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Captive or rent-a-captive programme?
Peter Willitts considers the alternative
advantages of captives and rent-a-captives.
Cayman Captive 2007
There seems to be a current craze to form rent-a-captives (RACs) that segregate the liabilities of participants. In fact, RAC programmes may be overtaking traditional equity or stand-alone captives in popularity. Unlike group captives, in which the performance of a single programme affects the results of all participants, or rent-a-captives where programme results may affect other participants, RACs set out to segregate the risks of various entities into vehicles often referred to as “cells”.
While RACs go by various names— segregated portfolio companies in Cayman, segregated account companies in Bermuda, protected cell companies in Guernsey and sponsored captive insurance companies in Vermont—the concept remains the same. The assets and liabilities of one cell are separate and distinct from the assets and liabilities of every other cell. Indeed, a legal firewall protects these cells, and there is no legal recourse for success or failure from one cell to another. Underlying these cells is a general or core account, the assets of which, in most domiciles, can be called upon in the event of cell insolvency.
Someone considering placing an insurance programme into a captive, but who has not yet decided which type of facility to use, must choose what he wants: cost or control. The three areas where participants have choices about control are: flexibility of investments, flexibility of form, and level of capital required.
In most captive domiciles, the rule governing the permissible investments that a captive may make is essentially ‘any asset regularly traded in a recognised market’. However, regulators will place limitations on the type and concentration of investments and, I believe, would frown on all the assets of the company being in one vehicle such as pork belly futures. Yet, there is normally some flexibility with equities, convertible bonds, mortgage-backed securities, municipal bonds and other quality instruments.
Typically, the RAC’s owner and board of directors determine the types of assets in which to invest cell capital and surplus, and then the investment manager places those assets. While this reduces participants’ control over investments, they may benefit from lower investment manager fees and better results from a larger pool of money. Overall, RAC participants enjoy reduced cost while giving up control.
Flexibility of form applies when the organisation wants to write direct policies. Programmes issued by admitted insurers will have to comply with regulations applicable to all admitted insurers. Admitted and surplus lines-fronted programmes will be drafted by the fronting carrier. However, for offshore domiciles, there is the possibility of writing a policy directly from the captive to the insured. Captives have long been known for writing these manuscript policies. If the ultimate owner has an interest in the insured, then somewhere, there is a meeting of the minds as to exactly what the intention of the policy is, even if that intent is never fully captured in policy language. With that premise, a legal case in which the captive can end up paying for something that was not meant to be covered is extremely unlikely. This level of flexibility may be good for a stand-alone captive owner, but it would create uncertainty for an RAC owner about the scope of coverage. Such uncertainty is not an area into which an RAC owner would want to venture. The RAC owner wants certainty and, therefore, the forms issued will be restricted to tried and tested policies.
Cell capital must be adequate to satisfy the regulators, the owners of the RAC and the fronting carriers. Normally, the aggregate limit accepted by either the cell in the inward policy, or the aggregate reinsurance that protects the front on the ceded policy, determines the amount of capital a cell requires. Some directly-issued policies can lack an aggregate limit, have a very high limit in comparison to premium—normally seen where the losses will be in the distant future—or have a variable loss level. Regulators may be satisfied with a gap between the aggregate limit and the level of capital if the individual exposures are small, the programme written is to a related party, and the loss projection is statistically sound. Take, for example, a reimbursement programme related to a warranty. With a well-funded parent company, the regulator may take the position that the public is actually relying on the corporation that issues the warranty because the reimbursement of the corporation is an internal financial arrangement. However, the RAC owner may not feel as comfortable with the same risk and therefore require higher capital levels than the regulator.
Finally, there remains uncertainty about the proper tax treatment of RAC segregated cells. In the US, while not addressing segregated cells, Inland Revenue Service (IRS) Ruling 2005-40 explained certain positions with regard to risk transfer and risk sharing. The IRS’s stated position is that, unless a number of entities share risk, sufficient risk transfer and risk sharing do not exist. One might then conclude that one cell would not qualify as risk transfer, per the interpretation of the IRS.
