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. &
A Salary Threshold Working Over Time
In December, new U.S. Department of Labor rules will require employers to pay overtime to salaried workers earning less than $47,476 a year, effectively doubling the current overtime annual salary threshold of $23,660.
Employers who have not yet audited their wage and hours practices are running out of time to make sure they are in compliance with this new base salary limit, experts warn.
The Department of Labor estimates as many as 4.2 million U.S. workers could be affected by the change.
By some estimates, as many as 70 percent of companies are in violation of the rules.
“For anybody who hasn’t looked at this yet, this is the ‘all-nighter before the test’ window,” said Noel P. Tripp, a principal at Jackson Lewis P.C., who represents employers in wage and hour cases.
Those that don’t comply may find themselves joining an ever growing club of litigants, including well-known companies such as DuPont Co. and Tyson Foods, scrambling to prove they paid their workers fairly.
Even before this change, the number of lawsuits filed under the Fair Labor and Standards Act (FLSA) more than tripled in the past decade and is expected to hit an all-time high this year.
With the election of Donald Trump to the presidency and his promise to roll back regulations, it’s unclear whether this new rule will be revoked in 2017.
Nonetheless, it’s important to conduct an audit of your workforce and bring all employees to compliance if they are not already, said Catherine K. Ruckelshaus, general counsel at the National Employment Law Project.
“For anybody who hasn’t looked at this yet, this is the ‘all-nighter before the test’ window,” — Noel P. Tripp, principal, Jackson Lewis P.C.
With many existing state rules already much higher than the federal threshold, companies often find they are already in compliance, which is much more cost effective than defending a wage and hour claim.
That’s because the company bears the legal burden of proof; it’s hard to manage payroll records on time worked for every single worker if the proper systems are not in place, and it takes a lot of money and time away from the core responsibilities of a business to fight a case in court.
With so many companies at risk of being non-compliant, this looming deadline is as good a time as any to review for problems, said Chris Williams, an employment practices liability product manager at Travelers.
“If you haven’t fixed it by Dec. 1 [and you are sued] you paint yourself in an even worse light in a courtroom,” said Lisa Doherty, co-founder and CEO of Business Risk Partners, a specialty insurance underwriter and program administrator.
States and business organizations have tried to delay the rule change by filing complaints recently with the federal courts. Experts say those are unlikely to prevail, so companies should proceed with greatest caution and keep the Dec. 1 deadline as the target.
Wal-Mart Stores was most likely aiming for broad-based compliance ahead of the deadline when just last month it raised all salaries for its entry-level managers to just above the threshold at $48,500 from $45,000 annually, according to Reuters.
A Change Long Overdue
The FLSA was enacted in 1938 and established the 40-hour work week salary threshold, which entitled workers to time-and-a-half their regular hourly wage for any overtime.
White collar workers making more than the threshold and meeting certain “duties tests” were exempt from receiving overtime pay if they worked more than 40 hours in a week. The current threshold of $455 a week or $23,660 annually, has been in place since 2004.
“It’s a long time overdue,” Ruckelshaus said. “Workers could be making around $23,000 and be called exempt white collar workers, which is kind of crazy.”
The new rule more than doubles the minimum to $913 per week, or $47,476 annually. And to make sure there’s not such a long gap before the threshold goes up again, it will now automatically increase every three years based on wage growth.
Employers with exempt salaried workers within this range generally face three options.
One: Raise the annual pay to above $47,476 to maintain the exempt status. This option works best for employees paid a salary close to the new level, such as those Walmart managers.
Two: Reclassify salaried employees as hourly and pay time and a half when they exceed 40 hours in a week. This approach works best when there are only occasional spikes that require overtime for which employers can plan for and budget.
Three: Strictly limit employees’ time to 40 hours and hire additional workers. That’s not always a welcome path if it triggers a new record-keeping system to track hours. It can be difficult to get workers to change their behavior to start recording when they arrive at work and leave.
