Most readers in the international benefits field will have been faced, at one time or another, with a bright eyed consultant telling them how to “tune up” their multinational pool by introducing more risk and managing that risk through a captive insurance company. As a former consultant, I have to plead guilty to that offence! The subject often comes up but, for a variety of reasons, it seems that very few companies are willing to take their program to this next level.
The inherent risks in most benefit plans are relatively minor compared with the business risks that many organizations face, often with the insurance companies that carry them being smaller than the insured organization! On the face of it, the risks attached to benefit plans would seem to be more manageable for most organizations than is often envisaged, but the idea of using a captive does not seem to be followed up with action. Some quick research turned up no more than a dozen company-sponsored, benefits-only captive insurance or reinsurance companies.
So why the reluctance to go down this road? The answers are many and I shall attempt to address some of them in this article. I would also like to share some of the experiences we had when setting up a vehicle for R.J. Reynolds International (RJRI) in January and perhaps, in the process, encourage others to look at whether such a project would be beneficial.
WHAT’S IN IT FOR RJRI?
We took the view that using more self-insurance and establishing a captive to manage the risk over time would add significant value to our benefit programs. Cost was the initial motivator but, as we began to work through this project, it became clear that the approach was going to bring a much sharper focus to the management of our employee related risks than we ever imagined.
Before embarking on the project it is very important to decide what your organization is trying to achieve, as this will materially influence the structure and design of the arrangement. Obviously the objective is to take on more self-insurance; in our case, a captive reinsurance company provided a vehicle through which to manage the exposure. Over time we may decide that we can do without it and move to some type of “hold harmless” model* but we believe that, initially, the establishment of a captive disciplines the organization to look closely at experience and provides a funding vehicle for other employee promises.
We began the project with the recognition that increased risk exposure was manageable and, what is more, we would benefit by avoiding paying for insurance company risk charges, by negotiating down our administration fees and by being able to invest reserves and cash flow at a higher rate of return. Having implemented our program on 1 January of this year, we are optimistic that these gains will be made; however, the process of implementation was equally rewarding and was a significant learning experience for us at HQ and for our operating entities, in terms of how we had been managing our benefit programs in the past. For example, we quickly realized that our local HR managers had been relying heavily on local brokers and agents and were often using a less than efficient product. In looking at the proposed new arrangement, many learned how much commission they were actually paying and for the first time could assess the value of that expenditure. Some operating entities terminated their relationships with the local brokers as a result; others determined to retain them for the short term, but now pay an unbundled fee for those services. In conjunction with our insurance partners, we now believe we can offer objective, simplified claims-experience reporting and management. We did not and do not want our local HR managers to become experts in insurance. We do, however, want them to have better information about how their plans are being used, presented in layman’s terms, in order that they can assess whether the benefit program is doing the job it was planned to do in terms of employee perceived value and return on investment.
* This would involve RJRI reimbursing the fronting insurance provider for any deficits and receiving from them any surpluses directly without having the interim step of premiums and claims going via the reinsurance captive.
As our analysis progressed we realized that we were going to create a vehicle that potentially would be able to carry other employee risks that were currently self insured or unsecured. For example, lost social security benefits and excess pension promises could be funded through this arrangement. While there may not be any additional security or tax deductibility, the arrangement will capture the liability and enable us to manage it. Presently many of these commitments are not evaluated nor looked at in aggregate. At this stage we have decided that we will only consider employee related risks that can be actuarially determined and a premium that is calculated and collected from the operating entity that is making the promise.
TIMING AND PROCESS
Once we had determined our objectives and assessed our comfort level in terms of exposure, the first step was to get our operating companies involved in the project. At the earliest opportunity, we provided them with an outline of the project, advised them of the parameters under which they would be invited to participate and shared with them an action plan. Our experience is that you cannot communicate too early or too much! We followed up this initial communication with regular general and individual specific updates throughout the process, culminating in making available via our intranet site the entire report, justification and presentation used to satisfy internal approval requirements.
The next step was to select an insurer that would provide fronting insurance for all RJRI local contracts. Local insurance is needed to ensure that benefits receive preferential tax treatment in the hands of beneficiaries. Six providers were asked to submit proposals and three finalists were selected. Our proposal request included the requirement for a fixed percentage fee for claims administration worldwide. We finally determined that the AIG/Winterthur Alliance was best suited to meet our needs. We had worked with the Alliance on one of our prior multinational pools and it was able to provide introductions to other companies with which it had completed similar projects so that we could assess its experience and approach. The selection of a carrier is the most important part of the process and should be done carefully. Selecting a carrier that could move from an insurance to a client service mindset and that could become a partner in helping meet our commitments was the objective.