Those are the disadvantages of the cell structure. While there are benefits to stand-alone captives, I do not intend to address them here, as the intention is to discuss comparative structures. During a recent conference, I asked a panel of RAC owners: “What equity rights does a cell owner have?” and the unanimous response was: “None—other than to receive dividends”. However, RACs are probably the fastest-growing part of the captive industry. So the attraction is substantial.
The cost advantages of an RAC lie in three areas: programme formation, operation and closing costs. The RAC cell formation process varies considerably by domicile. In some domiciles, while regulatory oversight is quite limited, the cell owner or captive manager is still subject to the ‘know your client’ requirements and anti-money laundering regulations. In other domiciles, post-approval of the cell owner and the programme is necessary, and in others still, pre-approval is required. However, the process of forming a cell in any domicile is considerably easier than forming a captive.
With an RAC, a company does not have to be formed, it already exists—although the participant will need to execute a shareholders’ agreement. Sometimes, a governing instrument controls the relationship, especially if the RAC is a non-controlled foreign corporation, and the participant should have its legal and tax advisers review these documents. Still, this formation process is considerably easier than creating a name, agreeing internally on directors and officers, taking a standard company with its by-laws and adjusting it, selecting auditors, investors, managers, etc.
The running expenses of a captive can be split into two elements: the hard costs and the soft costs.
By soft costs, I mean management time, which does not show up in the captive’s financial statements but is nevertheless a reality. The hard costs are the expenses paid as a direct result of owning a captive. To the extent that an RAC is not a wholly-owned subsidiary, the finance department’s accounting role is less burdensome. The parent company’s finance staff do not spend time on dealing with auditors at the detail level, the members of the management team do not attend board meetings, etc. All this saves soft costs.
Then there are the hard costs that any company incurs, such as secretarial fees, audit fees, management fees, local taxes, bank charges and legal fees, as well as the cost of meetings, etc. In an RAC, cell owners spread the costs among the entity, so that the actual running costs should be lower for everyone. The fees charged by an RAC comprise three parts: an allocation of the incurred costs, a fee for running the facility, which includes a profit element, and a capital fee or fees for use of the facility. If the owner of the RAC is different from the manager, the fees become easy to see as separate costs. However, for many RACs, the owner and the manager are the same. Often the fees are split into two, one being based on assets under management or investment income, and the other being a straight management fee. The overall concept is easy: expenses shared should be expenses lessened.
The final advantage of an RAC is that closing an RAC cell is easier and cheaper than closing a single parent captive. For both an RAC and a stand-alone captive, closing out the insurance liabilities is the initial step in closing a parent’s investment in the alternative market. But two factors give an RAC the edge in this process. First, when a programme begins to wind down and the tail gets smaller and smaller, the low cost base of an RAC becomes a more positive advantage. Second, when closing either a captive or an RAC programme—assuming it is not claims made—the liabilities must be commuted back to the front or novated to another carrier. At this point, a stand-alone company has to go through a liquidation process. But for an RAC cell, the company merely declares a final return of capital and the termination of the relationship, and the wrap-up is complete.
For those corporations thinking of forming a captive, occasionally the concept of forming an in-house RAC is floated. The normal suggestion is that it gives more flexibility. While this is true, the disadvantage is that, in most jurisdictions, more capital is required. It should perhaps be noted when considering this option that, in domiciles where cell and captive data are published, few RACs actually have many cells, so it’s good to really think about how many cells will be needed before choosing the RAC. It may be a good idea if there is a strong possibility of other business coming in or if it does not adversely affect the tax position of those involved. However, keep in mind that, in reality, there are really a limited number of situations in which RACs can be used.
With the number of captives and RACs being formed, there are obviously advantages to both structures. There is no simple answer as to which is appropriate in all situations. The simplest advice is: ‘make sure the structure meets the basic objectives’ and then make ‘control versus cost’ the deciding factor. Size is one of the factors that will influence the decision, with smaller programmes normally ending up in an RAC. However, careful research with the captive manager to establish how much flexibility will have to be sacrificed, and a frank discussion about all costs, normally helps the potential captive or cell owner reach the appropriate decision.
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“The simplest advice is: ‘make sure the structure meets the basic objectives’
and then make ‘control versus cost’ the deciding factor.” |
