CAPTIVE FEASIBILITY STUDY (CFS)

(May 2022)

Captive insurance companies can be a tremendous method for a large business or group of similar businesses to handle certain loss exposures. However, forming a captive is also a tremendous investment. Care should be taken before deciding to create and use a captive. A critical step to assist such decisions is to prepare a Captive Feasibility Study (CFS). Besides helping to determine if forming a captive is the right move, a proper CFS should also reveal what type of captive (if any) should be used.

It is difficult to imagine a company or group of companies deciding to create a captive without performing due diligence. Most insurance authorities will either mandate or request a CFS be included in a captive insurance submission. However, an important reason why feasibility studies are NOT performed is that organizations contemplating the move are worried about others having access to the detailed financial information that could become public knowledge.

Related Article: Captive Insurers

A CFS may be performed by either internal or external sources. Internal sources include persons in the areas of accounting, finance, legal and risk management. External sources may be captive insurance brokers, or independent risk managers. Typically, a combination of sources is used. Regardless what resources are selected, they must have the expertise to collect and analyze information at the level necessary to make a solid decision. The sources must also have a proper understanding of captive markets, captive types and familiarity with the strengths and weaknesses of various captive domiciles, both U.S. and Foreign.

Agents, brokers or other parties may be invited to act as consultants to create a study. Another way to secure the information is to make it part of a request for proposals (RFP). Naturally if the party sponsoring the project has the required expertise, it may perform a study on its own. A feasibility study will include valuable information to assess the viability of a wrap-up. The following is an illustrative, NOT a comprehensive list:

• A cost benefit analysis (comparing acquiring conventionally [individual lines of business] v. under a sponsored controlled program)
• Study of applicable jurisdiction’s Workers Comp laws
• Determining payroll estimates
• Estimating contractor profit margins
• Determining needed lines of insurance and premiums
• Determining labor, materials, supplies costs
• Estimating length of project
• Estimating loads for plan administration and contingency costs
• Other hard and soft costs

Briefly, a feasibility study should address the following:

Initial Examination

A CFS should begin with a thorough review of an organization’s current insurance program and financial statements, with a focus on the most recent, audited financial information and the complete insurance schedule. Having a good perspective of an entity (or entity group’s) coverage needs, financial stability, revenue flows, and premium volume should be enough to decide whether attempting to form a captive includes an enough, ongoing opportunity to take advantage of significant financial rewards. Naturally, if the answer is no, the CFS effort should end.

Detailed Financial Analysis

A more thorough examination should include a review of financial statements over the previous five to ten years in order to provide reliable estimates of a captive’s income and expense flows, its anticipated assets and liabilities and other relevant financial information. This portion should include a cost benefit analysis projection on a near, intermediate and long-term basis.

Selection of Insurance Lines

What types of insurance should be handled by the captive? Traditionally, certain lines lend themselves to captives (particularly Automobile Liability, General Liability, Products and Completed Operations, Professional Liability, some forms of Workers Compensation) and others do not (essentially all lines not previously mentioned–particularly, any form of property coverage). Even with preferred lines of business, there must be an enough premium volume, claims activity and access to reinsurance to justify the use of a captive (particularly to offset hard and soft expenses) as opposed to other methods to finance risks or make investments.

Tax Analysis

This part of the process involves determining the tax (Federal and State) impact on the organization considering captive formation. It must also determine what is required to comply with IRS requirements. Tax implications and compliance are critical. In this step, organizations must get expert assistance.

Captive Structure

The type of captive selected is highly dependent upon the various objectives that an organization wants to meet by forming a captive. This can become circular because of this dependency. The smart move is to spend sufficient time to clearly establish objectives and to focus on the longer time horizon. If the priority is meeting long term objectives, a different form of captive may be necessary. It could mean absorbing more complexity and cost in the short term, but the higher initial time and expense could be justified.

Captive Domicile

The domicile that best fits an organization’s need depends upon the selected captive structure, the lines of business to be covered, preferences regarding regulation, tax laws and, if applicable the fronting arrangement.

Related Article: Captive Domiciles

Claims

A CFS should include enough details on how claims will be administered and if outside services will be used. Much has to do with determining whether the organization’s loss vulnerability is frequency or severity.

Exit Strategy

This is NOT a defeatist step. Captives are a major investment with significant regulatory and tax implications. An entity must have a plan or at least a solid idea of what it would take to terminate its use of a captive. Captives may remain in operation due to regulatory, reinsurance arrangements or because of prohibitive shutdown costs. However, there are specialists with the expertise to handle captives when they no longer fulfill an entity’s needs. Solutions may involve loss portfolio transfers, arranging for special reinsurance or a captive’s purchase.