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Captives for Rent

Companies are flocking to rent-a-captives for risk transfer.

1Apr

Directory Distributing Associates Inc. (DDA) stopped paying through the nose for workers' compensation insurance in 1994. Fed up with expensive state assigned-risk pools, DDA rented a captive facility instead--and slashed its expenses by half. "The strategy has driven down our costs and provided more claims control," says Michael Shelton, CFO of the St. Louis­based order-fulfillment company, which currently has 60,000 employees. "I can finally budget the expense. In the past, I never knew what the next year would bring."

Renting risk transfer may seem off the wall, but it's a proven concept that has kicked around for more than three decades. With commercial property-and-casualty insurance prices up 5 to 10 percent this year and headed for further increases, many alternative risk- transfer strategies are being dusted off and reconsidered. Among them is the rent-a-captive.

Think of a rent-a-captive as a mall of stores, with each store representing the self-insurance program of a particular company. The concept is akin to that of a traditional captive--a subsidiary owned by a corporation to insure its own exposures. The difference is that with a rent-a-captive, the corporation doesn't have to go through all the hoopla of incorporating the captive; it leases one instead.

"A company doesn't have to come up with the initial capitalization and endure the regulatory legwork to create and fund its own captive, since we've already done that for it," says David Alexander, president of Mutual Indemnity Bermuda Ltd., a Hamilton, Bermuda-based rent-a- captive that represents the insurance interests of 155 active clients.

Rent-a-captives promise pretty much what most corporate-owned captives offer: more control over losses through improved claims management, the ability to garner underwriting profit and investment income on the funds set aside in the facility, and even potential tax benefits. What's different is that the company avoids the usual accounting and auditing issues, which are handled by the rent-a-captive sponsor.

What do sponsors get for providing capital and administrative services? Most charge a percentage of the premium paid to them; some take a share of the investment profit.

Rent-a-captives have evolved considerably since their debut in the 1970s. Early programs involved the sharing of risk among the individual renters, which was great if your company had a high-loss year, but less great if you had a low one. In recent years, as the competition among rent-a-captive domiciles has intensified, new structures have been unveiled that wall off each company "cell" (the preferred nomenclature for a corporate account) from the loss experience of other cells.

In Bermuda, the seedbed of the captive movement, segregating cells had been legal but difficult, requiring a private act of Parliament. New legislation enacted in 2000 (The Segregated Accounts Companies Act) makes this a walk in the park today, requiring only a simple application process. This has dramatically increased interest in rent-a- captives.

So has, of course, the tightening insurance market. "Applications are up tremendously, and we're executing quite a few deals," reports Alexander. In the fourth quarter of 2000, Mutual wrote 16 new corporate accounts, compared with 5 in the same quarter of 1999.

Both offshore and onshore domiciles support the novel insurance facilities, including Bermuda, Gibraltar, Guernsey, the Cayman Islands, and several states. Altogether, about 1,000 companies are said to be leasing a captive (Mutual's various rent-a-captives have more than 500 of these companies) at some 75 rent-a-captives in these domiciles.

ATLAS IN THE VANGUARD

Atlas Van Lines Inc., a national moving company based in Evansville, Indiana, was an early adherent to rent-a-captives. "We joined Mutual back in 1988 simply because we had to get affordable workers' compensation insurance for our truckers, which at the time wasn't available," says Howard E. Parker, CFO of Atlas, which has annual revenues of $550 million.

Parker says the rent-a-captive strategy has paid off nicely. "I'd estimate we've put an extra $1.2 million on the bottom line, pretax, each year since we joined," he says. "Had we started our own captive, we'd have had to train people to manage it, and put up a ton of capital just to incorporate it. I get the benefits of a captive without all the hassle."

Atlas establishes a premium based on its understanding of the risk, and charges that amount to the 1,100 independent truck owners-operators that have elected to buy workers' compensation insurance through its program. In between, however, are a number of complex transactions.

For example, for policy issuing and tax reasons, Atlas buys insurance from a so-called fronting insurance company. The fronting carrier (Milwaukee-based Legion Insurance Co.) is theoretically liable for the policy losses, although it cedes this risk entirely to IPC Cos., a Mutual subsidiary. "I collect the premium from the owners- operators, and pay a premium to Mutual that is less than that amount [providing a profit to Atlas], which in turn pays a premium to IPC Cos.," explains Parker. "IPC then assumes the entire risk from the fronting carrier."

Atlas covers the first $250,000 in per- claim losses, plus 10 percent of losses that exceed $350,000, up to $1 million. IPC buys reinsurance to cover the remaining 90 percent risk. Losses above $1 million also are covered by a separate reinsurance policy that IPC buys. To pay claims, Atlas draws from its rented captive's loss reserve fund, which is composed of the premium it has charged and collected, plus the accrued investment income.

Given good underwriting and investment results, the reserve fund accumulates year over year, garnering significant revenue. "My overriding financial motive was for us to receive the underwriting profits and investment income, instead of just giving them away to an insurance company," says Parker. After one bad year--ironically, Atlas's first with the strategy--the company has made a profit every year.

A MIDSIZE FIT

While large corporations also may avail themselves of the strategy, rent-a-captives are really designed for midsize companies. "Basically, a medium-size company spending about $1 million or $2 million in premiums, with a good loss ratio and a desire to share in its own risks, is a prime candidate," says Allen Taft, president of W.A. Taft & Co., a Bermuda-based alternative risk management consultancy.

