Can a Captive Insurance Company Insure Employee Benefits?

Early captive insurance companies were used almost exclusively to insure their owners' property and casualty risks. Today's captive insurance company can provide virtually any type of coverage, provided the coverage is permitted by the regulations of its selected domicile. Captives are routinely used to insure risks, such as contractors professional liability, environmental liability, terrorism, directors and officers liability, employment practices liability, cyber security, and warranty programs.

Organizations may also use captive insurance arrangements to fund or reinsure employee benefits such as medical, life insurance, accidental death and dismemberment, long-term disability (LTD), and retiree benefits. The regulatory requirements depend on the type of benefit, whether the benefit plan is subject to the Employee Retirement Income Security Act (ERISA), and whether the captive writes the coverage directly or reinsures an unrelated insurer.

Advantages of Funding Benefits Through Captives

Five reasons are frequently cited for funding employee benefits through a captive.

• Claims and loss control. A captive arrangement can provide an employer with greater access to claims data and more control over claims management. Depending on the benefits covered, the employer may use this information to support medical cost management, utilization review, pharmacy management, disability management, and return-to-work programs.
• Cash flow. When a benefit line is actuarially predictable or has a relatively slow claims payout, such as life insurance or LTD, the captive may earn investment income on reserves. An effective investment policy and disciplined claims management may help reduce the long-term cost of providing benefits compared with traditional insurance.
• Potential tax efficiency. Premiums paid to a captive may be deductible when the arrangement qualifies as insurance for federal income tax purposes and satisfies the applicable requirements for deductibility. The timing and availability of deductions, as well as the captive's tax treatment, depend on the structure and facts of the arrangement. Employers should obtain specialized tax advice before relying on potential tax benefits.
• Risk distribution. Covering benefits associated with a sufficiently large population of employees may contribute to the captive's risk distribution. However, the presence of numerous covered employees does not automatically establish that an arrangement qualifies as insurance for federal tax purposes. Risk shifting, risk distribution, policy terms, capitalization, claims practices, and other facts must also be considered.
• Reduction in insurance expense. Commercial insurance premiums include expenses associated with administration, risk, capital, and profit. A captive may allow an employer to retain a portion of these costs. However, potential savings must be weighed against fronting fees, captive operating expenses, premium taxes, regulatory costs, and the possibility of adverse claims experience.

Employee Benefit Structures

The regulatory treatment of an employee benefit captive arrangement depends heavily on the benefit involved.

ERISA-covered benefits may include employer-sponsored life insurance, accidental death and dismemberment coverage, and disability benefits. When an employer-owned captive directly insures or reinsures these benefits, the arrangement may constitute a prohibited transaction under ERISA unless an applicable exemption is available.

Employer medical stop-loss coverage is generally structured to insure the employer against claims exceeding specified thresholds rather than to insure plan participants directly. Because the employer is the insured, medical stop-loss arrangements generally do not require the same Department of Labor (DOL) prohibited transaction exemption as an arrangement involving ERISA plan assets. The structure should nevertheless be reviewed carefully because the treatment depends on the facts and applicable state law.

Governmental plans, church plans, and certain other benefit arrangements may not be subject to ERISA. They remain subject to other applicable insurance, tax, fiduciary, and regulatory requirements.

Disadvantages of Funding Benefits Through Captives

The disadvantages of funding employee benefits through a captive are similar to those associated with using captive insurance for property and casualty exposures.

When an ERISA-covered benefit is insured through an unrelated insurer and reinsured by the employer's captive, the program generally requires a fronting insurer. Establishing and maintaining an agreement with a financially sound fronting company can be difficult and expensive. The fronting insurer may impose collateral, reporting, claims administration, and other requirements.

A captive also requires the involvement of several outside entities, leaving the employer dependent on third-party service providers. These may include a captive manager, investment manager, claims administrator, accountant, actuary, attorney, independent fiduciary, fronting insurer, and reinsurer. If the employer already operates a captive for other risks, some of these providers and administrative processes may already be in place.

