Given good underwriting and investment results, the reserve fund accumulates year over year, garnering significant revenue. "My overriding financial motive was for us to receive the underwriting profits and investment income, instead of just giving them away to an insurance company," says Parker. After one bad year--ironically, Atlas's first with the strategy--the company has made a profit every year.
A MIDSIZE FIT
While large corporations also may avail themselves of the strategy, rent-a-captives are really designed for midsize companies. "Basically, a medium-size company spending about $1 million or $2 million in premiums, with a good loss ratio and a desire to share in its own risks, is a prime candidate," says Allen Taft, president of W.A. Taft & Co., a Bermuda-based alternative risk management consultancy.
Nicholas Dove, president of Sinser Management Services (Bermuda) Ltd., a Bermuda-based captive manager, says a company spending between $500,000 and $1 million in premiums should consider a rent-a-captive strategy. "If it's less than a million, a regular captive won't make sense; if it's less than $500,000, you're probably best off with traditional insurance," he says.
DDA, which has $50 million in annual revenues, fits the rent-a- captive profile. Previously, it was paying more than $2 million a year in premiums to cover its workers' comp costs, largely through state assigned-risk pools, the market of last resort for high-risk companies. But DDA and its clients didn't think such high rates were merited. "Our employees deliver heavy publishing material like phone books, and are subject to trips and falls or getting bitten by the family dog," explains Shelton. "This is not high-risk work."
Accordingly, the CFO reviewed his options. Owning a captive was deemed too time-consuming and capital-intensive. Joining an association captive, in which companies share one another's risks, was also nixed. Then Shelton "stumbled onto" the rent-a-captive strategy, he says. Today, DDA leases a captive from Mutual, and Shelton estimates the company has cut its workers' comp costs in half.
While midsize companies own most of the cells within rent-a- captives, larger companies such as NiSource Inc. also lease space. "We operate these delicate and complex gas turbine compressors that have a tendency to surprise us, tossing budgeted maintenance costs to the wind," says Jeffrey Grossman, vice president and controller of the Merrillville, Indiana-based diversified energy concern. "While we insure our turbines, commercial insurance is largely unavailable for significant unexpected maintenance exposures. Our best alternative, we felt, was a rent-a-captive [Bermuda-based COR Ltd.]."
Considering NiSource's size ($6 billion in annual revenues), why didn't it just fund a traditional captive to transfer the maintenance risk? "We didn't want to put up the capital to start our own insurance company," replies Grossman. "We have a captive, but it's for risks that are more predictable."
TAX WARNINGS
As far as tax deductibility is concerned, "rent-a-captive is a safer bet than single-parent [captive]--as long as what you're buying is deemed to be insurance," says Jim Ostertag, risk management specialist at NiSource's newly acquired Columbia Energy Group. "With a rent-a- captive, we just pay a premium [to the fronting carrier], much like we would to an insurance company."
But since the fronting carrier may not bear any real risk, having ceded it back to the rent-a-captive, is the premium paid truly tax- deductible? Tax experts advise caution. "These are uncharted waters," warns Tom Jones, a partner and head of captive insurance at law firm McDermott, Will & Emery, in Chicago. "The problem is the lack of case law and IRS pronouncements on the subject. Not all rent-a-captive strategies would pass muster taxwise if challenged."
Others agree. "If you structure the rent-a-captive program correctly, you can have a real transfer of risk so you have both off- balance-sheet financing and tax deductions," says Kathryn Westover, director of Strategic Risk Solutions Ltd., a Colchester, Vermont-based captive manager and part of the Credit Suisse group of companies. "But this is a big 'if,' because if you don't do it correctly, auditors will say this isn't off-balance-sheet financing, it's just a banking plan and not deductible." (Westover and other captive managers routinely counsel companies to obtain a tax opinion before pursuing a rent-a- captive strategy.)
The worst thing to do "is to create these vehicles simply for tax purposes," sums up Jones. "A rent-a-captive, like any captive, may have tax advantages, but that better not be the main reason why you take that route--or you'll end up regretting it."
Russ Banham is a contributing editor of CFO.
Captivating Vermont
Spreading from offshore domiciles, rent-a-captive structures have worked their way into the regulatory framework of several U.S. states, including Vermont, Hawaii, and South Carolina.
Vermont was the first, passing legislation in 1999 that permits the establishment of "sponsored captives"--rent-a-captives that are sponsored by an insurance company, reinsurance company, or captive insurance company. (In offshore domiciles, rent-a-captives can be owned by any type of organization.) "The state wanted to be sure that whoever was running these complex facilities was very knowledgeable about insurance," says Michael Smith, chief operating officer of Yankee Captive Management Inc., a Burlington, Vermont-based captive management company.
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