Captive insurance companies are now a well established mechanism used by medium to large corporations to finance risk within their organisations in an economic way, as well as these days being used for more esoteric purposes such as insuring third party or related risks, for instance customer insurance.

Paul Bawcutt, in his book Captive Insurance Companies – Establishment, operation and management, cited a definition of a captive as being “a limited-purpose, wholly-owned, insurance subsidiary of an organisation not in the insurance business, which has as its primary function the insuring of some of the exposures and risks of its parent or the parent’s affiliates.” He goes on to qualify this by referring to the various other types of captive, and uses to which they are put, however this definition still holds true for the majority of the 4,000 plus captives operating in the world today.

What Types of Captive are there?

There are a variety of types of captive apart from the pure or stand-alone vehicle, which only insures its parent’s risks.

Captives can be established by commercial organisations that wish to insure their customers’ risks. For example, high street domestic appliance retailers in the UK have in Gibraltar a captive which underwrites extended warranty insurance for products sold to their customers.The combination of an established customer base, and the low costs of running a captive make this type of operation attractive.

Another variation is group or association captives, where organisations with similar risks in a particular trade combine to form a jointly owned insurer to insure those risks. A good example of this is the many medical malpractice captives in the USA, where groups of doctors combine to insure professional indemnity risks, an expensive insurance in the traditional market in litigation-conscious USA.

Becoming more prevalent in today’s alternative risk financing world are rent-a-captives and cell captives, and in recent years Protected Cell Companies. Their principle is that organisations wishing to benefit from a captive structure, rather than establishing their own vehicle, rent or buy shares in an existing insurer, which has investment and reinsurance facilities already set up. This can be a lower cost option to the traditional stand-alone captive route, and can be tax-efficient. More about PCCs in Gibraltar can be found here.

What do Captives do?

Most captives start in a relatively small way, selecting certain areas of the parent’s risks to insure, whilst other elements are placed in the traditional insurance or reinsurance markets. The captive’s capacity depends on its capitalisation, and parents are usually conservative when it comes to retention of risk within the captive. The types of risk usually insured “in-house” will be those of a predictable nature, usually high-frequency low-severity risks (such as small liability claims), leaving catastrophic risks, by their nature more volatile and harder to predict, to traditional markets. In this way the captive’s capital (which at the end of the day is group capital) is not overly exposed to uncertain losses.

In all captive insurance structures, the principle motivating factor is a reduction in costs to the parent, or production of additional profit (as in the case of customer-insuring captives). The main area where this is achieved is usually in the expense ratio: captives do not have to advertise or maintain substantial overhead costs of sales staff, branch networks, corporate image and so on. A captive is often managed by a third party manager for a fee, rather than maintaining its own personnel, which reduces not only costs but commitment of management time from the parent. Captives are also often established in offshore domiciles, where statutory regulation is more straightforward than in the major countries.


The Cost of Fronting

A specific area where cost savings can be achieved is in the cost of writing the insurances in various territories, especially within Europe. Historically, to write insurance in another country, the captive insurer would in theory have to obtain an insurance company licence in each state where it wished to insure. In practice this was not feasible, and captives, usually based in offshore centres such as Bermuda or Cayman Islands, would use the services of a local insurer in the country where the risk was situated to provide a “fronting” service.

This simply meant that the local insurer would issue policies to the local insured (subsidiary of the parent), then reinsure 100%, or close to it, to the captive. The disadvantage of this is that the fronting insurer will usually charge a facility fee for the service, of as much as 15%, thus increasing the cost of insuring the risk. Arrangement of fronting programmes would also imply an increased administrative load for the risk manager , or the manager of the captive, with associated expense. With the advent of European domiciles such as Gibraltar, and under the European Insurance Directives, business can be written direct on a services basis, without the need for a local licence, and thus avoid that element of cost.

Other than costs, why else form a Captive?

