Bermuda: A Spoonful of Sugar: Captive Review 2003

Article by Jai Cedenio & Bala Nadarajah

America’s health system is under threat as both medical institutions and practitioners face the real prospect of going out of business as a result of not being able to find or afford coverage in a hard commercial insurance market, especially for medical malpractice coverage.

In January of this year, the critical nature of the situation was highlighted in the State of the Union address by George W. Bush, as the President gave recognition of the unprecedented circumstances in which doctors are striking or ceasing practice because they cannot afford medical malpractice insurance.

In some cases annual premiums have more than doubled and medical professionals such as neurosurgeons are paying more than $100,000. As more insurers pull out of the market-place due to out-of-control costs the limit of cover decreases (the average limit of cover on a medical institution now is $5 million), premiums increase and the pressure on the health systems increases.

A possible solution to the problem facing many health-care providers is the use of a captive insurance company - an insurance company whose business is to exclusively or primarily insure the risks of its parent company, affiliated companies or shareholders. There are captives that are owned by hospitals or a group of hospitals or by their respective holding companies or foundations. Captives have also been established by physician groups or medical facilities such as blood centres and laboratories. The idea of using a captive insurance company to cover medical malpractice liability is not new. From as early as 1975, Bermuda - as the birth-place of the captive concept - has been the domicile for more than 100 successful captives covering risks arising from the operations of health-care institutions. The use of captives in the health-care industry for risk transfer started in the 1970’s in response to the litigious flood-gates of medical malpractice that had been unlocked - the industry was facing a similar situation to that of present US health-care. During the soft market cycle, many entitities were tempted to abandon the captive insurers they formed and returned to the "run-of the mill" coverage of the commercial insurance market and as a result are now in the hapless position, amongst others, of purchasing insurance in a hard market in addition to not being able to benefit from the increase in premium and, perhaps, accumulated surplus. Those providers who do not have a favourable loss history or efficient risk-management policies and procedures in place will not fully realise the potential value of a captive, but some of the benefits in operating a captive that can be realised by a health-care provider with a strong risk-management culture are:

Reduction in overall costs - there are numerous cost benefits in operating a captive. For example, every premium dollar of direct insurance purchased from a commercial insurer, 40 cents goes to pay the insurer’s overheads and not the risk, whereas a captive’s overhead is usually between 10-20 cents of every premium dollar. A captive can save costs in reducing or eliminating commissions to intermediaries; can choose administrative and other services necessary to deal with the particular risk of the captive instead of being compelled to pay for a bundled group of services already contracted for by commercial carriers and revenues, ‘siphoned’ to the commercial market through profit, would also be retained by the captive and the parent company group.

Access to the Reinsurance Market - as an insurance company in its own right, the captive is in a position to access the benefits of the ‘wholesale’ market of reinsurance. A well-run, adequately capitalized captive covering well-managed programs and established in a reputable domicile with a strong reinsurance market, such as Bermuda, should have no difficulty in obtaining reinsurance protection for the risks it underwrites. In effect the health-care provider can obtain a two-tiered insurance protection program – the captive and the reinsurance it purchases- substantially saving the costs of the retail commercial insurance market. In the hardened global reinsurance market, Bermuda is geared towards serving the reinsurance needs of a captive. Of the fresh wave of capital to flow into the global reinsurance market, Bermuda saw more than 50% of the estimated $33 billion - $16 billion break on its shores.

Coverage and Administrative Flexibility- an obvious but often over-looked advantage of the captive is the ability of the captive to cater to the needs of its parent company and provide continuous coverage. A captive should be able to provide the breadth of coverage that is unavailable or available only at an excessive price from commercial insurers and provide greater flexibility in the choice and funding of various retention levels and programs. In a system with multi-corporate structures, where individual subsidiaries cannot afford premiums to commercial carriers nor take the risk of operating uninsured, a captive can provide the necessary protection for the entire corporate family structure.

A self-insurance trust is often considered as a first option by health-care providers, when examining how best to cover any liability arising from its operations.

