Employee Benefit Captives Momentum Building

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.