There are other motives for forming a captive:

  • The captive can give a group corporate focus on its risk management strategy – it is group money at risk in the insurance, rather than that of a third party organisation.
  • The captive can remove the uncertainty inherent in the fluctuating cycle of pricing in the traditional market.
  • The captive can insure risks at an economical cost that may be acceptable hazard within the context of the parent’s risk profile, but which the traditional market regard as highly volatile and therefore either deliberately over-price or simply refuse to cover – terrorism cover is one such example.
  • The captive can provide access to the reinsurance market – this is the equivalent of a wholesale market, where cover is sold in large blocks of homogenous exposure (e.g. All Risks cover for large schedules of properties), with low overheads incurred by the sellers of cover, and therefore a lower price. Traditionally reinsurers only deal with insurance companies, although this is beginning to change as reinsurers become more willing to approach large corporate clients direct.
  • Where a parent company has a developed risk management culture, the captive can reflect that in its pricing of the insurance. With a traditional insurance, a corporation will pay a rate according to its trade, regardless of whether its risk management is better than that of its peers in the same trade.
  • The captive provides a cash flow advantage, in terms of retaining the funding for losses within the corporate group, as well as the opportunity to earn investment income on the accumulated contributions and loss reserves, which would otherwise accrue to the benefit of the traditional insurance company. As the captive matures, provided it is feasible from a taxation point of view, the retention of accumulated profits from the captive can increase its capacity for assuming risk, and allow it to play a more and more meaningful role within the organisation’s risk financing programme. The contribution to corporate cash-flow can be enhanced, especially with a well-capitalised captive, by loan-backs of funds to the parents. Care has to be taken that the captive’s solvency margin is not prejudiced as a result, having taken into account admissibility limits on debt (i.e. the proportion of the debt that can be taken into account to count towards the solvency margin).
  • A subsidiary but still important area of reducing costs is in the taxation of the captive. Taxation is becoming a less important factor in the overall decision-making process, due to home states’ increasing reluctance to allow corporations to earn low-taxed profits by having an overseas subsidiary, and the enactment of Controlled Foreign Corporation legislation in many countries. Nevertheless, it is still worth examining how taxation issues can affect a captive – Domiciles such as Gibraltar can offer a low tax rate, which can at least defer the impact of taxation on the captive owner.

Why Gibraltar?

With all of these issues to be addressed, a flexible domicile is needed from a taxation point of view, as well as one which can provide other advantages.

Gibraltar has the following advantages to a captive owner:

  1. A Gibraltar insurance company can insure risks in another European State without having to have a separate licence for each state – its Gibraltar licence is sufficient. The facility is achieved either by insuring the risk direct (services business) or, if a presence is required in the other state, a branch of the Gibraltar insurer can be established.
  2. Gibraltar’s tax regime is a flexible one, with a low tax rate of 10% across the board due to come into effect 1 July 2010
  3. Gibraltar operates from a low cost base, especially compared with domiciles such as Dublin and Bermuda. Salaries are relatively low, there are no job quota requirements as some other territories, and office space is relatively inexpensive. These elements tend to be reflected in competitive levels of fees from captive managers.
  4. Having been a finance centre for over 30 years, Gibraltar enjoys highly developed legal and accounting professions, and an established and successful insurance sector.
  5. UK standards of regulation apply, giving a credible regulatory base; at the same time access to regulators is good and sympathetic treatment is given to captives and specialist insurers. Time to establish an insurer is usually between 3 to 6 months.
  6. There is presently considerable flexibility on equalisation reserving, subject to any tax considerations.
  7. Gibraltar is exempt from VAT rules, which may have advantages for an insurance company, depending on its circumstances, and is relevant to services operations considering an European base, e.g. to centralise European claims handling.
  8. Additional benefits include:
    1. English Law
    2. English language
    3. Bilinguality in Spanish
    4. Reciprocal redomiciliation legislation
    5. Capped stamp duty on capital
    6. Currency Gibraltar pound, on par with Sterling, and no exchange controls
    7. Assets representing shareholders’ funds need not be maintained in Gibraltar, nor need they be managed there

Another string Gibraltar has to its bow is the existence of various Protected Cell Companies, established under legislation passed in 2001, which can provide a ready-made facility for potential captive owners who wish to enjoy the benefits of their own risk finance vehicle, but without the associated costs and management time investment of establishing a stand-alone captive insurance company. PCC cells can also act as an “incubator” until such time as the captive owner decides to take the step of their own corporate entity, and the PCC legislation allows cells to be migrated with relative ease.

All of these benefits can be found in other offshore captive centres – for example insurers in Dublin can write risks in Europe, but costs are high; taxation in Guernsey is zero, however Guernsey insurers are restricted in their ability to write cross-border – the uniqueness of Gibraltar stems from its combining all of the factors into one domicile. That has to give it the competitive edge when formation of a captive or other insurance operation is being considered.

More about Gibraltar as an insurance domicile can be found here