Using captives for employee benefits delivers major advantages to companies and workers, says John Miskel of Zurich Global Life, North America
For decades, captives have helped companies across North America and around the world achieve their enterprise risk management strategies. Today, the value of captives is indisputable, with more than 6,800 now operating in scores of domiciles across the globe. But while the number of captives meeting property and casualty (P&C) exposures is growing, the number used in the delivery of employee benefits remains quite small.
Reasons range from the still relative newness of the concept to perceptions about the complexity, regulatory hurdles and frictional costs of transitioning employee benefits into captives. But interest is growing as captive managers seek ways to diversify and broaden their risk portfolios, reduce volatility, and strengthen their value to parent organisations.
Back in 2000, the first company to introduce employee benefits into its captive was Columbia Energy. Since then, we’ve seen some pretty big names using their captives for benefits, but only about 30 or so to date. While captives are universally accepted for P&C risks, we’re still not quite there with broad-based acceptance on the employee benefits side. It remains a promising and exciting opportunity for many captive managers.
From a financial and loss experience perspective, it makes sense to get the employee benefit risk into the captive so you can benefit from some additional risk smoothing. Employee benefit risks tend to be very predictable, with exposures that do not correlate with those of a company’s traditional P&C exposures. That means you most likely will not see the kinds of ‘shock losses’ in employee benefits that can be experienced when a large property loss hits a captive.
Hence, the addition of the employee benefit risk diversifies the captive’s risk and helps to drive greater stability across the entire portfolio.
With captives, as with any kind of insurance vehicle, you want to add premium but also take positive steps to level out your total exposure to increase predictability. Adding employee benefits is a good and relatively safe way to do that.
Regulatory approval required
One factor that may have delayed the utilisation of captives for employee benefits among some companies is the perceived hurdle of securing required US Department of Labor (DOL) approval for programmes that fall within Employee Retirement Income Security Act (ERISA) guidelines.
ERISA is primarily concerned with group life and disability. With good reason, the DOL wants complete assurance that any captive assuming employee benefit risk is solid, well organised and well capitalised, possessing the skill set and administrative depth to make sure everything is done right. As an employee, the last thing you want is to have your employer insuring your benefits through a captive and then see the captive become insolvent or run into some other kind of trouble down the road.
DOL approval is mandatory when a carrier is insuring or reinsuring employee benefits risk if the plan sponsor owns 50 percent or more of the insurer. Since this is clearly the case with single parent captives, any company seeking to fund employee benefits through its captive must first receive a “prohibited transaction exemption”. In 1979, the DOL expanded its statutory exemption process to allow insurance companies, including captives, to fund their own benefits as long as such employee benefit risk would not exceed 50 percent of the captive’s business, including all internal and external (third party) P&C risk.
Sweetening employee offerings
Among its various requirements and considerations, the DOL requires the fronting carrier to be A-rated at minimum. In addition, the captive must be either a domestic, US-domiciled entity or, if an offshore captive, it must have a permanent US branch.
One of the most significant, non-negotiable DOL requirements in approving a captive-based employee benefits programme is the inclusion of improvements and enhancements in features provided to employees above and beyond what would typically be included in a plan from an external provider. These can include enhancements in programme design or lower premiums paid by employee members.
In effect, what the DOL is saying is that if you want to move your benefits into your captive to enjoy greater control, cost savings and administrative efficiencies, there has to be something in the transaction for your employees, too.
One example of a benefit enhancement under a group life plan is an accelerated death benefit in the event of a medically certified case of terminal illness. Under this enhancement, someone deemed to be terminally ill by a physician, with the doctor’s prognosis regarding time remaining, would be able to access his or her life insurance proceeds prior to death in order to help pay for expenses.
Historically, that’s been 50 to 60 percent of the death benefit, although we’ve seen that percentage rising over the past few years. We’ve seen cases in which plans might allow for 75 to 80 or 90 percent in order to qualify as an enhanced benefit worthy of DOL approval. What you want to avoid is increasing any benefit in such a way that it might have an overall cost impact.
