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  • John Neal
  • Role
    Managing Director of Symphony Management Limited
    Location
  • I think [the captive industry] is expanding again. We’re seeing new people coming in and businesses starting to look to the future again.

John is an independent captive manager based in Bermuda. He is very entrepreneurial in his approach and has a focus on managing group captives and rent-a-captives.

1) What is a captive?

2) Can captives work as a profit centre?

3) What is a captive cell?

4) Who would be involved in a captive set-up?

5) What are the major business processes involved in a captive?

6) What financial risks are businesses exposing their company to by entering a captive? What might be the impact of a catastrophic claim?

7) What returns can I expect from a captive and when are these paid? Are these offset against losses/claims? Could capital returns also be used to reduce premiums?

8) Is it the case that, because of the size and nature of your clients, there is less tendency to push back the money into large treasury operations?

9) A lot of people have been exiting captives on the basis that they’re stuck in cash. What’s your view on that?

10) Is being stuck in cash stopping people from setting up captives?

11) Who have you seen innovating within the industry, what steps being taken by your own organisation to stay fit for the future?

12) Cost v return is an ongoing challenge for captives, what actions do you see being taken to manage against this? What effect is this changing challenge having on new entrants?

13) Have you witnessed any changes in the size of firms involved in captive insurance?

14) How have banks adapted their services for the captive industry over time?

15) What’s the difference in cost between Letters of Credit and trusts?

16) How else is the captive industry expanding and developing?

17) What impact do you foresee Basel III having on the captive industry? Will certain parties be affected more than others? Is there anything Captives can do in preparation?

18) What other regulation should captives be prepared for this year (in your jurisdiction or globally)?

19) What impact has 831b had on captives in the US? Could this result in re-domiciliation?

20) What’s your view on using a captive to cover a company’s Life Insurance obligations?

21) How and when should you expand your captive portfolio?

22) How and why would you choose to run-off your captive portfolio?

23) How and why do captives re-domicile? What impact will capitalisation costs and substance requirements across the jurisdictions have on these decisions?

24) Captive insurance arrangements in the US have recently come under scrutiny from the IRS? Do you see them taking a greater interest than they used to?

1) What is a captive?

If I were defining a captive I would take it a lot further than the basic definition you read on most websites – you’d read a definition of a captive as being a company providing insurance to its owners.

Bermuda, where I do most of my business, has taken that quite a lot further. Bermuda has started in its regulations to try and separate commercial insurance from the captive world – so basically it has taken classes 1, 2 and 3 and said they are captive business, and 3a, 3b, and 4 are commercial insurers, and it’s trying to regulate them differently now.

Within our captives we have businesses that are very close to commercial insurers doing third party business. We don’t just do people’s own business, we do agents that are providing facilities for their clients, rent-a-captive operations, group captives where people are doing business for their customers – they still come under the captive definition, but it’s a much wider definition than is usually provided.

I see growth in captives right now. People are interested in captives again – the type of people with better than average losses who want to leave the standard market and people who want to control their own destiny in terms of setting their premiums, policy wordings and also probably control of claims. Nobody is ever satisfied with their claims handlers. That’s a big part of why you’d want to go into your captive – so you can unbundle some of these services and get some of your own claims handling in place.


2) Can captives work as a profit centre?

Yes, they can. We focus on group markets – we don’t do a great deal of single owner captives. We do a lot of business with auto dealers and similar groups in the United States and Canada. They tend to set up captives to provide insurance on the various products they offer after selling a car. So extended warranties, paint protection, fabric protection, tyre and wheel protection, losing keys, having an accident when the owner is in a negative equity position and so on – anything a dealer sells you after you buy a car, we can reinsure.

The auto industry right now is in a good place. 2008 and 2009 were very bad years but we’re now back to a similar amount of sales as in 2008 and 2009 with a lot fewer dealers – those that remain are really quite strong. They’re looking at captive insurance companies as a profit centre – it’s a type of business they would not have participated in unless there was a captive. It gives them an opportunity to take some money at the back end and be a partner for the insurance company.


