Health+Benefits the October 2014 issue

Wanted: The Young and Healthy

Will Obamacare play fair with small-business captives?
By Dave Lenckus Posted on October 30, 2014

Since a relatively short interruption in growth in 2008, the captive formation numbers have turned around, and “it feels to me like 2013 was up over prior years,” says Julie Boucher, Captive Solutions-Americas practice leader at Marsh USA.

Captive managers expect 2014 to be another strong year for growth based on their conversations with prospective owners.

Consultant Demotech reports the number of active U.S. captives has grown more than 20% over the last five years to about 2,350 in 2013 from about 1,950 in 2008. During the same period, worldwide growth was 32%, with the active captive count swelling to 3,950 from about 3,000.

“There’s definitely been steady captive growth in spite of the economy,” says Nancy Gray of Aon Global Insurance Managers.

Notably, the number of micro captives is booming as small and midsize companies recognize they have the financial means to either form their own facilities or participate in a sponsored cell or a series limited liability facility, according to captive managers. Micro captives are facilities that collect no more than $1.2 million of premium annually, which potentially qualifies them for a federal income tax break under Section 831(b) of the Internal Revenue Service Code.

“This is not just for large companies anymore,” says Steve Bauman, head of captive services for Zurich Global Corporate North America.

Captive managers tell Ross Elliott, captive insurance director at the Utah Insurance Department, that the micro captive market has barely scratched the surface despite a plethora of formations in recent years. In Delaware, about 97% of 455 business units are micro captives, according to Steve Kinion, director of the Delaware Bureau of Captive & Financial Insurance Products.

Smaller employers need medical stop-loss coverage to kick in at around $25,000.

The owners of micro captives are covering more than traditional property-casualty exposures, according to captive experts. These captives often are covering risks such as cyber liability, loss of computer system data, employment liability, difference in conditions, tax audit costs, loss of a professional license, earthquake, terrorism and medical malpractice liability. In addition, many owners of micro captives use their facilities to cover, or buy down, the large deductibles they assume on various risks, such as workers compensation and property. The commercial insurance cost savings realized by accepting a large deductible far exceeds the premium paid to the captive for the buy-down coverage.  

But even midsize companies with too much risk for their captives to qualify for the tax break increasingly are setting up the self-funding vehicles, captive experts say. “Half of our captives write less than $5 million a year” in premiums, notes David Provost, the Vermont’s deputy commissioner of captive insurance.  

In the near term, Kinion and other captive experts do not expect to see growth slow.

“I always ask myself: When is it going to plateau?” he says. “It has to plateau at some point.”

ACA Affect

Concerned that the Affordable Care Act will drive up health insurance costs, more small and midsize companies are exploring self-funding options, including the use of captives for medical stop-loss coverage. As Obamacare fuels interest in captives, however, regulatory obstacles could stymie that growth.

Even with all the uncertainty, the use of group captives to help small businesses manage their employee benefits costs is a natural step in the evolution of the captive industry.

For decades, Fortune 500 companies drove the growth of captives in Bermuda and other offshore jurisdictions. Though Vermont was the first and most successful U.S. state to allow the formation of captives, about two thirds of states now compete for that business, giving captive owners far more choices about where to set up shop. The types of risk insured through captives have also expanded vastly, ranging from terrorism insurance to cell-phone protection plans.

Smaller companies that are not prepared to make a financial commitment to their own captive insurers are flocking to sponsored cell or series facilities, a structure that Delaware regulator Kinion labels “captives on training wheels.”
The facilities create opportunities for smaller companies to follow the lead of large employers that have been using captives to self-fund a portion of their medical stop-loss coverage. “Captive utilization increases the certainty and predictability” of overall employer healthcare costs, says Zurich’s Bauman.

The Affordable Care Act “has done more to start that discussion” with employers of all sizes, says Andrew Kuykendall, assistant vice president of Alternative Risk Strategies for Bolton & Co.

Companies with as few as 50 lives are self-funding and examining the feasibility of moving a layer of their medical stop-loss coverage into a group captive insurance arrangement, according to Karin Landry, managing partner of Boston-based Spring Consulting Group.

Captive owners first must determine whether they have as much faith in the state regulators new to the trend as they do in those in well-established jurisdictions.

Interest is so high that many brokerages have created distinct practices for employee benefits captives. For example, Artex Risk Solutions, Arthur J. Gallagher’s captive management unit, recently opened an employee benefits division.

Seeing several of its California competitors move into this space, Bolton hired Kuykendall a few years ago to develop its own consulting practice. Bolton offers small and midsize clients a bundled product that includes plan design and placement with a captive manager and provider of third-party administration services.

Pareto Captive Services is one of Bolton’s captive managers and a relative newcomer in the market. Using a small network of brokers and consultants since early 2012, Pareto has put 100 small and midsize self-funded employers into four group captives writing medical stop-loss coverage. The size of the employers ranges from 45 to 400 employees, with the average being 125, says managing director Andrew Cavenagh.