Establishing a 40-hour week was meant to encourage employers to hire more people rather than pay one worker overtime, but often adding staff is not in the labor budget.
In many cases, there’s tremendous pressure from the higher level to the middle level to be more efficient and less costly, said attorney Thomas More Marrone who represents employees in FLSA cases.
“A mid-level manager with a labor budget and no compliance training regarding overtime rules is a loaded weapon you have pointed at the business because you have given that manager an incentive with no context,” Tripp said.
What’s at Stake? Legal Cases Are Growing
There were 8,000 FSLA wage and hour claims filed last year, making it the single fastest growing type of employment litigation, Doherty said.
One reason for that claims volume is that there are a variety of ways a company can violate the rules.
There’s straight-out failure to pay overtime when a worker is entitled to it. There’s “donning and doffing” claims when an employer doesn’t include the time to put on protective gear as part of the work day. DuPont and Tyson were both targets of class action lawsuits citing donning and doffing.
“A mid-level manager with a labor budget and no compliance training regarding overtime rules is a loaded weapon you have pointed at the business because you have given that manager an incentive with no context.” — Noel P. Tripp, principal, Jackson Lewis P.C.
DuPont argued that the employees recouped that time by taking paid breaks throughout the day.
“It has been the law for many decades; if you don’t keep track of it there’s a presumption against you,” said Marrone, who is representing employees against DuPont.
Some newly emerging FLSA cases involve the time employees spend checking email and on computers at home, Williams said.
Often, it’s not until a claim is filed that employers — who bear the burden of proof in most cases — realize they haven’t maintained the appropriate records to defend the business, Williams said.
He adds that it is not unusual to see wage and hour claims filed after an employee is fired. That’s why it is so important to keep in compliance and maintain accurate records.
FLSA cases are often “lawyer driven,” he said. It’s not uncommon for a fired employee to inquire with a lawyer about a wrongful termination case. “The lawyer says, ‘I don’t care about [your termination] but answer these 10 questions about the hours you worked and how you were paid.”
Something to keep in mind: Employers who are liked by their workers are far less likely to get sued, said Tripp.
Protect Your Business
It’s important that companies talk to a broker about coverage for some of that exposure, Williams said.
A coverage endorsement attached to employment practices liability insurance (EPLI) policy forms may cover the cost of defending claims alleging that an employer failed to pay overtime to a nonexempt employee — that is, an employee who is not exempt from, and therefore eligible to receive, overtime pay under the FLSA.
Travelers can provide a $100,000 defense expenses sublimit for wage and hour claims for most clients, Williams said. No coverage typically applies under these endorsements to settlements or judgments (i.e., they cover only defense costs), and a sublimit usually applies.
As for when to be ready for the higher threshold, Williams said “the prudent employer should plan on the law going into effect on Dec. 1 until there’s a definitive word to the contrary.”
A group of 21 states filed a complaint in the Eastern District of Texas challenging the new U.S. Department of Labor regulations that redefine the white collar exemptions to the overtime requirements of the FLSA. The States argue the DOL overstepped its authority by, among other things, establishing a new minimum salary threshold for those exemptions.
More than 50 business groups including the U.S. Chamber of Commerce, the National Association of Manufacturers and the National Retail Federation also filed a lawsuit in the same court, on the same day, contending the new regulations were implemented in violation of the federal Administrative Procedure Act.
Travelers recommendations to protect against wage and hour claims:
- Consult with an attorney and a human resources representative to understand all obligations required by the law.
- Review all employee job responsibilities and wages to determine whether they are entitled to overtime, and document those decisions.
- Ensure you have a process in place to document all hours worked for non-exempt employees.
- Communicate and train managers on the new regulations and requirements.
Hot Hacks That Leave You Cold
Thousands of dollars lost at the blink of an eye, and systems shut down for weeks. It might sound like something out of a movie, but it’s becoming more and more of a reality thanks to modern hackers. As technology evolves and becomes more sophisticated, so do the occurrence of cyber breaches.