For instance, in the case of life insurance, if you double the automatic benefit from one times salary to two times salary, you’ve pretty much doubled the cost of the life insurance you are providing because your volumes have just doubled.
The good news about securing DOL approval is that the process can proceed remarkably smoothly, with six-month review and approval processes not uncommon for organisations that have done the required homework up front. The DOL also has an expedited, fast-track process in place (EXPRO) for companies that have earned two prior exemptions, making the securing of any future exemptions even faster.
Employee benefit coverages most often included in captives are basic and supplemental life for active employees or retirees, as well as long-term disability.
Medical stop-loss protecting the company against large losses can be a common feature too, with the added benefit that it is not subject to DOL or ERISA oversight and exemptions. Workers’ compensation is another typical coverage that can be administered through a captive.
Less common programmes are accidental death and dismemberment and business travel accident, which are low-premium, high-exposure coverages that can result in unexpected, large losses that may affect the expected predictability delivered to the captive with the inclusion of employee benefits.
Collaboration is the key to success
While gaining regulatory approval may not be as burdensome or formidable as some risk managers may believe, occasional pushback from employee benefits and human resources (HR) units can be a speed bump, although not an insurmountable one with good, interdisciplinary collaboration.
We have heard from a number of risk managers about getting some degree of pushback from the HR and employee benefits sides of the house. Within many organisations, there is still a chasm between risk management and HR on this issue. As an experienced captive fronter, Zurich discusses P&C captive services with risk managers all the time. However, in those cases there is little or no interaction with HR or employee benefits.
When it comes to employee benefits in the captive, it’s another story, and it can be a challenge for the risk manager to navigate through the HR channels to get to the right employee benefits decision makers. However, if the risk manager can engage the C-suite and get the CFO’s support, it’s more likely to get serious consideration.
The intent is not to circumvent the oversight of the HR and employee benefits teams, but rather to initiate constructive communication among key players. As with any change initiative, collaboration and transparency is the surest way to lay the groundwork for a successful transition of employee benefits into a captive.
We emphasise to risk managers and employee benefits leaders that communication and collaboration are very important in engineering a smooth transition to a captive solution.
It’s important to engage with both sides of the shop to embed a clear understanding of the administrative and financial advantages to the organisation as well as the enhancements that will ultimately benefit their employees.
Better data, greater customisation
Beyond the purely financial perspective, one of the most compelling benefits of placing employee benefits into a captive is a greatly enhanced degree of control over risk data and analysis, something that most HR leaders crave. In addition, the organisation will gain much greater latitude and flexibility in dictating programme design.
When your employee benefit risks are housed in your captive, you have much more flexibility to design the individualised plan you want. Since the captive is bearing most of the risk, the insurance company will be less hesitant about helping you implement the features you want. The insurer is usually ceding at least 80 percent of the risk back to the captive, and is pricing it at a pure mortality or morbidity rate.
With the exception of charging fronting fees to cover administrative expenses and use of the paper, all the other traditional market costs are largely eliminated, and in a sense you can dictate to the fronting insurance company what you want. For instance, they aren’t going to argue if you want additional amounts of guaranteed issue in your plan, as long as the requests are reasonable and the captive is willing to take that risk. It’s a balancing act, however. You don’t want to push too far because at some point the price is going to go up.
The administrative benefits of placing employee benefits into your captive are significant. You can manage your risk charges and frictional costs better, and you can negotiate for more flexible benefit designs.
In addition, plans can be harmonised more readily and greater coordination of data through the captive more achievable. These are some of the additional benefits that have to be communicated to the HR teams to get buy in.
In addition to having better control over your employee benefit design and features, you can keep your employees happier, harmonise employee benefits, workers’ compensation, long-term disability and return-to-work programmes, and create a risk management architecture that is much more adaptable to changing conditions.
But it takes a long-term vision and a collaborative spirit on everyone’s part to create the architecture for a truly world-class, highly flexible and successful captive-based employee benefits programme. When that commitment to collaboration is present, success is virtually assured.
My advice to companies considering using their captive insurers to manage employee benefits is simply to think about it and definitely look into it. It’s a good option for harmonising and gaining better control over the total picture of your risks, and it can definitely be worth the effort.
