insurance company (Willis Australia, 2010). The problem in opening a captive company in Australia is that treasury perceives a captive insurance to be an actively organised business; hence the use of new Part 30 Integrity Rule would bring losses to Australian businesses functioning for a captive insurance design relatively to businesses who normally deal insurance via the traditional insurance markets. On the same parameter, the “Grouping Relief” provisions together with “Part 30 Integrity Rule” have the ditto impact (Willis Australia, 2010). 7. Guernsey Guernsey has had a flourishing insurance industry for many years. One of the leading benefits of the Guernsey insurance market is the richness of experience and insight of the experts in the industry, while the market is also wonderfully varied in terms of its participants. The island's ranking as the biggest captive insurance domicile in Europe is well known (Pelley, 2013). 7.1 Guernsey Plus-side There are some leading characteristics of the Guernsey insurance market, which make it very competitive as an insurance domicile. The island is distanced from the impact of the European Union. It has followed a beneficial legislative mechanism for insurance. The Guernsey insurance market is innovative. It was the first to initiate Protected Cell Company legislation in 1997, which led to the opening up of the market to smaller captives by minimising the entry hurdles (Pelley, 2013). A range of industries get a friendly climate in Guernsey from its insurance professionals, such as the accounting firms, the legal firms, the actuarial firms, the banks and investment managers. The density of experience and insight of the professionals available in Guernsey is difficult to trace in other captive insurance domiciles. Other than Bermuda, which has led the growth of global insurance and reinsurance, no other domicile has the same depth of talent in one location than Guernsey (Pelley, 2013). 7.2 The Non-EU Status of Guernsey Being a smaller and non-EU economy, Guernsey is well-positioned to get leverage of the economic change from the opportunities coming through the dynamic social and political scenario relatively to a bigger economy like the EU, whose market is afflicted with political tussles, recession and financial mismanagement by its member states (Pelley, 2013). Guernsey has its own set of insurance regulations, which adhere to global best practice, as defined by the International Association of Insurance Supervisors. More than that, Guernsey follows an elastic approach over these high level codes to help the insurers in getting a competitive edge relatively to their EU counterparts. The GFSC has been keen on creating a customised regulatory mechanism, which is not deficient in any way to the concurrent global parameters, and efficiently controls the regulatory risk of its insurance market (Pelley, 2013). 7.3 The Advantageous Legislative Design Guernsey boasts of the Companies (Guernsey) Law 2008, which strengthens and updates the Protected Cell Company law, the Migration and Conversion laws, the Insolvency laws and a number of other corporate laws to guarantee that Guernsey companies can adjust fast and efficiently to changing opportunities (Pelley, 2013). Other than leveraging from the Company Law, the island's Zero-ten Corporate Tax regime is both tax-saving and easy to understand for insurers. Together with an increasing number of double tax contracts, the corporate tax regimen for Guernsey insurers is suitable. Finally, Guernsey has followed all of the Financial Action Task Force suggestions on anti-money laundering (AML), and it is taken as an 'equivalent' jurisdiction to AML and with other developed global economies like Australia and others. Off late, the regulator in Guernsey has distanced away from the hard line needs for general insurance to appreciate the low-risk category of this kind of insurance in relation to money laundering and financial crime. It provides a competitive edge to Guernsey insurers to remain on an equal footing with other European domiciles on the AML adherence front (Pelley, 2013). 8. Bermuda In Bermuda, there are in total 862 captives operating, as per 2011 figures. There are four classes for capitalization needs, the minimum solvency margin. Class 1 requires capital of more than $120,000 or a premium test, requiring first $6million ‘net premium written (npw) or fulfilling the condition of Loss reserve test of 10%. The loss reserve test for Class 4 is 15% while the minimum solvency margin is $100,000,000, with the alternative of premium test, which is 50% of npw (PWC, 2013). Liquidity Requirements -- Related assets must be equal to 75% of related liabilities. Registration and incorporation expenses -- Incorporation fee is $2,600 while BMA Registration fee is $580. Investment Limitations -- There are no controls other than that only related assets are permitted for consideration in liquidity computation, excluding investments in funds and intercompany receivables. LOCAL Taxes -- There are no taxes till the year 2035 as global firms are assured by the Bermuda government that in case of income or capital gains taxes are enforced, these firms will be relieved from such taxes. Tax Treaties --The Bermuda government has signed a contract with Australia like many other countries, as of March 1, 2013. Reporting Needs -- Firms are excused for filing GAAP financial statements. For Class 1 and 2, statutory financial statements are to be filed six months from the year-end, and four months from the year-end for Class 3. Loss Reserve Specialist consultation is not needed for Class 1, but is needed tri-annually for Class 2, and each year for Class 3 (PWC, 2013). 