Repurposing Aging Captives
Many companies could be losing out on thousands or even millions of dollars in tax benefits as well as significant cash flow and cost savings by neglecting or leaving their old captives dormant, according to industry experts.
Captives are effectively insurance subsidiaries used by a parent company to insure against its own and affiliates’ risks.
Such is their popularity, particularly in property and casualty, that it’s estimated that more than 90 percent of Fortune 500 companies now have at least one captive.
However, there are many dating back to the 1970s, domiciled offshore in places like Bermuda or the Cayman Islands, that are no longer used or have been put into runoff.
The risks of having an older captive are numerous — exposure to long-tail claims, the loss of institutional claims knowledge and records, and many are written without an aggregate limit.
But increasingly now instead of putting the captive into runoff or a solvency scheme, risk managers are starting to use them as part of a broader risk management strategy to deal with their legacy and emerging liabilities.
As a spin-off, this enables companies to potentially derive an accelerated tax benefit if the captive is properly structured, increase their cash flow, use their capital more efficiently and see significant cost savings.
“It’s fundamentally about using the captive to provide a dedicated funding source to meet legacy liability claims in a tax-efficient manner,” said Daniel Chefitz, partner at Morgan Lewis & Bockius.
Michael Serricchio, senior vice president of Marsh Captive Solutions’ captive advisory group, said that the main reason for a captive becoming dormant is a company not realizing its intended purpose or value.
“Maybe there’s been a change of risk manager or the management team and whoever set up the captive is no longer there and the captive is sitting there doing nothing because there’s no perceived value or it’s not properly understood,” he said.
“But even if the captive is just sitting there dormant or it is in runoff, you are still incurring running costs and claims, not to mention the capital that’s tied up in it.”
Chefitz said that among the main risks associated with a dormant captive are obligations to meet new legacy claims, a lack of control over the flow and handling of claims following a merger or acquisition, and exposure to liability from released trapped equity.
Sean Rider, executive vice president and managing director of consulting and development at Willis Towers Watson, said that the biggest risks of having a dormant or older captive were adverse claims development and investment outcomes.
“The main risk is leaving it dormant for too long. Then it’s ultimately harder to get it started up again and ready for when you really need the coverage.” — Gloria Brosius, corporate risk manager, Pinnacle Agriculture Holdings
Gloria Brosius, corporate risk manager at Pinnacle Agriculture Holdings and a RIMS board member, said that the longer a captive is left dormant, the harder it is to get it up and running again.
“The main risk is leaving it dormant for too long,” she said. “Then it’s ultimately harder to get it started up again and ready for when you really need the coverage.”
Call to Action
Chefitz said that dormant captives are often revived because of a need for additional insurance to cover legacy liabilities such as asbestos, product liability, toxic tort and environmental claims.
“Typically this arises when a company has a large reserve on its books, and a need for additional risk transfer,” he said.
But oftentimes risk managers and companies will be prompted into action when a loss occurs, said Jason Flaxbeard, executive managing director of Beecher Carlson.
“What will usually happen is that something bad occurs,” he said. “Companies will then start to question why they have that captive and that’s when decisions need to be made. But a well-managed captive shouldn’t have that issue.”
In this situation, Serricchio said that it was essential to undertake a thorough strategic review of the captive.
“The first question you need to ask is, ‘Does it make sense to keep the captive or even have it in the first place?’ ” he said.
Rider said that risk managers need to decide whether these older or dormant captives can be used as an execution tool within the company’s risk financing strategy.
“It’s really about understanding the captive’s role in facilitating an evolving risk financing strategy and how it can be used going forward,” he said.
Managing Legacy and Emerging Liabilities
The main advantage of resurrecting a dormant captive is for a company to deal with its legacy liabilities by fully insuring against any outstanding or future claims, said Chefitz.
This can be achieved by using the captive to establish a dedicated funding source to supplement the existing insurance coverage or to fill in any gaps in a tax-efficient manner, he said.
