While the primary motivations for establishing a captive insurance company may vary, the vast majority are formed in order to (re)insure the underlying risks of their holding company, parent, and/or other related entities. However, along with the benefits captives can bring – flexibility, stability, lower coverage costs, at the end of the first reporting period, auditors and accountants are often asked a key question: “how do I account for my investment in this captive?” This question applies whether a parent corporation wholly owns a captive, a number of shareholders are pooling their risk within a group captive, or an insured entity is participating in a segregated portfolio company structure. Below is a quick walk-through of the general accounting rules that apply to investors in pure captives, group captives and segregated portfolio companies.
Pure captives, or single-parent captives, are normally 100 percent owned and controlled by their parent or holding company in which the risks of related group entities are (re)insured by the captive. Under current U.S. Generally Accepted Accounting Principles (GAAP), a company is required to consolidate the financial reporting from an entity in which it has a controlling financial interest.
To keep matters simple and straightforward, the parent and the captive should record corresponding entries on a ‘gross’ basis. This will enable easy elimination during the consolidation process. For example: A captive’s claims recovered or recoverable can be separately recorded relative to the parent’s claim expenses paid or payable. Netting the two may cause complications when consolidating both entities. By introducing a reconciliation process between corresponding balances in the parent’s and in the captive’s financial records, any consolidation challenges at the end of a reporting period can be reduced even further.
Sometimes, legal ownership of a pure captive is held in a trust where the beneficial owners are not the underlying insured. In such cases, a retrospective rating mechanism is often built into the insurance contract. This mechanism allows any unused excess premium funding to be returned to the policyholder by way of a policyholder distribution. Though the insured may not be considered the legal owners, there may be a variable interest entity (VIE) relationship that could result in a requirement to consolidate.
In a VIE relationship, the captive’s insured may be deemed to have a controlling financial interest when it has (a) the power to direct or control the insurance activities which most significantly affect the economic performance of the captive, and (b) the obligation to absorb losses or the right to receive benefits that could be potentially significant to the captive. If a VIE relationship is present, then the insured will be required to consolidate the captive into their financial statements.
The story for shareholders of a group captive may differ from that of a pure captive as the former may not have to consolidate the results of the group captive into their own financial statements; especially when ownership interest represents less than 50 percent of the captive. However, they may still have significant influence that requires equity accounting (ASC 323-10) or they may be required to record the fair value (ASC 320 and ASC 825) or cost (ASC 325) of their investment as an asset.
Under US GAAP, significant influence is normally assumed if an investor holds between 20 and 50 percent of the voting stock of the captive. Other factors are also considered, including board representation, ability to influence control over policy decisions and the extent of ownership by the member relative to other owners. When significant influence is deemed, the member can use the equity method to account for its investment in the captive. Generally, the equity method is the cost of investment, plus a proportionate share of income or loss at each reporting period (normally accounted for in a separate equity account), less any dividends paid.
If significant influence is not deemed then the member should account for its investment in equity at fair value or at cost. Fair value is defined as the price the member would expect to receive should they dispose of their investment. Importantly, there are various assumptions used for estimating fair value, especially for a private company like a captive. Where it is not practical to estimate fair value, the member can use the cost method under ASC 325-20, but must disclose that fair value was not used because of the impracticalities to do so. The member must also ensure that there is no impairment to the carrying value of their investment.
In addition to accounting for their interests in the captive, the members should consider disclosing any cash security, letter of credit posted, and/or the possibility of premium assessments levied by the captive.
Segregated Portfolio Companies (SPC)
The legal structure of a segregated portfolio company makes it possible for common shares held in the core of the company to be held by an owner who is not related to the participants within some or all of the cells. However, similar to the trust structure referred to above in the section on pure captives, the participants of each cell may still have variable interests in their cell.
To determine which accounting model applies, it must be first determined whether the SPC as a whole (core and cells) is a voting interest entity or a variable interest entity (VIE). An SPC as a whole is considered a VIE if it possesses one of the following characteristics:
- The entity is thinly capitalised
- Residual equity holders do not control the entity
- Equity holders are shielded from economic losses
- Equity holders do not participate fully in an entity’s residual economics
In many cases, especially in rent-a-captive SPC scenarios, the SPC may be deemed a VIE based on the criteria above. Furthermore, under the requirements of ASC paragraph 810-10-25-57, silos of segregated assets and liabilities (the cells) are treated as separate VIEs if the host entity (the core) itself is deemed to be a VIE. ASC paragraph 810-10-25-57 precludes the primary beneficiary of a host VIE from consolidating a silo VIE if the variable interests are held by third parties.
Each SPC is different depending upon the interests of the equity holder and/or the participants of each cell, but there may be a requirement for cell participants to consolidate their variable interests in their cell even though they have no voting rights in the share capital held or even if no share capital is held at all.
In summary, not surprisingly, the answer to the question, “how do I account for my investment in this captive” is determined by the nature and structure of the captive or SPC under discussion.
There is no question that captives can bring their owners many benefits, but it is important to seek professional help when reporting requirements loom; if these, and other, accounting issues are appropriately handled it will minimize the risk of any reporting errors in the financial statements.