Common assumptions usually made when contemplating the trust option as opposed to the captive: a captive requires more funding than a self-insurance trust; a captive’s operating expenses are far greater than those for a trust; a trust can provide similar coverage as a captive. Self-insuring trusts are often subject to the covenants of the bonds they hold. The coverage provided by a trust may be restricted for example, for tax reasons, but a captive domiciled off-shore could quite lawfully avoid tax constraints, particularly more so if the parent is a U.S. not-for-profit organization, and allows the health-care provider to offer complete coverage for itself and its subsidiaries and affiliates. In addition reinsurers will not generally reinsure self-insuring trusts resulting in the provider incurring the expense (roughly between 10 – 20% of premium) to access the reinsurance market. In an award winning analysis, captioned " From Trust to Captive ", published in Captive Insurance Company Reports, Dale E.Creech Jr., Senior VP and General Counsel of Miami Valley Hospital, Dayton, Ohio - one of the hundred largest hospitals in the United States - considered the trust vs. captive option. The analysis concluded that funding costs, including expenses resulting from doing business in Bermuda, for a captive are significantly lower taking into account the fees that would have been incurred through using a fronting company. Furthermore, the use of the offshore captive did not adversely affect the tax-exempt status of the hospital and its parent organization and was approved by the US tax authorities under an IRS letter-ruling issued to the parent.

Health-care providers generating annual insurance premiums for medical malpractice coverage of $750,000 or more are suitable candidates for considering forming their own stand-alone captives. For smaller hospitals, however, the use of a rent-a-captive arrangement, instead of forming their own captives, may be a good way to test the waters. A rent-a-captive can be defined as a third-party owned insurance or reinsurance company that is made available to provide captive-type advantages through the use of an insurance or reinsurance agreement. Rent-a-captives are an attractive alternative risk financing tool for smaller health-care providers where it is not possible or, to the provider’s advantage to commit the full capital and other resources necessary to establish a captive. The health-care provider will ‘hire’ a cell within the rent-a-captive – the cell will be compartmentalised, resembling a company within a company – never co-mingling funds of other cells in the company and legally preventing the pooling of assets or liabilities in the event of a liquidation. Statutory protection is available under Bermuda law to facilitate the compartmentalization of programs of different health-care providers and ensure the segregation of their respective assets and liabilities. Although there are administrative expenses, participation in a rent-a-captive allows the health-care provider to benefit from underwriting profits and investment income.

Contrary to an unjustified misconception that Bermuda is apathetic to health-care captives, Bermuda continues to keep attracting substantial health-care captives and is home to more than 100 such captives. Bermuda’s continuing success has also sometimes resulted in ‘Bermuda bashing’ as was recently evidenced in the United States following the ‘corporate inversions’ controversy about attempts by US corporations to re-domicile in Bermuda. The setting-up of captive insurance companies and the issue of corporate inversions are two totally unrelated and separate issues. In any event, notwithstanding these misconceptions discriminating buyers of insurance will find that Bermuda’s strength lies in its pre-eminent position as the world’s leading captive domicile, with expertise and experience to understand and deal with every captive nuance. Bermuda’s long-term commitment to captives, greater experience in dealing with captives, established regulations and interpretations thereof, and a regulatory philosophy consistent with captive management has added to its success. Offshore domiciles also offer legitimate tax advantages over onshore ones particularly where the parent is a not-for-profit entity.

The additional bonus unique to Bermuda is that it also provides captives with the reinsurance and retrocessional support within the Bermuda market itself - Bermuda is a one-stop, full service insurance and reinsurance jurisdiction.

As the editor of the leading insurance journal, Business Insurance stated, ‘Captives are here to stay’. Even when the conditions of the commercial market improve, captives will continue to serve their useful purpose as a tool of effective risk management- those players in the market that did not abandon their captives find themselves in an enviable position. Every year the number of new captives increases and the fact is that many captives are legitimately incorporated and used to insure the operations of a parent company and its subsidiaries without ever upsetting US tax and regulatory authorities. It should well be noted that if it were not for the captive and its role in providing alternative means for risk-management, the market would not only be portraying the symptoms of a hard market but could well have found itself facing a critical condition.

As a satisfied customer of the services Bermuda had to offer, Dale Creech Jr remarked in his article: "Bermuda’s experience, stable government, receptivity to medical malpractice captives and overall regulatory environment convinced the hospital that a Bermuda domicile would serve its purposes well."