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The Columbia Energy case paved the way, but what’s the holdup?

Anecdotal evidence suggests that there are inefficiencies in how companies procure their employee benefit programs. These programs can profit from lessons learned from the property and casualty industry, including concepts such as unbundling, self-insurance and captive insurers.

While placing benefits in a captive is no panacea, for many companies it can facilitate better management and long term cost savings.

The fundamental question, however, is whether a captive will add value to the management of employee benefit risk? Our experience is that the utilization of a captive mandates a constant review of loss data and a thorough study of the component parts of a premium–leading to improved risk management. Involving a captive also encourages discipline and supports better loss control and claims management.

The insured, in other words, no longer pays a premium and transfers risk, but manages and measures risk by studying the financial impact of loss.

Employee Retirement Income Security Act of 1974 is a federal law that sets minimum standards for most voluntarily established pension and health plans in private industry to provide protection for the individuals in these plans.

ERISA requires plans to provide participants with information, including important facts about the plan’s features and funding; it provides fiduciary responsibilities for those who manage and control plan assets; requires plans to establish a grievance and appeals process for participants to get benefits from their plans; and gives participants the right to sue for benefits and breaches of fiduciary duty.

ERISA’s prohibited transaction rules ordinarily would prevent employers from insuring or reinsuring their employee benefit plans through captives. However, ERISA authorized the U.S. Department of Labor to grant two types of exemptions from the prohibited transaction rules:

Class exemption–this may be relied upon by any employer meeting the conditions in the exemption;

Individual exemption–this can be relied upon only by the employer that applied for the individual exemption.

The DOL granted a class exemption allowing an employer to use its captive to insure or reinsure employee benefits plans if the captive derives no more than 50% of its annual premiums from related business. Therefore, at least 50% of the captive’s business must be unrelated third party risk. This requirement was still a major hurdle since most captives focus on related risk and are not interested in exposing risk capital to unrelated business.

Fortunately, Columbia Energy and Archer Daniels Midland have overcome some of the DOL obstacles, paving the way for other organizations.

Columbia, ADM & EXPRO

The significance of the Columbia Energy ruling was that it was the first individual exemption allowing the use of a captive for employee benefits without requiring a specific amount of third-party risk.

Columbia Energy reinsured its long-term disability program to a Vermont branch of its Bermuda captive. A second individual exemption was granted to Archer Daniels Midland to reinsure both its basic and supplemental group life insurance plans through its Vermont captive. In both instances, the captive would not have passed the 50% unrelated business requirement in the class exemption.

The additional significance of the ADM ruling was that it triggered “EXPRO.” This is an expedited DOL approval process for proposed transactions that are substantially similar transactions, for which DOL has granted at least two exemptions.

EXPRO allows for approval in as little as 90-120 days compared to approval times of more than one year for Columbia and ADM.

To date, the EXPRO process has been used by International Paper and Alcon Laboratories to gain approval for the use of their captive for benefits. An additional individual exemption involving Swedish-based company Svenska Cellulosa Aktiebolaget was granted in July 2004.

But why haven’t more companies taken the captive route for employee benefits, given the significant cost of benefits and the number of active captives? The answer is that there are still many hurdles to successful completion of a benefit captive. These include:

o An inability to properly assess the level of profit in the current structure. We have found that current providers are resistant to opening the “black box” and provide sufficient detail on historical claims information. In the client/prospect feasibility process, the lack of quality data leads to conservative actuarial projections based on industry patterns. An inflated projection makes the current price appear affordable and supports maintaining the status quo approach. Our client experiences reflect actual losses being superior to actuarial projections and market pricing being a better benchmark for consideration.

o A need for fronting and an alignment of interests. The development of benefits in captives has significant consequences for the life-health industry, where much of the current profits are derived from the management and control of assets. Inclusion of a captive in a benefits program is a direct attack on the asset control issue. When faced with losing control of assets, carriers look to maintain margins through increases in other related fees such as fronting, reinsurance and claims handling.

The fronting carrier relationship is a critical element needed to receive DOL approval and develop a long-term successful benefits captive program. The concept of a captive holding 100% of the assets while being able to aggressively manage program expenses, such as fronting and claims costs, is not supportable under current market conditions. Under a DOL required structure, captive and carrier need to coexist and must share in the risk/reward equation to create an alignment of interest that will last. Many of the structures being implemented are on a quota share basis reflecting this need.

o Internal Coordination–Many organizations struggle with the internal politics of coordinating cooperation among several different corporate functions–finance, human resources and risk management. In many instances, the human resources department resists changes in control as the risk management department takes on a more active role in program structuring. Coordinating all three disciplines is critical to the program success and has been a major hurdle to successful implementation.

oOpportunity Cost of Allocated Capital–Employee benefits in captives are subject to the same issues as those of traditional property and casualty captives, where the cost of allocated capital to pre-fund risk over a pay-as-you-go approach is too significant and outweighs the program benefits.

Assessing Feasibility

The best approach for assessing the viability of benefits in captives begins with a review of the status quo approach, including an assessment of the embedded profit, if any. A thorough economic analysis includes cost of fronting, reinsurance, claims, fiduciary, increased benefits and opportunity cost of allocated capital. All related costs must be compared to the status quo as well as alternatives such as a “pay-as-you-go” or ASO, “Administrative Services Only” approach to determine the optimal choice.

Michael O’Malley is a managing director at Strategic Risk Solutions in in Waltham, Mass. His work focuses on captive feasibility and alternative risk structures.