It also enables the company to maximize the value of its historical insurance coverage by smoothing the cash flow, he added.
“If a company has legacy liabilities, rather than trying to avoid or defer it, a sensible approach is to use the situation to your advantage by fully funding the legacy liability. This will then enable you as a risk manager to focus on your emerging and ongoing liabilities instead.”
Serricchio said that a dormant captive could also be used for writing emerging and non-traditional risks such as employee benefits, supply chain, cyber security, medical stop-loss and environmental risks.
Flaxbeard added that the current soft market allowed risk managers to be more creative with their captives through the sale of add-on products.
“Many companies are going into ancillary products that they can sell to their clients alongside their core products, such as extended warranties,” he said.
Tax Benefits and Issues
If qualified as an insurance company for tax purposes, captives can also provide a host of other benefits, said Chefitz.
By insuring these existing reserves on a company’s balance sheet with a captive, they are then effectively moved from the parent to the captive’s balance sheet, he said.
He added that the loss reserves from a captive were immediately deductible, thus accelerating the tax deduction within the parent’s consolidated group and monetizing the associated deferred tax asset.
Furthermore, the premium paid to a captive is also tax deductible if certain tests are met, he said.
“The increased cash flow as a result of the accelerated tax deduction can be invested in a tax-efficient manner and used to support the treasury goals of the organization,” he said.
When added up, all of these deductibles could potentially provide companies with thousands or even millions in tax benefits.
Meanwhile, another advantage has been provided under the recent 831(b) tax code change, with the annual limit at which captives and insurers can elect not to be taxed on their premium income being increased from $1.2 million to $2.2 million, effective from 2017, said Gary Osborne, president of USA Risk Group.
“This is a real opportunity for companies to put some good risks into their captive and to derive the tax efficiencies,” he said.
Another key consideration for companies looking to redomicile their captive is the self-procurement tax under the Nonadmitted and Reinsurance Reform Act for surplus and excess lines, said Flaxbeard.
“This is a problem for many companies who may look to redomesticate to their home state,” he said.
“Some have got around this by setting up a branch to write direct policies to the parent company incurring captive premium tax rather than a self-procurement tax.”
Among the other factors when considering a domicile are the captive’s legal, management and operational structure, as well as its capital use, said Chefitz.
Ultimately though, Rider said, companies need to consider whether it’s worth changing the captive’s structure or moving it at all.
“You need to consider whether the original domicile is still the best domicile and whether the original structure is still the best structure for you, or should you abandon the captive altogether and transfer the liabilities to a new one,” he said. &
Waves of bankruptcies convulsing the coal industry in the United States leave billions of dollars in mine remediation costs potentially unfunded, and raise ominous questions for both tactical insurance and strategic risk management.
Dozens of coal companies are in court-supervised reorganization or liquidation, some of them for the second time in just a few years.
Many had taken advantage of the Surface Mining Control and Reclamation Act of 1977, or SMCRA, a federal law that allowed self-bonding in lieu of surety bonds, dedicated cash reserves or other provisions for environmental obligations.
Self-bonds are legally binding corporate promises without separate surety or collateral, available only to entities that meet certain financial tests.
In response to the volatility in the coal industry and recent bankruptcies, the Office of Surface Mining Reclamation and Enforcement (OSMRE), part of the Department of the Interior, sought public comment in response to a petition from WildEarth Guardians asking the office to consider restricting or eliminating self-bonding.
Specifically, the group wants to prevent coal companies with a history of financial insolvency, and their subsidiaries, from using “self-bonding” as a means to ensure disturbed lands are restored after mining operations are completed.
VIDEO: There are many challenges when working to remediate abandoned mines.
OSMRE received more than 117,000 comments on the petition to restrict or eliminate self-bonding, and announced on Aug. 16 that it would begin the rulemaking process to “strengthen regulations on self-bonding to help ensure that companies are financially able to restore lands disturbed by coal mining when extraction operations are completed.”