3) What is a captive cell?

I do like to call them captive cells – they’re called different things in different places. In Bermuda they are segregated account companies. I see cells as an area of growth in captives. We have two cell companies right now and use them for people who are either slightly too small to have own captive or who don’t want to have their own captive.

We can do in a cell almost everything that people would do in their own captive, and we find them very easy to establish. Cells don’t require commitment from the management of the owner to manage them – they don’t have to set up a board of directors to run them or participate in the management of the cell because that’s all provided by the management company. So what cells enable these people to do is get into a captive situation very quickly and very easily, and test the waters.

So we use them for ease of getting in, we also use them as incubators for people who aren’t sure if they want to be in a captive long term – they might like to have their own captive at some point but they aren’t sure. These people can stay in the cell for as long as like and, if they want to, can spin themselves off into their own captive.

To me the cell provides nearly all the benefits of a captive, at a similar cost, but with a lot less administration and involvement of management.


4) Who would be involved in a captive set-up?

Everybody’s involved in the captive set up. Actually, it is quite labour intensive – which is why I was saying cells are easier.

Setting up captive is quite a major decision for an organisation and it does demand a lot of an organisation’s time and commitment at all levels – the insurance, the risk managers, the finance and capital people – everybody.

A cell takes a little bit of that away, including the requirement for a feasibility study. In Bermuda the regulatory authorities don’t approve each cell, they approve the incorporation of the cell company originally – which is generally formed either by insurance agents or the insurance managers themselves. So each cell does not require a separate application to regulators. This is purely in Bermuda and is a big advantage Bermuda has – I believe other jurisdictions do require some sort of applications for cells.


5) What are the major business processes involved in a captive?

The same processes you’d see in your own company. Auditing, accounting, risk management and, more and more governance is involved, as captives are getting larger. We have captives with fairly developed governance models.

The legal side of things is involved – we use local lawyers. Then we’ve got banks, Letter of Credit issuers, investment managers – so it’s everybody that is involved in your own company, I believe.


6) What financial risks are businesses exposing their company to by entering a captive? What might be the impact of a catastrophic claim?

When you’re getting into a captive, you’ve got to understand the risk that you are taking on. In some cases, you have got those risks anyway and you are moving them from your own balance sheet to your captive. In the ones that I manage, you are accepting a risk that you wouldn’t have, but you’re capitalising for it.

In terms of catastrophic claims, you can either limit the amount of loss that you take – which is what most of my clients do – or you can buy reinsurance to protect yourself from a catastrophic claim.

So you’re making a positive decision to either take on extra risk that you haven’t had before, or take a portion of the risk that you have had before and that you understand the history of, and take it into your own captive. A properly constructed programme really leaves you where you want to be.


7) What returns can I expect from a captive and when are these paid? Are these offset against losses/claims? Could capital returns also be used to reduce premiums?

It’s a good question – what can you expect from a captive? You can expect what you plan – so what are you looking for in your captive? Are you looking, like the car dealers, for a profit? They’re looking to take on business that they wouldn’t have before and make money from it. Are you looking to provide some insurance that you couldn’t find anywhere else? There are people who haven’t been able to find the insurance and just want to fund a part of a claim that might come up. They might not want to make a profit – they might just want to fund to break even for estimated future losses, so that they’re ready to pay a claim when it happens.

So, the returns that you can expect are basically what you planned right at the beginning. What are you in it for? Are you funding losses, using it as a place to build a fund, or are you doing this as a profit centre to make money? We have both. And depending on that is when you will take the money out.

The directors of the company will determine when you can distribute profits and you can only distribute profits as dividends, as policyholder dividends, or a cancellation of shares with a return of capital. We have a lot of companies that allow shareholders to redeem their shares and end their relationship with the company because it has served its purpose.

