Capital AllocationInsurance

Where Captives Fit in the Insurance Puzzle Corporates Want to Solve

By March 18, 2021No Comments

Captives offer tax advantages and flexibility, but treasury teams must make sure trapping cash in them is worth the benefits.

Rising insurance costs are putting more focus on captives, a solution that offers tax advantages, flexibility and lower costs than traditional insurance.

  • For those reasons and others, several members at a recent meeting of NeuGroup for Retail Treasury said they plan to expand their captives to cover more risk.
  • Other members say captives are not a good use of capital for their companies.

The case for captives. “A captive brings a few benefits, and a few challenges,” one member said. “From a financial standpoint, managing the risk within the captive brings a lower general cost than translating those risks to a third party. There are some limits, but the day-to-day expenses for, say, worker’s compensation, can be lower.”

  • One retail treasurer whose company works on a franchise model said she had success with an offshore captive, which did a “bang-up job,” and proved a boon as insurance costs began to rise.
  • “Instead of paying premiums to the insurance company and the insurer keeping those profits, we are able to charge our stores individually for our expected losses; and when we didn’t reach those expected losses, we kept those profits,” the member said.
    • “Over a 10 year period, we were able to build up capital to increase our retentions, which minimizes the actual risk transfer insurance that we’re buying from an insurer, and we’re able to weather market swings much better.”
  • Members also discussed the non-financial benefits of captives, including a faster claims process and control over the standards used to handle claims.

Capital concerns. Saving on taxes and speeding up the claims process “may or may not be sufficient reasons to start up a captive,” one member warned. The big reason: captives trap capital.

  • “From a P&L perspective, [a captive] looks good, as it lowers tax expense,” another member said. “However, from a capital allocation perspective, we have trapped capital and it returns less than our WACC, and much less than the targeted ROIC we expect the business to return. So it’s not a good use of capital for us.
  • “It’s a capital allocation decision at the end-of-the-day,” she added. “You can allocate capital to the captive, to the business or back to shareholders. This would be a circumstance specific to each company.
  • “For instance, for us, many states do not allow us to self-insure workers’ comp without an insurance company backing the self-insurance. In this case, the captive acts in that capacity. We would need to analyze whether it’s worth the capital.”

Monitoring performance. To combat capital inefficiency, multiple members recommended incorporating routine strategic reviews, measuring a captive’s benefits against its cost.

  • During one of these reviews, one treasurer saw that a captive established before he had the job had more cash trapped than he found justifiable reduced the “static” balance in the captive by one-third without significantly impacting the captive’s tax benefit.
  • Another member learned during an internal review that the location of the company’s international captive was no longer viable due to recent regulation.
  • “The captive was set up because it could provide direct policies to some companies, saving us some fronting costs,” the member said. “Since recent policy has been implemented [in this country], we’ve found the capital requirements and solvency requirements overly burdensome.
    • “We undertook a study to see if there is a different domicile that we should be using for that risk and opened a new captive and shifted those policies over.”
Justin Jones

Author Justin Jones

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