“The U.S. coal market is dramatically different from when our self-bonding regulations were last updated 30 years ago,” said OSMRE Director Joe Pizarchik.
“This is a turbulent time of energy transformation in our country, of declining use of coal and increased use of cheaper natural gas and renewable energy. These conditions have exposed the limitations of the current self-bonding rule and we have a responsibility to protect the public’s interest by keeping up with these changes.”
Requests for public comment on similar initiatives are underway in several states for mines under their jurisdiction; states where taxpayers could be on the hook for cleanup costs for busted mines if bankruptcy courts do not set those funds high enough in the hierarchy of expenses to be paid.
Within the broader economic and social dislocation in the near-collapse of a major industry, there are two key questions for insurance markets and risk managers.
On the commercial side, will the surety and broader insurance markets have the capacity and the willingness to underwrite billions in new coverage for an industry with a notorious past and a checkered future?
In risk management, there is a larger question of whether the 1977 self-bonding provisions were flawed from the start, or whether they were functional until overwhelmed by the tsunami of corporate failures in recent years.
“We know that there are many companies that rely on the surety bond market for meeting their compliance obligations,” said Tom Sanzillo, director of the Institute for Energy Economics & Financial Analysis (IEEFA), based in Cleveland.
“We imagine that would expand significantly if there were new regulations that restricted or even eliminated self-bonding for coal companies.”
In response to an inquiry from R&I, an OSMRE representative stressed that, “self-bonding remains a legal option sanctioned by [SMCRA] as a means that a qualified company can guarantee reclamation. There are cases in which self-bonding guarantees have been replaced by surety and collateral bonds.
“In addition, it is important to note that no operator currently in operation with self-bonds has ceased operations and forfeited on the bonded obligations. OSMRE stands committed to ensuring that mine operators will be held accountable to complete the legally required reclamation when or if they complete mining operations.”
The forthcoming rulemaking process is intended to modify “self-bonding eligibility standards, including for parent and other corporate guarantors, to include criteria that are more forward looking, instead of only focusing narrowly on past performance.”
It also will require an independent third-party financial review of self-bonded entities, establish the percentage of self-bonds supported by collateral and provide regulatory authorities with better tools to obtain replacement bonds when a self-bonding entity no longer meets the eligibility criteria.
However, federal rulemaking, even the simplest, is a long and complex effort. Congress can also amend SMCRA to modify the bonding system.
“What we have here is a [self-bonding] system that is flawed in many respects, and the industry’s decline exposes those flaws graphically,” Sanzillo said.
“When I saw the OSMRE statement expressing concern about possible collusion between state regulators and coal companies,” he said, “I nodded, because we did an initial study on the self-bonding program in Texas several years ago and found that it was completely inadequate,” he said.
In addition to West Virginia, Texas recently became one of the states that intervened in bankruptcy proceedings pressing for full funding of remediation costs.
In Texas, the IEEFA findings were submitted to the state Railroad Commission, which has jurisdiction over coal mining, and the legislature.
“We had a robust discussion,” said Sanzillo, “and they took some diligent action, including requesting $1 billion in notes from one debtor-in-possession financing.”
OSMRE added that the State of Texas successfully navigated the problems associated with self-bonding, through its actions with respect to Luminant, the largest electricity producer in Texas, in 2011-2012.
The Railroad Commission, the state attorney general’s office, and the operator devised a way to have Luminant replace several hundred million dollars in self-bonds with collateral bonds when the company declared bankruptcy.
In a recent large bankruptcy case involving Alpha Natural Resources, “the West Virginia Department of Environmental Protection has been very vocal that the $1.1 billion in remediation costs have got to be addressed in the reorganization plan,” said Ted O’Brien, CEO of Doyle Trading Consultants, a coal-industry advisory.
Reorganized as Contura Energy Inc., the producer will contribute up to $100 million to help Alpha’s ongoing reclamation activities, according to published reports.
