Taxiing for takeoff: recent applications to fund benefits captives have been approved in record time. Several pending applications before the U.S. Department of Labor will signal to the markets just how serious regulators are about approving alternative finance vehicles

Risk & Insurance, August, 2004 by Peter Mead

The speed at which U.S. Department of Labor regulators are approving the creation of captive finance companies to fired the rising cost of employee benefits is getting faster, evidence suggests.

Advantages to captive benefits include lower administration and tax costs, with better control of corporate risks by centralizing them into one structure. Usually, an employer already manages property and casualty risks through a captive before adding employee benefits such as life, retiree medical or long-term disability to the risk portfolio.

The DOL's Expedited Procedure (ExPro) program reduces the time it normally takes to approve exemptions from ERISA requirements that otherwise would prohibit assuming employee benefit risks into a captive. Last November, DOL took 78 days to approve International Paper's captive benefits program under ExPro. International Paper's approval came on the heels of two other applications, Columbia Energy in October 2000, and Archer Daniels Midland in March 2003, whose approvals took much longer.

Captive employee benefits are getting a lot of buzz in U.S. corporate insurance circles. The practice is less regulated in Europe, so the market is more developed there. The handful of approvals in the United States so far is hardly the avalanche hoped for by some.

A captive must be domiciled in a U.S. state or territory--one of several DOL requirements--to be approved for assuming risks of employee benefits in the United States.

Domiciles such as Vermont and Hawaii permit substantial tranches of assets to be held in an offshore parent captive, opening the door to a full range of captive solutions. Vermont's captive insurance service industry could gain substantially if the idea takes off in the United States, because more than 70 percent of U.S.-based captives are domiciled in Vermont.

THE PAYOFF

Funding employee benefits through a captive offers significant advantages.

Employers can save up to 50 percent of "frictional" (non-loss) costs compared to a typical fully insured program in life or long-term disability, says Karin Landry, managing partner of Spring Consulting Group in Boston. The share of frictional cost in the total cost of insurance ranges anywhere from 5 percent to 40 percent, Landry says.

Captives also offer tax advantages. Funding benefits through a single-parent captive may give employers a corporate income tax shelter. An employer can deduct all premiums it pays to a captive if 30 percent or more of the captive's total revenue is third-party (employee benefits fit in this category) or unrelated to property, says Rosemary Moore, vice president and managing counsel of UnumProvident Advanced Risk.

Landry says that due to a recent tax law precedent involving Wells Fargo & Co., an employer can now pre-fund a retiree medical benefit and deduct the total amount from that year's corporate income tax, rather than amortizing the cost over the life of the beneficiaries. This aligns tax practice with the accepted accounting practice of pre-funding retiree benefit obligations.

Consolidating employee benefits with other risks in a captive may help employers diversify their risk portfolio to reduce the coverage cost of risk. Bill Fitzpatrick, vice president of national accounts for AIG Employee Benefits, says advantages include a single funding mechanism for consolidating global programs, better control of corporate governance through financial reporting, more leverage over local insurers to set flexible terms based on particular risk-tolerance limits, and a more diverse risk portfolio that makes losses more predictable.

HURDLES TO CLEAR

The DOL's expedited procedure process is only the final hurdle at the end of a long trek. Several factors prolong the journey, suggesting the market may expand only gradually.

One factor is overworked risk management departments. In addition, there's a tricky balancing act between risk and benefits. "More than once, the risk manager and the benefits manager introduced themselves to each other for the first time when meeting with me," says Moore of UnumProvident. "There can be internal tension around the concept of funding benefits with a captive, because people are afraid of losing control of their turf." In this regard, the process may resemble an integration initiative, especially where a benefits program must change insurance vendors in order to implement the captive funding program, Moore says. Michael Lusk, manager of risk and insurance for Archer Daniels Midland, says, "When Columbia Energy and ADM went through their DOL exemptions, they were based on reinsurance into a captive. Most employee benefits people would not necessarily be that familiar with reinsurance."

There is also a complex feasibility phase. Although a captive sometimes can yield savings by accepting risk from only one employee benefit, a feasibility study may review a broader swath of benefits risks. It may also require a broad, cross-functional team, says Mitchell Cole, a principal of Towers Perrin in New York. In addition, corporations are averse to red tape. Up to 20 of the employers with captives domiciled in Vermont have expressed interest in captive benefit funding to the state's captive staff. However, "they don't want to be the guinea pigs for the (ExPro) process," so they hesitate to apply, says Dan Towle, director of financial services for the Vermont Department of Economic Development. ExPro may be faster than DOL's former process, but it's still a unique and complex passage for each player.