The Pros and Cons of using Captives for Employee Benefits
Over the past few years, there has been an emerging level of interest in the use of captives as a funding mechanism for employee benefits. Why has this topic been receiving so much attention lately?
The cost of providing employee benefits continues to rise at a faster pace than inflation; brokers, risk managers and benefits managers are becoming more familiar with alternative risk methodologies; and the US Department of Labor (DoL) has issued 'fast-track' approval guidelines.
But while there has been an increasing interest, there has been very little movement in the use of captives to fund employee benefits. Why? Much of what has been written or discussed on this topic has been broad and theoretical, rather than specific and practical. I have yet to see anyone address or define when and at what level the use of a captive for employee benefits might be realistically appropriate. In all practicality, at this stage it is only feasible for the economy's largest employers.
To date, there has been, quite literally, only a handful of employers (five or six) that have gained DoL approval to use a captive for their employee benefit plans. Each of these employers is very large and provides benefits to several thousand employees.
Not an option
For most employers, the use of a captive simply would not provide enough economic benefit or regulatory relief to be considered a viable funding option. In fact, the opposite is more likely.
In this article, I will endeavour to explain why a captive is probably not the most suitable funding tool for the majority of employers and present some of the economic and regulatory reasons why other options (namely self-insurance) are more practical for the majority of employers.
As I outlined in Part I of this series (Captive & ART Review 36). most employee benefit plans are regulated by the US DoL via the Employee Retirement Income Security Act of 1974 (ERISA). ERISA sets forth regulations and guidelines regarding the involvement of parties-in-interest (employers, fiduciaries, certain service providers), and prohibited transactions between a party in interest and benefit plan.
One of the primary uses of a captive is to serve as a reinsurer to an insurer. Since, within the context of an employee benefit plan, the captive would be owned by the employer (a single-parent captive) and used to provide facultative reinsurance to the insurer specifically for the employer's benefit plan, a party-in-interest relationship exists.
This essentially creates a conflict of interest, which would be deemed a prohibited transaction under ERISA. The DoL issued a set of guidelines to be followed by employers seeking exemption from the prohibited transaction provisions, clearing the way for approval to use a captive for an employee benefit plan.
But since most employers are too small to make use of a captive feasible, that topic does not need to be addressed in this article. The first step in considering a benefit captive is to determine if it even makes sense for the employer in question to consider.
I am not going to say benefit captives don't have their use, because in certain circumstances they do. The employer just has to be large enough to make it worthwhile from an economic and regulatory standpoint. The following are a few (semi-random) considerations:
• Loss of ERISA pre-emption capabilitySince self-insured benefit plans are deemed by ERISA not to be engaged in the business of insurance, they are not regulated as insurance and are not susceptible to state insurance regulations or benefit mandates. The plan therefore maintains complete flexibility to design and provide just about any type of benefit definitions, terms and limits to plan participants.
With regards to a captive scheme, the DoL requires that the plan be fronted by an insurance company. Further, for fast-track approval, the carrier must be nothing less than an 'A'-rated carrier. Because the captive plan is fronted, it essentially becomes an insured plan and loses all pre-emption ability relative to state-level insurance regulations and benefit mandates.
• Increased plan costs due to additional fees and services Since the DoL requires that a captive plan be fronted by nothing less than an 'A'-rated admitted insurer, it will more than likely incur a substantial fronting fee from the issuing carrier. Fronting fees for highly rated accident and health (A&H) paper will generally run in the neighbourhood of between 4% and 8% of the subject premium, depending on the size of the risk and the scope of services to be provided.
In many cases, insurers will also require some form of collateralisation from the employer to cover the carrier's potential credit risk and offset the corresponding surplus reduction inherent in using a captive as a non-admitted and unauthorised reinsurer. I would suspect collateralisation requirements for an A&H front might, however, be waived or at least reduced for some large employers. In any event, some collateralisation from a benefit captive would most likely be required and would probably be structured through a 'funds withheld' arrangement. This would greatly reduce, or possibly eliminate, the cash flow advantages that would otherwise be enjoyed by a self-insured plan.
The DoL also requires a captive plan to show an immediate and material enhancement to plan participants.
The DoL has, to this point, been somewhat ambiguous in defining the amount of 'enhancement' level required; however, it is generally regarded as a 'significant increase' to benefit terms/ levels or, in the case of a contributory plan, lower premiums to plan participants.
Further, the formula used to calculate premiums and subsequent premiums charged must be comparable to those of other insurers providing the same coverage. While a self-insured plan would (should) still use actuarially sound rating formulary, it is not an 'official' requirement. The self-funded plan maintains the flexibility to use whatever rating methodology is desired to fund the plan.
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Costly requirements
In any event, the requirement to enhance benefits or reduce employee contribution levels could translate to an increased financial burden to the employer.