“What this down market is revealing is that there is far more coal being claimed as reserves than is economically available for mining. Insurance companies should ask if the valuations that are being reported to them are valid,” Sanzillo said.
“Any insurer looking into coal as a new market may get some pushback from other stakeholders,” said O’Brien, “but there has always been a market for surety, if you have someone willing to get their hands dirty. Coal is not going away. ” &
Mind the Gap in Global Logistics
Manufacturers and shippers are going global.
As inventories grow, shippers need sophisticated systems to manage it all, and many companies choose to outsource significant chunks of their supply chain management to contracted providers. A recent survey by market research firm Transport Intelligence reveals that outsourcing outnumbers nearshoring in the logistics industry by 2:1. In addition, only 16.7 percent of respondents stated they are outsourcing fewer logistics processes today than they were three years ago.
Those providers in turn take more responsibilities through each step of the bailment process, from processing, packaging and labeling to transportation and storage. Spending in the U.S. logistics and transportation industry totaled $1.45 trillion in 2014 and represented 8.3 percent of annual gross domestic product, according to the International Trade Administration.
“Traditionally these outside parties provided one phase of the supply chain process, perhaps transportation, or just warehousing. Today many of these companies are extending their services and product offerings to many phases of supply chain management,” said Mike Perrotti, Senior Vice President, Inland Marine, XL Catlin.
Such companies are known as third-party logistics (3PL) providers, or even fourth-party logistics (4PL) providers. They could provide transportation, storage, pick-n-pack, processing or consolidation/deconsolidation.
As the provider’s logistics responsibilities widen, their insurance needs grow.
“In the past, the underwriters would piecemeal together different coverages for these logistics providers. For instance, they might take a motor truck cargo policy, and attach a warehouse form, a bailee’s form, other inland marine products, and an ocean cargo form. You would have most of the exposures covered, but when you start taking different products and bolting them together, you end up with gaps,” said Alexander McGinley, Vice President, US Marine, XL Catlin.
A comprehensive logistics form can close those gaps, and demand for such a product has been on the rise over the past decade as logistics providers search for a better way to manage their range of exposures.
“Traditionally these outside parties provided one phase of the supply chain process, perhaps transportation, or just warehousing. Today many of these companies are extending their services and product offerings to many phases of supply chain management.”
–Mike Perrotti, Senior Vice President, Inland Marine, XL Catlin
A Complementary Package
XL Catlin’s Logistics Services Coverage Solutions takes a holistic approach to the legal liability that 3PL providers face while a manufacturer’s stock is in their care, custody and control.
“A 3PL’s legal liability for loss or damage from a covered cause of loss to the covered property during storage, packaging, consolidation, shipping and related services would be insured under this comprehensive policy,” McGinley said. “It provides piece of mind to both the owner of the goods and the logistics provider that they are protected if something goes wrong.”
In addition to coverage for physical damage, the logistics solution also provides protection from cyber risks, employee theft and contract penalties, and from emerging exposures created by the FDA Food Modernization Act.
This coverage form, however, only protects 3PL companies’ operations within the U.S., its territories and possessions, and Canada. Many large shippers also have an international arm that needs the same protection.
XL Catlin’s Ocean Cargo Coverage Solutions product rounds out the logistics solution with international coverage.
While Ocean Cargo coverage typically serves the owner of a shipment or their customers, it can also be provided to the internationally exposed logistics provider to cover the cargo of others while in their care, custody, and control.
“This covers a client’s shipment that they’re buying from or selling to another party while it’s in transit, by any type of conveyance, anywhere in the world,” said Andrew D’Alessio, National Ocean Cargo Product Leader, XL Catlin. “When provided to the logistics company, they in turn insure the shipment on behalf of the owner of the cargo.”
The international component provided by ocean cargo coverage can also eliminate clients’ fears over non-compliance if admitted insurance coverage is purchased. Through its global network, XL Catlin is uniquely positioned as a multi-national insurer to offer locally admitted coverages in over 200 countries.