As already explained, RJRI decided that a captive reinsurance company was the right approach for its circumstances and further decided that Dublin offered the most attractive location because of the financial services infrastructure, the favorable tax regime and its close proximity to our centers of operation.
The next step was the recruitment of a local administrator to manage the day to day requirements of the captive. Here we considered the arguments both for and against using an administrator that was part of the selected insurance company and concluded that an integrated approach was the best one for us.
Despite the apparent potential for conflict of interest, we wanted an open partnership between the participants and were keen to avoid checkers checking checkers.
Throughout the whole process we were well supported by Towers Perrin, which was able to contribute at all stages including, through its Tillinghast group, advice on structuring the insurance company. Working with its actuarial input and our own treasury staffs, we determined what reinsurance the captive would require and then went to the market to obtain this.
Concurrently and in conjunction with our internal legal department, we began to incorporate a new subsidiary in the Republic of Ireland that would become the captive reinsurance company. We recruited the support of local legal advisers to assist with compliance issues in Dublin and the company’s ongoing needs as required.
From start to finish the process took around seven months of almost uninterrupted effort. While there are still several loose ends to tie up, this was a very short lead-time. Looking back, I can only suggest that this was because we had clear objectives and excellent external help and kept all of those involved up to date all of the time.
We decided that we wanted the captive to be an efficient, active company. The board of directors therefore is small and its members are active participants in the risk management process. Under the terms of incorporation, we are required to hold one meeting a year in Dublin and this will be at the time of premium reviews; otherwise our communication is via telephone conference calls. Not only is Dublin central to our operations, but it also has the advantage of lacking the resort cachet of some of the other captive insurance company locations.
THE SIZE QUESTION
RJRI is a company with more than US$3 billion* in revenue, operating in 170 countries. Our premiums for risk benefits total about US$5 million from more than 20 countries, with about 85% coming from two countries. Our limited research indicates that we are in the middle of the pack of benefits-only captives in terms of premium revenue. While our survey sample was not large, I would by no means suggest that this is the optimum size. I think smaller companies could be ideal candidates too, provided that they have the right philosophy and mix of exposure, while other larger companies may feel very uncomfortable taking on more risk. The decision of whether a company is the right size to take a captive reinsurance approach for benefits is unique and must be based on a consideration of overall risk philosophy, management style and a clear understanding of expense and cash controls.
* £1 = US$1.61; €1 = US$1.08 as at 9 April 1999
THE RISK QUESTION
In deciding whether or not more risk is justified, an organization has to be clear on what the risk really is. For some companies an excess cash call in a challenging year would be a disaster; for other organizations cash is a smaller problem than the expense impact (i.e. an operating loss within the captive). The risk of adverse claims experience can be offset with reinsurance but this has to be weighed against the cost of the reinsurance. Too much will absorb the profits. An assessment of the possible, probable and worst case claims scenarios needs to be developed and reviewed – with management and the appropriate protection established. It is essential that benefits people do not make this decision in isolation from their other, functional peers: finance, legal, treasury, HR and risk management will all have something to say about risk.
An area where we ran into a significant problem was reinsurance coverage. The benefits reinsurance market is very thin. Insurers appear reluctant to take on multi country risk and, in particular, aggregate exposure. Despite being led to believe by AIG/Winterthur that this would be a straightforward process, it proved to be challenging and in the end required several different reinsurers to provide coverage, which was not as comprehensive as we would have liked.
DECIDING WHAT’S RIGHT FOR YOUR COMPANY
As previously indicated, to take on more risk is not a decision for benefits people alone and needs to involve a range of other professionals within the organization. I believe that this is one of the primary reasons that so few companies have set up an employee benefits captive. Based on our experience, before a decision to proceed is taken, a review should include input from the following stakeholders:
- Treasury. Once an assessment of the risk profile has been made and possible worst case claims scenarios developed (including high individual and aggregate claims), the treasury function can help to establish contingent financing in the event (hopefully unlikely) that claims exceed reserves or reinsurance in a particular period. A combination of reinsurance and less costly internal resources to cover contingencies is likely to be the optimum approach. In our case, the cash exposure is considered manageable and an internal line of credit at an advantageous rate has been arranged in the event that we need additional resources to cover any adverse claims experience. Our internal treasury function was very helpful in providing investment and banking advice. As a result, we were also able to arrange a loan back facility for all excess reserves. While this route will not appeal to everyone, for our company it was part of the risk management decision and proved to be a far more attractive rate of return proposition than we had previously enjoyed with these reserves.