Obviously you’ve got to settle your losses and claims first, and your forecast claims and set up claims reserves, before you can distribute any profits. But you can decide how you handle claims. Insurance companies might have to stick by the book and might not want to settle a claim – they might want to contest a claim to set a precedent. In your case, you might not want to set a precedent, you might just want to get a claim off your books, or you might want to make a 'goodwill' claim payment, and you can do that in a captive.

But you can also build investment income in a captive. We do have some very long-term captives that have built a lot of investment income and are able to reduce their premiums going forward because they have capital, they have past profits that they haven’t taken out of the company and they’re earning returns.


8) Is it the case that, because of the size and nature of your clients, there is less tendency to push back the money into large treasury operations?

Yes, I would say they don’t. To the FTSE clients we have, loaning money back to treasury makes a lot of sense and several of them do that. With our mid-size clients, the tendency is to keep the cash here and keep it for rainy day. Of course doing that probably helps them now fiscally or tax wise – not that there has ever been a reason, in my opinion, to set up a captive or a cell for tax – but given the recent changes in CFC rules, I think some of our clients now see a bit of icing on cake that they’ve never seen before.


9) A lot of people have been exiting captives on the basis that they’re stuck in cash. What’s your view on that?

We’ve been fairly aggressive with our investments – we have quite a lot of captives that are old and established. Several of my captives celebrated their 25th anniversary last year and I’ve got some that are 30 years old. So they’ve been through various cycles of underwriting and investments and they’ve built a capital base, and that has enabled them to invest a lot more widely than cash. We have been able to invest in equities and other instruments to try and supplement our investment income.

A brand new captive without much surplus really is stuck in cash and that is not a place you want to be right now. But as you build a life cycle, and you build some capital and surplus, you can start to put other investments in.

There are no restrictions in Bermuda on what investments you can have in your captive – you don’t have to have a specific percentage of equity and a specific percentage of bonds. Bermuda looks at your ability to pay your claims, so it really looks at the liquidity of your investments compared to your assets – and provided you meet the requirements for liquidity, you can invest in whatever you like.


10) Is being stuck in cash stopping people from setting up captives?

I don’t think so. We are continuing to see interest in captives. Investment income hasn’t been a big part of what people are looking for. The ones I’ve seen lately have been looking to get into a captive to take the underwriting profits and they’re looking at long-term planning. And if they can move to an investment portfolio that makes investment income, they would like to do that. But I don’t think getting a zero return initially is that much of a concern – they understand.


11) Who have you seen innovating within the industry, what steps being taken by your own organisation to stay fit for the future?

I think we’re still seeing innovation in the use of cell companies – I think there are things we can do within cells that we’re not doing yet. The investment managers are trying to innovate. People think of trusts as only having cash and treasuries, but actually the state regulations are a little bit wider than that. Some investment managers are looking at those state regulations and working on investments, trying to put together a portfolio that complies with the regulations, qualifies for the trust arrangements, but still provides an investment return.


12) Cost v return is an ongoing challenge for captives, what actions do you see being taken to manage against this? What effect is this changing challenge having on new entrants?

We’re always under pressure for costs, and we’re always trying to manage them. The cells/segregated account companies give people a simpler and cheaper way into a captive because there is no major incorporation process.

When we take people into our segregated account company we don’t charge them any incorporation costs at all – we charge a percentage of premium, which gives them easy, cheap entry into a captive. Ongoing costs are relatively similar but are based on a premium so it gives them a chance to ramp up. And our management fees – we try to work with our clients to keep these fees down when they’re trying to establish themselves. We do everything we can to keep costs as low as we can.


13) Have you witnessed any changes in the size of firms involved in captive insurance?

No, not really. Some people have a figure in mind of premium, but I don’t really. We have some bigger captives but we also have some smaller captives, I don’t really see that the firms involved are getting larger and larger and it’s only for the big boys. We have seen quite a lot written lately about taking captives down to second tier companies and entrepreneurial companies by putting groups together, and that seems to work quite well.