“In the past, the underwriters would piecemeal together different coverages for these logistics providers. For instance, they might take a motor truck cargo policy, and attach a warehouse form, a bailee’s form, other inland marine products, and an ocean cargo form. You would have most of the exposures covered, but when you start taking different products and bolting them together, you end up with gaps.”
–Alexander McGinley, Vice President, US Marine, XL Catlin
A Developing Need
The approaching holiday season demonstrates the need for an insurance product that manages both domestic and international logistics exposures.
In the final months of the year, lots of goods will be shipped to the U.S. from major manufacturing nations in Asia. Transportation providers responsible for importing these goods may require two policies: ocean cargo coverage to address risks to shipments outside North America, and a logistics solution to cover risks once goods arrive in the United States or Canada.
“These transportation providers are expanding globally while also shipping throughout the U.S. That’s how the need for both domestic and international logistics coverage evolved. Until now there have been few solutions to holistically manage their exposures,” D’Alessio said.
In another example, D’Alessio described one major paper provider that expanded its business from manufacturing to include logistics management. In this case, the paper company needed coverage as a primary owner of a product and as the bailee managing the goods their clients own in transit.
“That manufacturer has a significant market share of the world’s paper, producing everything from copy paper to Bible paper, wrapping paper, magazine paper, anything you can think of. Because they were so dominant, their customers started asking them to arrange freight for their products as well,” he said.
“These transportation providers are expanding globally while also shipping throughout the U.S. That’s how the need for both domestic and international logistics coverage evolved. Until now there have been few solutions to holistically manage their exposures.”
–Andrew D’Alessio, National Ocean Cargo Product Leader, XL Catlin
The global, multi-national paper company essentially launched a second business, serving as a transportation and logistics provider for their own customers. As the paper shipments changed ownership through the bailment process, the company required two totally different types of insurance coverage: an ocean cargo policy to cover their interests as the owner and producer of the product, and logistics coverage to address their exposures as a transportation provider while they move the products of others.
“As a bailee, they no longer own the products, but they have the care, custody, and control for another party. They need to make sure that they have the appropriate insurance coverage to address those specific risks,” McGinley said.
“From a coverage standpoint, this is slowly but surely becoming the new standard. A logistics form on the inland marine side, combined with an international component, is becoming something that a sophisticated client as well as a sophisticated broker should really be asking for,” McGinley said.
The old status quo method of bolting on coverage forms or additional coverages as needed won’t suffice as global shipping needs become more complex.
With one underwriting solution, the marine team at XL Catlin can insure 3PL clients’ risks from both a domestic and international standpoint.
“The two products, Ocean Cargo Coverage Solutions and Logistics Service Coverage Solutions, can be provided to the same customer to really round out all of their bailment, shipping, transportation, and storage needs domestically and around the globe,” D’Alessio said.
The information contained herein is intended for informational purposes only. Insurance coverage in any particular case will depend upon the type of policy in effect, the terms, conditions and exclusions in any such policy, and the facts of each unique situation. No representation is made that any specific insurance coverage would apply in the circumstances outlined herein. Please refer to the individual policy forms for specific coverage details. XL Catlin, the XL Catlin logo and Make Your World Go are trademarks of XL Group Ltd companies. XL Catlin is the global brand used by XL Group Ltd’s (re)insurance subsidiaries. In the US, the insurance companies of XL Group Ltd are: Catlin Indemnity Company, Catlin Insurance Company, Inc., Catlin Specialty Insurance Company, Greenwich Insurance Company, Indian Harbor Insurance Company, XL Insurance America, Inc., and XL Specialty Insurance Company. Not all of the insurers do business in all jurisdictions nor is coverage available in all jurisdictions. Information accurate as of December 2016.
This article was produced by the R&I Brand Studio, a unit of the advertising department of Risk & Insurance, in collaboration with XL Catlin. The editorial staff of Risk & Insurance had no role in its preparation.