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Below is a general overview of Captives with particular information regarding Labuan International and Business Financial Centre (Labuan IBFC).
Kensington Trust Labuan Limited is a licensed trust company in Labuan and please feel free to contact us if you have any questions on establishment and operation of a Captive Insurance Company in Labuan.
A Captive is simply an insurance company that is owned and controlled by its insured. It must be kept in mind that creating a captive means forming a new insurance company, which is very different than simply incorporating a company. Captives are normally being domiciled in an offshore jurisdiction because the regulatory environment onshore may not be conducive to the creation and operation of a captive insurance company.
In its simplest form, a captive can be defined as a wholly-owned insurance subsidiary of an organisation not in the insurance business whose primary function is to insure some or all of the risks of its parent, associates or affiliates. Since captives were first formed, the industry has looked at new ways of developing the captive model to provide appropriate vehicles for a wide range of different owners and users. Today, there are a variety of captives but generally they can be grouped into one of the following five categories:-
Single Parent (Pure) Captive
A single parent captive is owned and controlled by one owner, typically the parent organization, and is formed as a subsidiary company. The captive subsidiary underwrites policies for the parent, and solely bears the risks of the parent.
A group captive is owned and controlled by multiple insured. They may or may not be related entities or a part of a homogeneous group like industry or trade groups. Typically, companies of similar size pool their risks in an industry captive with customized insurance plans. Similarly, companies of similar size in different industries can also form group captives to enjoy the benefits of a captive model. More recently, associations have been forming association captive insurance companies to offer captive services as part of their membership benefits.
In a rent-a-captive setting, a captive sponsor owns the company and manages its operations. The captive company "rents" its services to other parties in exchange for a management fee, and insured generally do not share each other’s risk. The main purpose of a rent-a-captive is to provide captive facilities to parties that cannot afford the fixed cost of a captive company or are not interested in the ownership and maintenance responsibilities.
Protected Cell Companies (“PCC”)
PCCs are essentially rent-a-captive companies that ensure complete separation among program participants. According to the laws of specific domiciles, PCCs generally guarantee complete separation of each cell’s assets, capital and surplus from each other.
Agency captives are companies typically owned by groups of brokers or other insurance intermediaries and are typically structured like rent-a-captives.
Captives may be established as direct-writing companies issuing policies to, and receiving premiums from, their insured but the insurance industry is generally highly regulated and, in many jurisdictions, the laws may not permit an offshore captive insurance company to issue policies to the onshore parent without being admitted in the jurisdiction. The term “admitted” simply means licensed in the jurisdiction.
In order to comply with the local laws, the parent may purchase a policy from an admitted insurer, who acts as a fronting carrier for the non admitted captive. The fronting company then reinsures the risk with the captive. The fronting company will charge a fee for its services and may require a letter of credit to guarantee the captive’s ability to pay claims.A fronted program offers four major advantages:
- Insurance policies are issued by the fronted carrier to meet local filing and financial responsibility requirements.
- Insurance policies are issued by the fronted carrier to meet local filing and financial responsibility requirements. Fronted companies can offer a wide range of services including risk prevention, underwriting, pricing, claims handling, accounting, policy services and reinsurance.
- A fronting arrangement allows the captive to generate cashflow and investment income benefits from lines of insurance which cannot be written by the captive because of local insurance regulation.
- Stable pricing and consistent coverage availability can be achieved from a long term partnership between the captive and fronted company.
Insurance companies benefit from fronting in several ways. Fronting insurance programs generate more business to the insurance companies that would otherwise be written by another insurance entity. A fronting program which is adequately secured with reinsurance and financial guarantees should generate a higher rate of return on equity to the fronted company than the traditional insurance company.
A significant risk for a fronted company is the credit risk of the captive. Credit risk is generated from the captive’s inability to meet its financial obligations from the business and financial risk. They include adverse loss experience, catastrophic loss or inadequate spread of risk.