“The more we rely on technology, the more everything becomes interconnected,” said Jackie Lee, associate vice president, Cyber Liability at Nationwide. “We are in an age where our car is a giant computer, and we can turn on our air conditioners with our phones. Everyone holds data. It’s everywhere.”
Phishing Out Fraud
According to Lee, phishing is on the rise as one of the most common forms of cyber attacks. What used to be easy to identify as fraudulent has become harder to distinguish. Gone are the days of the emails from the Nigerian prince, which have been replaced with much more sophisticated—and tricky—techniques that could extort millions.
“A typical phishing email is much more legitimate and plausible,” Lee said. “It could be an email appearing to be from human resources at annual benefits enrollment or it could be a seemingly authentic message from the CFO asking to release an invoice.”
According to Lee, the root of phishing is behavior and analytics. “Hackers can pick out so much from a person’s behavior, whether it’s a key word in an engagement survey or certain times when they are logging onto VPN.”
On the flip side, behavior also helps determine the best course of action to prevent phishing.
“When we send an exercise email to test how associates respond to phishing, we monitor who has clicked the first round, then a second round,” she said. “We look at repeat offenders and also determine if there is one exercise that is more susceptible. Once we understand that, we can take the right steps to make sure employees are trained to be more aware and recognize a potentially fraudulent email.”
Lee stressed that phishing can affect employees at all levels.
“When the exercise is sent out, we find that 20 percent of the opens are from employees at the executive level,” she said. “It’s just as important they are taking the right steps to ensure they are practicing what they are preaching.”
Locking Down Ransomware
Another hot hacking ploy is ransomware, a type of property-related cyber attack that prevents or limits users from accessing their system unless a ransom is paid. The average ransom request for a business is around $10,000. According to the FBI, there were 2,400 ransomware complaints in 2015, resulting in total estimated losses of more than $24 million. These threats are expected to increase by 300% this year alone.
“These events are happening, and businesses aren’t reporting them,” Lee said.
In the last five years, government entities saw the largest amount of ransomware attacks. Lee added that another popular target is hospitals.
After a recent cyber attack, a hospital in Los Angeles was without its crucial computer programs until it paid the hackers $17,000 to restore its systems.
Lee said there is beginning to be more industry-wide awareness around ransomware, and many healthcare organizations are starting to buy cyber insurance and are taking steps to safeguard their electronic files.
“A hospital holds an enormous amount of data, but there is so much more at stake than just the computer systems,” Lee said. “All their medical systems are technology-based. To lose those would be catastrophic.”
And though not all situations are life-or-death, Lee does emphasize that any kind of property loss could be crippling. “On a granular scale, you look at everything from your car to your security system. All data storage points could be controlled and compromised at some point.”
The Future of Cyber Liability
According to Lee, the Cyber product, which is still in its infancy, is poised to affect every line of business. She foresees underwriting offering more expertise in crime and becoming more segmented into areas of engineering, property, and automotive to address ongoing growing concerns.”
“Cyber coverage will become more than a one-dimensional product,” she said. “I see a large gap in coverage. Consistency is evolving, and as technology evolves, we are beginning to touch other lines. It’s no longer about if a breach will happen. It’s when.”
About Nationwide’s Cyber Solutions
Nationwide’s cyber liability coverage includes a service-based solution that helps mitigate losses. Whether it’s loss prevention resources, breach response and remediation expertise, or an experienced claim team, Nationwide’s comprehensive package of services will complement and enhance an organization’s cyber risk profile.
Nationwide currently offers up to $15 million in limits for Network Security, Data Privacy, Technology E&O, and First Party Business Interruption.
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This article was produced by the R&I Brand Studio, a unit of the advertising department of Risk & Insurance, in collaboration with Nationwide. The editorial staff of Risk & Insurance had no role in its preparation.