Off to a slow start: offering federal exemptions to captives to encourage the administration of ERISA-regulated benefits has met an unexpectedly tepid response. Many companies are still interested in creating captives, especially if they can find simpler approval options

Risk & Insurance, August, 2005 by Peter Mead

Last year, when the U.S. Labor Department approved an expedited procedure for granting exemptions to captives looking to administer ERISA-regulated benefits such as life insurance, disability or retiree medical benefits, many observers thought this would fuel the growth for employee-benefits programs based in captives.

But it hasn't turned out that way. Since Risk & Insurance[R] reported on captives last August, only Alcoa Corp., the metals manufacturing giant, and Alcon Laboratories Inc., a health-care company, were granted exemptions.

Whirlpool Corp., a manufacturer of washing machines and kitchen appliances, withdrew its application in December due to internal changes in the organization, although Labor Department regulators were prepared to approve it, according to Whirlpool's consultant, Karin Landry, managing partner of Spring Consulting Group in Boston.

However, other clients are in the pipeline toward captive ERISA-regulated benefits programs, say Landry and Sofia Tesfazion, a consultant with Towers Perrin's Global Consulting Group in New York.

Both consultants say they've seen a trend toward pursuing simpler options for the approval of a captive than the Labor Department's exemption process.

Spring Consulting Group's overall consulting activity in employee-benefits captives has increased dramatically in the last two years, driven primarily by these other options, the consultants say. While they have three or four clients investigating the Labor Department's "fast track" exemption process, they have as many as 25 clients ready to explore other options.

Other options include the formation of captive programs for non-ERISA benefits, which requires little or no Labor Department review. One example is a program to fund supplemental executive retirement plans above the caps in some defined benefits or defined contribution plans.

Even some captive ERISA benefits programs don't need special exemptions, such as when a captive manages benefits in which more than 50 percent of total premium in the captive is from non-benefits "unrelated business."

One example is a retailer that issues credit cards and sells life and/or disability insurance coverage to their cardholders. If more than half of the captive's total premium is paid by cardholders, an ERISA benefits program in the same captive doesn't need the special exemption.

Another example could be a manufacturer using a captive to sell its suppliers the insurance coverage for raw materials or finished goods traveling by truck or train.

The Labor Department is only part of the equation for placing employee benefits in a captive. The Internal Revenue Service also examines the level of "unrelated business"--as part of "risk shifting and risk distribution"--and may allow premiums to be deductible, potentially generating significant IRS tax advantages.

"The IRS issued a series of rulings on the amount of unrelated business needed to qualify a captive as an insurance entity," says Landry. "Our clients feel that's another clear stake in the ground as to what qualifies and reduces ambiguity around captives."

In some cases, less than 50 percent of unrelated business can qualify a captive as an insurance entity thanks to the ruling in Harper Group v. Commissioner, says Landry.

In Harper, 30 percent of total premiums coming from an unrelated third party was adequate to establish a captive as a risk-shifting and risk-distribution entity, thereby making premiums a deductible expense for the IRS.

"Risk distribution" or "unrelated business" is not only a regulatory, concern, it's also part of the basic logic that makes captives economical--spreading risk over a wider base. "You can leverage good years on one side (employee benefits) against bad years on the other side of the house (usually property/casualty), and vice versa," explains Jim Girardin, senior vice president of the Willis Group's captive practice. Beyond seeking to reduce premiums or taxes, some employers are also motivated to explore captives as a compliance tool for the Sarbanes-Oxley Act, consultants say.

For large international employers, starting a captive "can be driven by the desire to coordinate and control their worldwide benefits and governance issues raised by Sarbanes-Oxley," says Tesfazion. "They want to establish control of risks in their organization. They can use a captive as a data-management facility."

While corporations explore captive-insurance vehicles, the jury is still out on whether legal and regulatory issues could slow down any nascent interest in captives.

Risk transfer is coming under scrutiny due to investigations and potential litigation by the Securities and Exchange Commission, New York Attorney General Eliot Spitzer and other state insurance regulators.

And now there's an even more important investigatory agency poking into the insurance business: the Federal Bureau of Investigation. The FBI is doing broad-scope surveillance of the insurance industry.

A report issued by the FBI in May brings insurance-industry challenges down to the level where consumers live. The bureau estimates that insurance fraud costs the average family $400 to $700 a year in unnecessary insurance costs, with total losses exceeding $40 billion.