As with other forms of self-funding, actual losses may exceed projections. Some employee benefits create long-tail liabilities. LTD benefits, for example, may involve payments extending for decades. If a captive program covering these benefits is terminated, the captive must continue managing the liabilities or arrange for their transfer.

Inadequate reserves or unfavorable claims experience can lead to higher premiums and additional capital requirements. Employers must also account for the time and personnel needed to oversee the captive and coordinate the benefit arrangement.

DOL Prohibited Transaction Exemptions

Using an employer-owned captive in a transaction involving an ERISA-covered plan may constitute a prohibited transaction under ERISA. An employer considering such an arrangement must determine whether an existing statutory or class exemption applies or whether it must seek an individual prohibited transaction exemption from the DOL.

Prohibited Transaction Exemption (PTE) 79–41 provides relief for certain insurance transactions involving an insurer affiliated with an employer sponsoring an employee benefit plan. The exemption contains specific requirements, including limitations based on the insurer's business with the employer and affiliated parties. Because many captives cannot satisfy those requirements, employers frequently consider an individual exemption.

The DOL's 1999 Columbia Energy exemption represented an important development in the use of captives to reinsure employee benefits. The exemption demonstrated that the DOL could permit an arrangement even when the captive did not have the volume of unrelated business needed to rely on PTE 79–41.

The DOL has subsequently granted individual exemptions for other captive employee benefit arrangements. Although the precise conditions vary, captive exemptions have commonly included requirements such as the following.

• An independent fiduciary must review the arrangement, determine that it is in the interests of the plan and its participants, monitor compliance, and take appropriate action to protect participants.
• A financially sound, unrelated insurer must issue the benefit policies and remain responsible for paying claims.
• The captive must be appropriately licensed, regulated, and financially capable of meeting its reinsurance obligations.
• The arrangement must provide an objective benefit to plan participants, such as improved benefits or reduced participant-paid premiums.
• The arrangement must satisfy applicable reporting, recordkeeping, claims, and fiduciary requirements.

The DOL evaluates exemption applications based on their individual facts. Conditions imposed in earlier captive exemptions should not be assumed to apply automatically to a new arrangement, and prior exemptions may not reflect the DOL's current policies or procedures.

The EXPRO Process

PTE 96–62 established the DOL's expedited exemption procedure, commonly called EXPRO. It permits expedited review of certain transactions that are substantially similar to qualifying exemptions previously approved by the DOL.

An employee benefit captive arrangement does not qualify for EXPRO simply because the DOL has previously approved other captive transactions. The applicant must demonstrate that the proposed transaction and its safeguards satisfy the requirements of PTE 96–62, including its standards concerning substantially similar prior exemptions and the periods during which those exemptions may be relied upon.

Employers should confirm current eligibility requirements and expected review periods with qualified ERISA counsel and the DOL before filing an EXPRO request or an individual exemption application.

Evaluating an Employee Benefit Captive

A captive can provide an organization with greater control over employee benefit financing, access to claims information, investment income opportunities, and protection from some insurance market fluctuations. These advantages must be weighed against the costs of capitalization, fronting, collateral, administration, professional services, regulation, and potential adverse claims experience.

Before proceeding, an employer should conduct a feasibility study addressing the covered benefits, expected losses, capital requirements, domicile rules, insurance licensing, ERISA obligations, tax treatment, fronting arrangements, collateral, and long-term liabilities.

Employee benefit captive arrangements are subject to complex ERISA, tax, insurance, fiduciary, and domicile requirements. Employers should obtain legal, tax, actuarial, and regulatory advice based on the specific benefits and captive structure under consideration.

This article is based on information in "Utilizing Captive Insurance for Employee Benefit Programs," Risk Financing Perspectives, Volume 26, No. 4, and Captives and the Management of Risk.