Nicholas Dove, president of Sinser Management Services (Bermuda) Ltd., a Bermuda-based captive manager, says a company spending between $500,000 and $1 million in premiums should consider a rent-a-captive strategy. "If it's less than a million, a regular captive won't make sense; if it's less than $500,000, you're probably best off with traditional insurance," he says.

DDA, which has $50 million in annual revenues, fits the rent-a- captive profile. Previously, it was paying more than $2 million a year in premiums to cover its workers' comp costs, largely through state assigned-risk pools, the market of last resort for high-risk companies. But DDA and its clients didn't think such high rates were merited. "Our employees deliver heavy publishing material like phone books, and are subject to trips and falls or getting bitten by the family dog," explains Shelton. "This is not high-risk work."

Accordingly, the CFO reviewed his options. Owning a captive was deemed too time-consuming and capital-intensive. Joining an association captive, in which companies share one another's risks, was also nixed. Then Shelton "stumbled onto" the rent-a-captive strategy, he says. Today, DDA leases a captive from Mutual, and Shelton estimates the company has cut its workers' comp costs in half.

While midsize companies own most of the cells within rent-a- captives, larger companies such as NiSource Inc. also lease space. "We operate these delicate and complex gas turbine compressors that have a tendency to surprise us, tossing budgeted maintenance costs to the wind," says Jeffrey Grossman, vice president and controller of the Merrillville, Indiana-based diversified energy concern. "While we insure our turbines, commercial insurance is largely unavailable for significant unexpected maintenance exposures. Our best alternative, we felt, was a rent-a-captive [Bermuda-based COR Ltd.]."

Considering NiSource's size ($6 billion in annual revenues), why didn't it just fund a traditional captive to transfer the maintenance risk? "We didn't want to put up the capital to start our own insurance company," replies Grossman. "We have a captive, but it's for risks that are more predictable."

TAX WARNINGS

As far as tax deductibility is concerned, "rent-a-captive is a safer bet than single-parent [captive]--as long as what you're buying is deemed to be insurance," says Jim Ostertag, risk management specialist at NiSource's newly acquired Columbia Energy Group. "With a rent-a- captive, we just pay a premium [to the fronting carrier], much like we would to an insurance company."

But since the fronting carrier may not bear any real risk, having ceded it back to the rent-a-captive, is the premium paid truly tax- deductible? Tax experts advise caution. "These are uncharted waters," warns Tom Jones, a partner and head of captive insurance at law firm McDermott, Will & Emery, in Chicago. "The problem is the lack of case law and IRS pronouncements on the subject. Not all rent-a-captive strategies would pass muster taxwise if challenged."

Others agree. "If you structure the rent-a-captive program correctly, you can have a real transfer of risk so you have both off- balance-sheet financing and tax deductions," says Kathryn Westover, director of Strategic Risk Solutions Ltd., a Colchester, Vermont-based captive manager and part of the Credit Suisse group of companies. "But this is a big 'if,' because if you don't do it correctly, auditors will say this isn't off-balance-sheet financing, it's just a banking plan and not deductible." (Westover and other captive managers routinely counsel companies to obtain a tax opinion before pursuing a rent-a- captive strategy.)

The worst thing to do "is to create these vehicles simply for tax purposes," sums up Jones. "A rent-a-captive, like any captive, may have tax advantages, but that better not be the main reason why you take that route--or you'll end up regretting it."

Russ Banham is a contributing editor of CFO.

Captivating Vermont

Spreading from offshore domiciles, rent-a-captive structures have worked their way into the regulatory framework of several U.S. states, including Vermont, Hawaii, and South Carolina.

Vermont was the first, passing legislation in 1999 that permits the establishment of "sponsored captives"--rent-a-captives that are sponsored by an insurance company, reinsurance company, or captive insurance company. (In offshore domiciles, rent-a-captives can be owned by any type of organization.) "The state wanted to be sure that whoever was running these complex facilities was very knowledgeable about insurance," says Michael Smith, chief operating officer of Yankee Captive Management Inc., a Burlington, Vermont-based captive management company.

As in modern rent-a-captives, the assets of each participant or cell in sponsored captives are walled off from the exposures of other participants. The new strategy, however, has taken off domestically only in Vermont, which has eight sponsored captives licensed so far.

Five of the eight are mortgage insurance captives, including Triad Re, which is owned by Triad Guaranty, a Winston-Salem, North Carolina­ based mortgage insurer. Triad rents cells in its sponsored captives to mortgage originators seeking to transfer their mortgage risks. "The strategy helps them lay off risk much like they do in commercial insurance markets, but since it's a captive, they get to keep the underwriting profits and investment income," says Smith, who manages Triad Re.

Meanwhile, Hallmark Cards Inc. is the first cell occupant of an employee benefits captive sponsored by John Hancock Mutual Life Insurance Co. "We're using our cell for the health insurance benefits we provide retirees," explains Richard Heydinger, former director of risk management services at the Kansas City, Missouri-based greeting card manufacturer. (Heydinger retired in January.)

Prior to funding the cell, Hallmark did not fund its retiree benefits, other than through internal resources. "We wanted to fund our retiree benefits, and we knew we wanted to do it with an insurance vehicle," says Heydinger. "We passed on commercial insurance because of the cost. Basically, we wanted all the formalized self-insurance benefits of a captive without having to fully capitalize and operate it." -- R.B.

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