- Finance. The expense impact of an operating captive needs to be fully explored and understood if cost reduction is a primary objective. For example, companies subject to US GAP* need to consider the impact of the various FAS* directives on employee benefit accounting and the impact of reinsurance on these liabilities. RJRl’s captive reinsurance company’s accounts are consolidated into its parent’s results as if it were an operating subsidiary. Underwriting gains or losses are therefore consolidated and taxable as operating income. Another issue related to expensing is the method of determining renewal premiums for operating subsidiaries; this needs to be understood and communicated as fully as possible to operating subsidiaries for their planning purposes. Clearly, unpleasant surprises should be avoided and progress should be reported and measured against original objectives. In addition, the basis of cost allocation needs to be set out in advance. For example, an operating subsidiary should benefit from lower overhead and administrative expense but will still carry the effects of its experience. These two expense elements need to be separately communicated and monitored.
- Tax. Input from tax experts is critical and is also, in this area, relatively difficult to find. Based on our experience, few captive experts are knowledgeable on the special rules relating to employee benefit captive reinsurance companies as distinct from property and casualty captives. US tax legislation, for example, provides clear guidance on what can be deducted for reserving purposes, but regards employee benefit risk differently from corporate risk. In addition, there may be special rules in certain countries, which must be examined relative to the structure a company decides to establish, that limit the ability to achieve local deductions if the risk is ultimately self-insured. In our case, a combination of internal and external counsel proved to be a powerful combination in helping to identify the most beneficial structure.
- Legal. Again, a combination of internal and external legal support was instrumental in helping determine where the captive was to be domiciled and located within the internal legal structure and in physically setting up the company in Dublin.
* Generally accepted accounting principles
*Financial Accounting Standards
As the project manager, with our team working to a relatively tight deadline, I must stress the importance, for anyone undertaking this role, of good communication and the need to foster teamwork. I often felt like a house builder commanding and controlling a range of internal and external subcontractors who constantly needed to be managed to ensure, for example, that the roof was not being delivered before the foundations were in place.
The prospect of orchestrating a number of unfamiliar and different specialties will be enough to discourage most people! Based on our experience, we believe that the end result is going to be worth it and the process so far has proved to be a rewarding team effort too. The challenge is to identify a champion in the organization who is comfortable operating in unfamiliar territory, with the tenacity and relationships to keep operating companies and the various “subcontractors” in line and on schedule.
The most important group in terms of a smooth implementation is the operating companies. In most cases we were asking our operating units to transfer from their local carriers, some of which had been in place for many years, and often against the advice of their local adviser. Communication is critical to build and maintain support for the project. We did not make participation mandatory. Local operating companies were asked to meet with the local representative from AIG/Winterthur and to consider a proposal that would fulfill their needs locally as well as enabling them to participate in the projected benefits of the global program. We asked our local colleagues to satisfy themselves that both price and service needs could be met and, if necessary, to negotiate local service guarantees. Only if their needs were met were they to consider participation, which removed the impression of this being an HQ directive. We also made it clear that the captive would not be used as a financial engineering vehicle and that all surpluses would be retained and fed back to operating entities as lower premiums. Without exception, all countries joined the program voluntarily.
External professional help is essential. We worked with our long-standing benefit consulting and tax advisers who knew us and our markets, without whom we would not have achieved completion as quickly. Inputs covered tax, risk assessment, reinsurance marketing and general troubleshooting along the way. However, it must be stressed that this is not a project that can be handed over to consultants for completion. Project management must be internal if all of the issues are to be dealt with satisfactorily. We also found it very helpful to work with an insurance industry consultant to gain insights into the workings of the market and the creation of the various agreements that the captive must undertake with the insurance company, reinsurer and management company.
We will be waiting eagerly to see how our first year’s experience shapes up. We will be communicating extensively with our operating companies, preparing and encouraging them to use the information that will emanate from this new arrangement. We shall be examining other risks or unfunded liabilities that we can better manage from within the captive. Over time, we aim to build reserves from good experience that will enable us to reduce the level and cost of reinsurance and we will consider inviting our sister companies to participate with the aim of achieving further economies of scale.
I predict that more companies, possibly in conjunction with other organizations, will find ways to look at this approach and move on to setting up captives in order to share risk exposure and reduce costs. The reinsurance industry will need to be ready to meet this demand.