14) How have banks adapted their services for the captive industry over time?

Barclays is decreasing their loan-to-values and putting up their Letter of Credit fees. You know that side of things – Basel III and everything else.

We’d like banks to adapt their services. We’d like to do more Letters of Credit and less trusts – we are doing more trusts. We’d like more Letter of Credit banks to come into the market. I think banks are being driven by their own regulatory problems and capital issues, and we have to work within what they can provide for us.

I prefer Letters of Credit because a trust has very prescribed investment guidelines whereas with a Letter of Credit – providing you have enough assets in the custody fund and the bank is happy that it has sufficient collateral – you can actually do whichever investments you like within those guidelines.

So in a Letter of Credit you have more flexibility of investments and you can also remove excess assets from the Letter of Credit custody fund yourself, without the permission of the ceding companies or the beneficiary of the trust. When your relationship is reducing or ended you really don’t want to go back to the ceding company trying to take your excess assets out – there is no benefit to them in doing that. I think the assets are more under your control if you have them in a Letter of Credit portfolio.


15) What’s the difference in cost between Letters of Credit and trusts?

Getting more and more. Letters of Credit are getting more expensive, trusts are relatively inexpensive but they never seem to be quite as inexpensive as they first appear.

You can have multiple beneficiary trusts, but we tend not to. If you have three ceding companies you can have three Letters of Credit against the same portfolio, so you can have one big portfolio with multiple Letters of Credit against it. This means, administratively you’re not trying to manage several small portfolios. Whereas, with trusts, you’d probably have one trust for each beneficiary.

So it’s a cost/benefit thing – can you make more investment income than you’re paying in Letter of Credit fees? Up until now, we have been able to. Now Letter of Credit fees look like going up quite significantly, possibly we’ll go back and look at trusts again.


16) How else is the captive industry expanding and developing?

I think it is expanding again. We’re seeing new people coming in, a little bit of property insurance coming in and businesses starting to look to the future again – whereas for the last few years they’ve been taking money out of their captives, now we see them starting to look to build their captives again.

We’re out developing markets – looking at different geographical areas. Bermuda is looking at South America – we’re out trying to look at different jurisdictions. My own business is still North American – there seems to be enough business in North America for us to look at now.


17) What impact do you foresee Basel III having on the captive industry? Will certain parties be affected more than others? Is there anything Captives can do in preparation?

Basel III is dragging our Letter of Credit fees up. We are working with the banks in preparation – we’re looking at Letter of Credit fees, we’re looking at trusts again, we’re looking at our investment portfolios – we constantly are. So we’re working on those things with our banks.


18) What other regulation should captives be prepared for this year (in your jurisdiction or globally)?

In Bermuda we’re doing a lot of work on FATCA (the American Foreign Account Tax Compliance Act). All our captives are caught up in some way, shape or form with FATCA. We’ve had to do a lot of analysis of whether our captives are going to be FFIs (Foreign Financial Institutions) or NFFEs (Non Financial Foreign Entities).

We have a great deal of work to do with our ceding companies and our investment managers to provide our withholding agents with the information to demonstrate that we are categorising ourselves correctly and they don’t have to withhold tax from us. FATCA includes quite an onerous withholding tax regime, including 30% of gross premiums if you don’t get it right. It comes in on July 1st 2014 and we’re spending quite a lot of time now determining the status of our captives.

This requirement is not from the captive regulators, it’s from the US tax authorities. The UK have got their own FATCA which we’re going to have to comply with too, but the big drive right now is the US one.


19) What impact has 831b had on captives in the US? Could this result in re-domiciliation?

This is a section of insurance code. If an offshore company takes a 953d election to become a US taxpayer, it can take the 831b election if it writes less than $1.2 million in premiums a year. If it takes that election, it pays tax only on its investment income – it doesn’t pay any taxes on its underwriting income.