In both the development stage of a captive and for ongoing operations, one of the most important decisions management must attend to concerns reinsurance. In short, the reinsurance program selected can make or break a captive program. Management must consider:
- If they need reinsurance
- If needed, what type of reinsurance is most appropriate
- What level of reinsurance is required to ensure an appropriate mix of surplus protection versus the potential for retaining profit within the captive
- How to purchase reinsurance (brokered versus direct); Whom to purchase the reinsurance from
Not surprisingly, the breadth and complexity of captive reinsurance programs mirror the vast range of complexity associated with captive insurers. It's not unusual for a captive to simply purchase reinsurance to cover all of its losses for the life of the captive. In this scenario, it is likely that the captive was created primarily to gain access to the reinsurance market. On the other end of the spectrum, a captive may purchase multiple types of reinsurance from several reinsurers, in amounts that vary from one contract year to the next, with profit sharing or other specialty features that greatly increase complexity of the reinsurance program.
Functions of Reinsurance:
Whether setting up a captive or managing ongoing operation, captive owners and risk managers purchase reinsurance to serve a number of different functions. Some of the functions of reinsurance include:
- Stabilization of profitability
- Provides large limit capacity
- Catastrophe protection
- Supports high growth in premium volume
- Provides help with the underwriting process
- Facilitates withdrawal from a particular risk or line of business
Reinsurance requires a great deal of attention from a captive's management team. A program should be monitored to be sure the intended functions of the reinsurance are being met as the captive evolves. Few decisions will impact the overall success of a captive program more than those relating to reinsurance. The above information is intended to bring a bit more familiarity to those captive owners and risk managers who are considering setting up a captive or are altering the reinsurance structure of an existing company. However, the reinsurance market is complicated and the above barely scratches the surface of possibilities available. So do your reinsurance homework and make sure your program is the right one for your captive!
It is popularly thought that a captive is primarily a tax minimization device. In fact, captives are usually formed for other economic reasons with the main drivers being risk management and risk financing. Some of these reasons are summarized below:-
- Lower insurance costs. Commercial market insurance premiums must be adequate to meet the cost of claims but, in common with other commercial enterprises, insurers are in business to make money and will therefore include in the premium an element to provide for their acquisition costs, overheads and profit. This portion of the premium may represent as much as 35% or 40% of the whole. In establishing a captive, the parent seeks to retain the profit within the group rather than seeing it flowing to an outside party. A captive may also help reduce insurance costs by charging a premium that more accurately reflects the parent’s loss experience.
- Cash flow. Apart from pure underwriting profit, insurers rely heavily on investment income. Premiums are typically paid in advance while claims are paid out over a longer period. Until claims become payable the premium is available for investment. By utilising a captive, premiums and investment income are retained within the group and, where the captive domiciled offshore, that investment income may be untaxed. Additionally the captive may be able to offer a more flexible premium payment plan thereby offering a direct cash flow advantage to the parent.
- Risk retention. A company’s willingness to retain more of its own risk, particularly by increasing deductible levels may be frustrated by the inadequate discount offered by insurers to take account of the increased deductible and by the fact that the company is unable to establish reserves to pay future claims. Establishment of a captive can help address both these problems.
- Unavailability of coverage. Where the commercial market is unable or unwilling to provide coverage for certain risks or where the price quoted is seen to be unreasonable, a captive may provide the cover required. Captive insurance companies underwrite policies that are custom-made for its owner/program participants, allowing the insured to enjoy the benefit of purchasing specific coverage that they might not be able to purchase from a commercial insurer, or at all, and at competitive rates. One must bear in mind that the only insured has perfect information about its claims history; therefore it would design the optimal plan for itself.
- Risk management. A captive can act as a focus for the risk management and risk financing activities of its parent organization. An effective risk management programme will result in recognisable profits for the captive. Risk management can be viewed by a captive owner not as a cost centre but as a potentially profitable part of the company’s activities.
A captive can also be used by a multinational to set global deductible levels by enabling a local manager to insure with the captive at a level suitable to the size of his own business unit while the captive only buys reinsurance in excess of the level appropriate to the group as a whole.
Captive insurance company is one which has been set up primarily to insure the risks of its parent company. In other words, it’s like having your very own insurance company, so that when you pay the insurance premiums, you’re paying yourself rather than somebody else.
The obvious benefit of this is that if you don’t have any losses then you keep the entire premium. Captives then often buy their own wholesale insurance or reinsurance to protect them, which costs less than normal insurance.
From this simple explanation, it’s clear to see that captives work best with companies which have good control over their claims, i.e. those organisations which have good risk management processes in place. The more profitable the captive is, the more risk it can retain itself, and so further reduce its insurance costs.