The start of community rating in 2016 could drive more small employers to captives, says Bob Klonk, CEO at Oswald Cos. Under community rating, insurers offer the same rate to all individuals within a defined territory rather than medically underwriting separate groups of individuals. Community rating will drive up insurance costs for employers with young, healthy work forces, says Klonk.

Brokers can help these clients by educating them about self-funding and captives. “They have to know whether an option will be suitable for them,” explains Klonk, whose brokerage is spending a lot more time these days helping clients understand which options best fit their needs.

This, however, is easier said than done for producers who themselves lack expertise in this emerging area. “The biggest thought-shift is around education and broker training of how these programs work,” says Bolton’s Kuykendall. “We have this big book of employee benefits; we need to give producers the skill sets to understand what [captive programs] can and can’t do and which groups this is good for.”

Likewise, at Pareto, “We spend a lot of time training brokers on the product and who’d be a good fit,” Cavenagh says.

Regulatory Uncertainty

While Obamacare has driven smaller employers to self-fund, other developments surrounding the law have dialed down their enthusiasm. The benefits business at Artex, for example, is growing, but it’s “not growing at the rate I thought it would two or three years ago,” says Karl Huish, president of Gallagher’s captive services.

Smaller employers have good reason to fear that state and federal policymakers will place restrictions on stop-loss coverage to pressure them to abandon self-funding and either jump back into the commercial insurance market or force their workers into a health insurance exchange.

The concern is that by self-funding, small companies will remove healthy individuals from the broader risk pool, leaving the exchanges with a sicker and more costly population, says Mike Ferguson, COO of the Self-Insurance Institute of America. If claim costs—and premiums—in the health insurance exchanges go sky high, healthier people will avoid them, creating the potential for a death spiral.

Already, California has enacted a law that establishes the minimum medical stop-loss attachment point for new self-insurers at $35,000 per covered life beginning this year and at $40,000 in 2016. The law currently applies to companies with up to 50 eligible employees, but in 2016 it will cover employers with up to 100 workers. The law grandfathers in the lower attachment points set by companies that were self-insuring before the law took effect in January. Those companies, however, cannot reduce their attachment points further.

Unlike large companies, which typically self-fund at least $100,000 per covered life, smaller employers need medical stop-loss coverage to kick in at around $25,000, captive experts say. Since California is a bellwether state, smaller employers fear other states will follow its lead and perhaps set even higher minimum attachment point thresholds.

There’s definitely been steady captive growth in spite of the economy.
Nancy Gray, Aon Global Insurance Managers

“It is hard to tell the ultimate impact of this law and how other states will respond,” says Mike Madden, who heads the Artex employee benefits division. “My initial response is that these restrictions won’t affect what Artex is trying to do…Our sweet spot is 75 covered employees.”

Captive owners also await word from the Internal Revenue Service about whether it will allow medical stop-loss coverage to be classified as third-party business. With enough third-party business, a captive’s reserves qualify for favored tax treatment.

The IRS missed last year’s June 30th deadline to issue a ruling. Even without that clarification, some captive owners are declaring their medical stop-loss coverage as third-party business, says Gary Osborne, president of captive manager USA Risk Group in Greenville, S.C. “Whether the IRS is challenging them, I haven’t heard.”

Even without regulatory obstacles, some smaller companies that want to self-fund a layer of stop-loss coverage could have trouble overcoming internal hurdles. Risk management and employee benefits often exist in separate silos, making it difficult for companies to communicate about issues across departmental lines. While medical stop-loss coverage is not an employee benefit—it provides financial protection for companies, not individual employees—it certainly is intertwined with benefits, says Nancy Gray, regional managing director-Americas at Aon Global Insurance Managers.

Location, Location, Location

As a result of the proliferation of captive domiciles, some owners can hold down costs by creating facilities in their own backyards to avoid their home states’ self-procurement taxes. But captive owners first must determine whether they have as much faith in the state regulators new to the trend as they do in those in well-established jurisdictions.

In some cases, companies are forming additional captives to domicile them in states that aggressively pursue collections of self-procurement taxes against captive owners with facilities in other states. Many states even impose self-procurement taxes against insureds on the portion of the premium they pay non-admitted companies to cover risks within the taxing state. Thus, by domiciling their captives in those states, captive owners can avoid those taxes. Especially for many first-time captive owners, their home states’ policy on collecting self-procurement taxes is a prime factor in their decisions about where to domicile their facilities.

The proliferation of U.S. captive domiciles raises other issues that brokers and their captive practices have to help owners sort through. While captive insurance law from one domicile to the next is relatively consistent, regulatory expertise isn’t.

“Some domiciles don’t have qualified regulators,” says Richard Marshall, a former Arizona captive regulator who is president of R&Q Quest Management Services USA. “They’ve just moved people around in their insurance departments; they’re not bringing someone in from outside with captive experience.”

So while newer domiciles might draw some captives because of the self-procurement tax issue, those domiciles may not have the regulatory expertise owners need.

“A lot of captive owners are quite comfortable where they are; their taxes are not that much,” says Osborne of USA Risk Group.

“For us now, a lot more time is spent with clients on where the right domicile is for their captives,” says Huish.

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