Since a captive will need to be established (required to be in an on-shore US domicile) it will need to be capitalised according to domicile requirements and an approved (licensed) captive manager willneed to be hired to provide management services.
These capitalisation requirements and ongoing management fees (such as audit, actuarial and, potentially, premium taxes) can be substantial. A benefit plan would have to be quite large to absorb these capital outlays just to fund and maintain the captive and still return enough in underwriting and investment return and or tax considerations to make the implementation of a captive an economically plausible consideration.
• Benefit considerationsSo far, none of the employers that has explored using a captive scheme for their benefits has done so for medical coverage. The largest non-pension benefit cost to an employer is health insurance. Since there are fewer regulatory hurdles and there is more flexibility in plan design and funding, and since low-attaching medical stop-loss coverage is widely available, self-insuring of medical healthcare benefits is an easy and viable option for even relatively small (100 employees) employers.
Self-insurance remains by far the most economically efficient way for most employers to fund employee healthcare benefits. The regulations imposed to gain and maintain DoL approval to fund medical benefits through a captive would actually decrease flexibility and increase plan costs.
Exception to the rule
To date, the only existing benefit captives that I am aware of have been used primarily to fund life and long-term disability (LTD) benefits. Since premium rates for those coverages are relatively low, employers with less than several thousand employees rarely even partially self-insure life and LTD benefits, let alone consider captive participation. In these instances, captives would only provide a meaningful economic return for the largest of employers.
Even in instances where an employee population is large enough to offer a reasonable underwriting profit and investment return, there would have to be more than 5,000 participants to achieve a significant economic advantage. Since even large employers only partially self-insure life and LTD, and typically in conjunction with an insurer, it is one of the few instances where a benefit captive may be most applicable.
• Tax and liability considerationsMuch like a captive, a self-insured employer has the ability to gain advantageous tax treatment for a benefit plan by incorporating a qualified Voluntary Employee Benefit Association Trust (VEBA) as a funding vehicle.
A qualified VEBA trust can essentially allow an employer to deduct the 'funding premium', up to certain levels, for loss funds and to accrue investment income on a tax-efficient basis.
All funds held in the VEBA must remain 'in the plan', and are normally used either to offset future plan costs (for example 'premium holiday'), provide cost reductions to plan participants or to provide enhanced benefits. A similar requirement would apply to an employee benefit captive as the DoL would require that most proceeds be used to lower plan costs or enhance benefits.
A VEBA requires filing a trust document with the IRS and subsequent annual reports, just like the requirements for a captive. Thus, a self-insured benefit plan can procure tax advantages similar to those of a captive, but in a more simplified and cost-effective manner.
A captive is set up and incorporated as a separate corporation owned by the employer as a parent. A self-insured plan also becomes a separate legal entity under ERISA. As a separate entity, and as an ERISA qualified self-insured plan, employees contesting benefit decisions (such as claim denials, arbitrary and capricious administration) via litigation must bring suit against the plan, not the employer.
An advantage of an ERISA-qualified plan is that most litigation against the plan will be heard in federal court rather than state court. Federal courts are usually considered more favourable venues foremployers, and few employees or their attorneys are well-equipped to finance and fight a battle at the federal level. The intent is not to intentionally discourage employees from seeking justice; it is simply a proximate cause result of ERISA's jurisdictional reach.
Because a captive plan is required to use a fronting carrier, it loses self-insured status and the preemption abilities relative to state insurance regulation. Since captives, for all intents and purposes, are treated in the realm of 'insured' plans, any litigation against the plan may be extended while the parties dispute the proper venue; federal versus state court.
One additional advantage that may justify the use of a captive for employee benefits is the 'unrelated business effect' relative to an existing captive. The IRS would treat employee benefits as third-party or unrelated business when ceded to a captive that is used for other lines of coverage such as workers compensation.
Current guidelines indicate that, as long as a captive contains 30% or more of unrelated business to the captive owner, a deduction of all premiums paid to the captive may be justified. If the savings generated through the deduction of all premiums paid to the captive exceed the additional costs, an economic benefit can be created.
The value of the economic benefit will be relative to the amount of premiums paid to the captive and may only be of enough significance to large employers.
Devil's advocate
So there you have it-the condensed, devil's advocate view of one of the industry's most complicated risk management topics.
Personally,' I feel it isn't so much that the subject is complicated, it's just 'unfamiliar' territory caused by the convergence of a property and casualty-oriented alternative risk methodology with a vastly different A&H benefit culture. Because few people in our industry have the necessary understanding to bridge this gap, benefits captives are really only practical for the largest of employers at this time.
Phillip C Giles, CEBS, is vice-president of Innovative Risk Services (INRS) and Arthur J Gallagher Risk Management Services.