9. Singapore Singapore has 63 captives registered and this business is growing at the rate of 2 captives each year added to the list. Considering Singapore for an Australian business to open a captive domicile, there is in force the insurance Act with controls on Valuation and Capital, Accounts and Statements, and Actuaries. Captives in Singapore are exempted under the General Provisions and for Captives regulations, which has the lead effect: It demolishes the need from MAS of a statistical report (unless life captive) Relieves captives from Risk-based capital needs Streamlined reporting (Herbert, 2008). Singapore offers better tax regime as there is the provision of 10 year tax relief for captive domiciles. Companies can pursue to re-elect for another 10% rebate on the tax rate (Herbert, 2008). 10. Conclusion and Recommendation The Australian taxpayer may get a competitive edge by using a CFC captive insurance mechanism, but at the same time he is at a loss from the Treasury’s new Part 30 Integrity Rule, which will not permit tax deduction of the full insurance premium paid to its CFC captive insurer and a lost tax deduction. The outcome for the Australian taxpayers is that it would cost the tax-payer more expensive insurance cover via traditional means because of the tax effect. This may not be the intention of the Treasury as this rule is expected to increase Australian business’ competitiveness (Willis Australia, 2010). Guernsey stands on the top as an insurance domicile, considering its various strengths, including its industry support through the Guernsey International Insurance Association, the political advantage from the Commerce and Employment Department, and the regulator (the Guernsey Financial Services Commission), all striving to bring innovation through the introduction of new products and services (Pelley, 2013). 11. A class of insurance that the captive can’t cover Captives can not cover traditional insurance company products like home, motor, and crop insurance. These types of traditional insurances are covered only through traditional insurance methodology, which is about ‘taking and pooling premiums from many to pay the claims of a few’. Unlike captive insurance companies, most general insurance companies collect their premium income from a varied range of ‘risk lines’ including, for instance, typical home and motor products through to farming and crop insurance (RGIB's Captive Insurance Solutions, 2008). References England, P., Druker, I.E., & Keenan, R.M. (2007). Captive insurance companies: A growing alternative method of risk financing. Journal of Payment Systems Law. Retrieved from http://www.andersonkill.com/webpdfext/cic-riskfinancing.pdf Herbert, S. (2008). Singapore as a captive domicile. Marsh Captive Solutions. Retrieved from www.marsh.com Lowe, P. (2008). Asia Pacific captive rendezvous: domicile Panel. New Zealand Captive Insurance Association. Willis, New Zealand. Marsh. (2008). Captive updates: risk optimisation group, MMC. Pelle, M.T.L. (2013). Guernsey: Guernsey’s insurance advantage. Retrieved from http://www.mondaq.com/404.asp?action=login&404;http://www.mondaq.com:80/x/263756/Insuranc/Guernseys%20insurance%20advantage= PWC. (2013). Captive insurance domicile comparison for the Caribbean region. Retrieved from http://www.pwc.com/bm/en/insurance/captive-insurance-domicile-comparison.jhtml Research and Markets. (2013). Captive insurance: many captive domiciles such as Bermuda and Guernsey have agreed not to adopt standards equivalent to solvency II. Research and Markets: 2020 Foresight Report. Retrieved from http://finance.yahoo.com/news/research-markets-2020-foresight-report-173200337.html RGIB's Captive Insurance Solutions. (2008). Captives & traditional insurance company arrangements. Retrieved from http://www.ruralandgeneral.com.au/captive_insurance_solutions.php Robinson, A.A. (2007). Direct offshore foreign insurers–the exemptions. Financial System Division, Australian Treasury. Texas Department of Insurance. (2013). Company licensing and registration. Texas Department of Insurance. Retrieved from http://www.tdi.texas.gov/licensing/company/ Watson, M.C. (2008). Asia-Pacific rendezvous. Willis Captive Practice. Willis, Australia. (13 August, 2010). Reform of the controlled foreign company rules. Treasury Consultation Paper July 2010. Retrieved from http://archive.treasury.gov.au/documents/1896/PDF/Willis_Australia_Limited.pdf Wischmeyer, C.C., Gagliardi, B., & Levine, G. (24 September 2002) Captive Insurance. MMC Enterprise Risk, KPMG. http://finance.yahoo.com/news/research-markets-2020-foresight-report-173200337.htm Read More