Captive insurance companies are often owned by a large sophisticated financial entity, because there are minimum net worth and other regulatory requirements. In many cases, the regulatory authority will accept a letter of credit in lieu of an actual cash investment for the initial capital requirements of the captive. This results in “GAAP exception” financial reporting but is perfectly acceptable to the regulator.
Normally, single sponsor captives are wholly-owned subsidiaries and are included in consolidated financial statements based on the stock ownership of the entity. A group or protected cell entity is usually structured in such a way that it is essentially “off-balance sheet” for the sponsors. Specifically in the case of a protected cell captive, GAAP [Accounting Standards Codification 810, formerly FAS 167/FIN 46] would require an evaluation of what parties, if any, bear the overall risk and rewards of ownership and whether any one organization is the primary beneficiary of the captive as a “variable interest entity.” This would seem unlikely, especially if administrative fees were simply billed and collected by that one organization outside of the captive, thereby simplifying the accounting ramifications.
In any case, GAAP generally requires that the risk of loss must have been substantially transferred to the captive for “normal” insurance company accounting to be applicable. If this is not the case, then the premiums and losses are accounted for under deposit accounting and the captive’s operations would be included in the financial statements of the sponsor. There is also a tax issue regarding risk transfer.
In setting up a captive, a determination must be made whether to domicile the entity “onshore” in the USA or offshore, such as the Cayman Islands or Bermuda. This is usually the result of a comprehensive business feasibility plan and assessment. Onshore domiciled entities are subject to “clawback” or oversight by one or more state insurance departments. However, in the era of Sarbanes-Oxley’s emphasis on internal controls and transparence, some executives actually perceive this somewhat higher level of oversight as an advantage.
Captive insurance companies (especially onshore) are subject to comprehensive regulatory audits, normally on a three to five year cycle basis. Offshore regulation typically is limited to a desk review of statutory basis financial statement certified by a local CPA or chartered accountant. Administratively, the statutory auditor may be able to rely to some extent on workpapers provided by the auditor of the sponsoring organization that may provide management and TPA/third party administrator services or similar claims adjudication services.
There may be some limits on the type of risks insured, depending on where the entity is domiciled. ERISA type employee benefits may be limited to an onshore captive.
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