- Access to the reinsurance market. Reinsurers are the international wholesalers of the insurance world. Operating on a lower cost structure than direct insurers they are able to provide coverage at advantageous rates. By using a captive to access the reinsurance market the buyer can more easily determine his own retention levels and structure his programme with greater flexibility.
- Writing unrelated risks for profit. Apart from writing its parent’s risk, a captive may operate as a separate profit centre by writing the risks of third parties. In particular, an organisation may wish to sell insurance to existing customers of its core business. For example, retailers may sell extended warranty cover to customers with the risk being carried by the retailer’s captive. The claims pattern of this type of business is usually very predictable with a large number of small exposures and can provide the retailer with a valuable additional source of revenue.
- Tax minimization and deferral. The tax considerations in forming a captive will depend on the domicile of both the parent and the captive. Integration of a captive as part of an overall tax planning strategy is a complex subject so that professional legal and tax advice is essential.
At the end of the day, a captive is really a sophisticated way to reduce the amount of insurance you pay to somebody else, and also a way to build up a fund for a rainy day.The benefits the program participant or the owner enjoys will depend on capitalization requirements, investment restrictions, fees, taxes, reporting requirements, and other operating requirements. Moreover, commitment of the governing body to solvency and capital adequacy, the domicile political and economic stability, and the general infrastructure contribute to the quality of a domicile. Independent agencies and various financial institutions continuously monitor overall quality of all domiciles and provide guidance to general investors.
The process usually begins with a feasibility study which details expected premium and loss payments based on the parent’s past experience and risk profile.
The next step will be to settle on a jurisdiction. Ideally, the feasibility study would examine the issues involved in choosing a domicile for the captive, as well as any tax implications. Captive jurisdictions offer many benefits and should be considered with the following points in mind:
- Legislation governing the captive, including any restrictions on the lines of business the captive is permitted to insure.
- Regulatory environment including accessibility to the regulator
- Level of regulatory capital and margins of solvency requirements
- Investment restrictions
- Whether local directors are required
- Supporting infrastructure (captive managers, third party administrators, accountants, legal counsel)
- Regulatory reporting and maintenance of records requirements
- Flexibility for a captive to set its rates without prior approval of the regulator
- Whether there are any premium taxes or other taxes or stamp duties
- The requirements for meetings of directors and members of the captive
- Whether there is a charge for regulatory examinations and the frequency and timeliness of regulatory reports
Once a domicile has been selected, you will need to engage a host of service providers. The key to any successful program, and in fact a key to management buy in, will be assembling the proper group of people. You will need to consider the following providers:
- Captive Manager: Most jurisdictions require a local manager. In many cases, the captive manager can provide the necessary expertise to run the captive. You will need to determine the frequency of the financial reports you need and the cost difference. Costs will vary depending on the domicile, frequency of reports, the complexity of the underwriting program and any additional services required.
- Local Law Firm / Registered Agent: Determine the relationship the firm has with local regulators and the level of anticipated fees.
- Auditor: Discuss whether you want to retain a local auditor or use one from your jurisdiction. An auditor from outside the captive domicile may need to be approved by the regulator.
- Broker. Determine whether you will use a broker to obtain fronting insurance or provide claims-handling or as a general consultant to the captive.
- Investment Manager / Custodian: Discuss investment restrictions reporting requirements.
- Actuary: Determine whether an actuary is required. Determine the frequency of reporting that will be required.
Application Form and Business Plan
Once the service providers have been identified, the application process may commence. The comments here reflect the experience in Labuan IBFC, but the general framework should be expected in most offshore jurisdictions.
It will be necessary to complete and submit application in the form required by the local regulator, Labuan Financial Services Authority (Labuan FSA). Details concerning capital, insurance management, information on the proposed directors and officers (including personal references and a director/officer questionnaire) as well as information on the ultimate beneficial owners of the insurer will need to be set out in the application. The business plan must include:
- Reason for establishment – why selected Labuan as jurisdiction
- Type of Captive
- Captive insurance structure – schematic diagram
- Capital adequacy – source of fund/asset size/provisions
- Class of business
- Geographical spread and risks
- Market Segmentation – Commercial Captive
- Length of the tail of the business
- Third party business – name, nature of business involve, proportion
- Retention policy and reinsurance arrangement
- Fronted business – List of fronting companies/retention
- Investment of funds
- Management – own office or appoint underwriting manager
- Manpower planning
Labuan FSA will examine the business plan to ensure that the company has sufficient capital and surplus on an initial basis to cover the largest claims possible under the relevant policy. In other words, it will not be sufficient to take the position that the company will build reserves over the years, based upon premium payments, so that it could meet maximum claims in the future. However, it is acceptable for the company to include in its plan that it will be purchasing reinsurance to provide sufficient comfort in this respect. The business plan must also include financial projections for 3 years. Obviously it is expected that such projections will be favourable and reflect continued compliance with regulatory requirements and capital requirements.