This is a section that the auto industry uses quite a lot. Not really in jurisdictions like Bermuda because they’re low capital, low cost captives who take this option and they tend to go to places like Nevis, Seychelles and Anguilla. I don’t think it would result in re-domiciliation.

What 831b does is provide another form of captive that smaller people can get into. You have to do third-party business. It has to look like a captive but it is a section of the code that is being used and, if done properly, it can be a useful company. I do very little. My group captives are alternatives to multiple 831bs.


20) What’s your view on using a captive to cover a company’s Life Insurance obligations?

I’ve read quite a lot lately that life insurance would be a good product for captives and I’m looking at a group life programme right now. But this brings us back to FATCA.

If you write cash value life insurance in your regular captive, you could make yourself a Foreign Financial Institution. You would then have to register with the IRS, provide information on your US shareholders and so on. I don’t think any of us really know right now how onerous that is. Employee term life may be not have the same FATCA result, so may be OK.

I think we would have like to go forward with life programs, but we would be very careful in doing so.


21) How and when should you expand your captive portfolio?

When you can.

When you start a captive, really you start it for insurance purposes – your investment portfolio is probably very short and probably in cash and fixed income because you haven’t got a choice. As it builds capital and surplus, then you can do more.

We’re always looking for that development. The boards in my companies are very active, they’re looking at what the shareholders want. In our board meetings we always review our insurance business, review our free available funds and look to expand the investment portfolio. We’re always looking at what the aims for the company are – can we invest on a longer term because our shareholders don’t want money back yet, or do our shareholders want the money back as quickly as possible? If they do, then you almost have to stick with a short term portfolio.

So, when? The answer is “when it can”. Should you? The answer is “does it make sense” – are you looking for investment income in this company or are you looking to take underwriting profits back into the primary business?


22) How and why would you choose to run-off your captive portfolio?

We have exit strategies set up right at the beginning in my group captives and cell companies. We have the ability to cancel your shares, run-off your business and take your money out – as a dividend or a return of capital when your reserves have gone.

Why would you do it? You do it when you don’t need the captive any more. We’ve had people sell their business so they don’t need the captive anymore, we’ve had people feel that the money would be better used in their own business rather than sitting in the captive, we’ve had mergers and acquisitions and we’ve had insurance business that just didn’t make sense anymore, so we’ve closed the captive down.

How? If it’s your own captive you have to go through the full liquidation process, you’ve got to get rid of the reserves and the liabilities. An exit strategy with a long-term liability programme can take a long time and be expensive, so you really need to think about that when you set off.


23) How and why do captives re-domicile? What impact will capitalisation costs and substance requirements across the jurisdictions have on these decisions?

I haven’t seen many re-domiciliations. I saw one out of Bermuda last year to another jurisdiction mainly because the organiser had a lot of captives in the other jurisdiction and wanted them all in the same place. It’s not a very easy thing to do, so to me it would have to be a major reason to re-domicile. It wouldn’t be due to recapitalisation costs – it would be for consolidation or a major reason, it’s not something you’d do lightly.


24) Captive insurance arrangements in the US have recently come under scrutiny from the IRS? Do you see them taking a greater interest than they used to?


We haven’t seen the IRS taking a greater interest in captives themselves, but we’ve seen more involvement from the Federal Excise Tax people this year. They developed a theory of cascading Federal Excise Tax some years ago, where they felt if you took a premium from the United States to Bermuda then there would be federal excise tax of 4% if it was direct business and 1% if it was reinsured. But then if I reinsured it to somebody else in another jurisdiction, they then felt there would be another layer of federal excise tax.

We have seen a few Federal Excise Tax audits looking to see that we’ve paid the Federal Excise Tax we should have paid and whether we have paid it on any outward reinsurance.

On other arrangements, I haven’t really seen much more scrutiny from the IRS and I don’t think there have been any major changes in rules or any major things added to or taken off audit checklists.


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