Class of Insurance
The applicant must specify the type of license requested i.e. either life insurance or general insurance. There is no composite license issued in Labuan IBFC. The nature of the business to be carried on must be disclosed in the application and where there is to be any changes in such business, it is necessary to obtain the prior consent of the regulator in Labuan IBFC.
Regulatory Capital and Solvency Requirements
The minimum capital required as follows:
|Pure Captive/Group Captive/Association Captive||RM300,000|
|Rent-a-Captive/ Master-Rent-A-Captive/Protected Cell||RM500,000|
The Captive is also required to maintain a minimum margin of solvency (being the amount by which the value of its assets exceeds the total amount of its liabilities). In Labuan IBFC this is equivalent to, or more than the amount of the minimum capital requirement of RM300,000. However, a rent-a-captive and master-rent-a-captive insurer are required to maintain the minimum capital requirement of RM500,000 or 20% of the net premium income for the preceding year in respect of the general insurance business, or 3% of the actuarial valuation of the liabilities for life insurance business as at the last valuation date in respect of the life insurance business, whichever is the greater. For these purposes, net premium means the gross premium income earned in respect of general business during the year, reduced by any premiums paid by the insurer for approved reinsurance during the year.
Every captive insurer is required by Labuan FSA, the regulator provide
- Quarterly statistical return (within 15 days after the end of the quarter)
- Audited accounts for each financial year in accordance with the accounting principles accepted to Labuan FSA (within 6 months of the end of each financial year)
- Any other report as may be required by Labuan FSA.
- Annual return for each year and it must give particulars of shareholder, director, company secretary, issued shared capital, registered office and charges.
An Insurance company in Labuan IBFC must have at least 2 directors (preferably a natural person) and must have insurance or insurance related experience and approve by Labuan FSA. There is no residency requirement with respect to the director. However, if the Insurance Company has an office in Labuan, a resident director must be appointed. The Captive must establish a bank account with a licensed bank in Labuan IBFC and deposit the minimum paid-up capital into such account. A Labuan company in Labuan IBFC is required to have a resident secretary (individual or corporate) and must be appointed from a Trust Company in Labuan.
Organisations considering a captive should not assume that they will see an immediate return on their investment. The decision to create and run a captive must include recognition by management of the up-front costs and administrative burden associated with operating an insurance company. The parent must fund expected losses, meet capitalisation requirements, purchase reinsurance, budget for risk retention, and contract out services. These expenses can be particularly high during the captive’s first year. If the captive has money invested and earning interest, it should eventually generate a surplus that can be returned to the parent company in the form of dividends or used to fund future losses. Companies with losses that are consistently less than the premiums they pay to their captive have the best chance of achieving success in the long run.
In a soft market, it may be somewhat difficult to justify the expense of a captive. However, the decision to form a captive requires a long-term view and commitment from management. By working through the captive model, the risk manager has time to consider all the issues which may impact the decision, including assessing risk needs in advance, the capitalisation requirements and the overall tax structure of the parent and how the captive will fit in. A sophisticated risk manager will use their captive as a tool, taking on greater risk in a hardening market and as the market softens, they put less and less risk into their captives and may even put the captive on the shelf until prices rise again.
The information in this document is not advice of any kind but general information only and should not be relied on as legal advice. Kensington Trust Group recommends seeking professional advice on legal or tax issues affecting you before relying on it. While Kensington Trust Group tries to ensure that the content of this document is accurate, adequate or complete, it does not represent or warrant, express or implied, its accuracy, correctness, completeness or use of any of the information. Kensington Trust Group does not assume legal liability for any loss suffered as a result of or in relation to the use of this document. To the extent permitted by law, Kensington Trust Group excludes any liability for negligence, for any loss, including indirect or consequential damages arising from or in relation to the use of this document.