Jeffrey K. Simpson is a Director at the Wilmington law firm of Gordon, Fournaris & Mammarella. He is a graduate of Brown University and Villanova University School of Law. Jeff is admitted to practice law in Delaware and Nevada. Jeff’s practice focuses on the formation, regulation and governance of captive insurance companies.
He is a founder and director of the Delaware Captive Insurance Association. He chaired and continues to serve on the committee that drafted Delaware’s updated captive insurance statute in 2005. He is active in captive insurance industry associations and frequently speaks on captive insurance topics. Jeffrey can be reached at JSimpson@gfmlaw.com
More than once, I have started an annual meeting for an enterprise risk captive only to hear the client ask, “How fast can we get through this?” But usually, by the end of the meeting, they are saying, “I’m so glad we did this!” I would love to think the change is brought about entirely by my magnetic charm and charismatic personality. But since I am neither charming nor charismatic, I know better! The change comes because we educate our client during the course of the meeting to help them appreciate the how and why of good corporate governance and understand the way it helps them protect their captive.
What is Corporate Governance? Corporate governance is critical to the successful operation of any captive insurance company, and enterprise risk captives are no different. If the insurance business is the backbone of a captive, supporting the entire body, then corporate governance might be the ribcage, surrounding and protecting the vital organs. Without the protection of good corporate governance, a captive will almost certainly be unhealthy, vulnerable and unlikely to survive regulatory examination or IRS audit.
Generally, corporate governance is the process by which an enterprise makes and executes management decisions. Corporate governance is the mechanism for transmitting authority from the owners to the directors and on to the officers. At the same time, corporate governance protects all of the parties who have a stake in the performance of the enterprise by helping to implement appropriate controls and avoiding conflicts of interest. Investopedia, a website dedicated to financial education, defines corporate governance this way:
“The system of rules, practices and processes by which a company is directed and controlled. Corporate governance essentially involves balancing the interests of the many stakeholders in a company – these include its shareholders, management, customers, suppliers, financiers, government and the community. Since corporate governance also provides the framework for attaining a company’s objectives, it encompasses practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure.”
Corporate Governance and Enterprise Risk Captives
Enterprise risk captives (ERCs) are pure captive insurance companies covering privately held businesses and addressing risks that affect the enterprise but are typically outside of the routine commercial insurance program. In addition to risk management, they often contribute to ancillary objectives of their owners, such as wealth accumulation or retention of key executives.
ERCs are generally small enough to take the 831(b) election for tax purposes. In fact, they are often colloquially referred to as “831(b) captives.”
In the environment of ERCs, corporate governance can be easy to dismiss. Often, the principal is owner, director and officer of the captive and is engaged full time in the operating business insured by the captive. So the principal fills several stakeholder roles including shareholder, management and customer. From that posture, the principal knows everything that is happening with the captive and can easily convince himself that corporate governance is unnecessary. After all, if a purpose of corporate governance is to balance one stakeholder’s interests against another’s, who would think a person needs to balance his own interests against his own interests?
Leading private company owners further away from good governance for their ERCs is the nature of the ERC itself. For one thing, the ERC is not the principal’s primary business, and it is therefore going to get a lot less attention than the primary business. At the same time, the principal does not know how to run an insurance company and contracts out the operation to a team of service providers. From the principal’s point of view, the ERC basically runs itself as the professional service providers do their thing. It is easy for a principal to trust the service providers’ competence and professional reputations to run the captive while he focuses on his real business.
But there are other stakeholders, like unrelated policyholders, pool participants, regulators and even the IRS. It is their presence, along with the presence of third party service providers, that are the reasons to insist on good corporate governance.
Corporate Governance Best Practices for ERCs
If ERCs need good corporate governance, what are the best practices that amount to good corporate governance? Are they the same as for public companies and group captives, requiring features like audit committees, independent directors and D&O insurance? Thankfully, no. It is simpler than that. In fact, much of it is already built into requirements that appear in most captive statutes and corresponding regulations. What turns corporate governance requirements into best practices is how you implement and deploy them in your own ERC to operate as checks and balances.
Annual meetings are required by most captive statutes and represent an ideal opportunity for an ERC owner to get a complete summary of his captive’s activities. Best practice is to use the annual meeting to review and discuss every aspect of the ERC’s operation, with a focus on reviewing and updating the insurance program and consideration of the ERC’s financial performance and regulatory compliance.
A thorough and well documented annual meeting results in a detailed written record that supports the captive’s business purpose and affirms the captive’s existence as a separate entity that should be respected by regulators, tax authorities and courts. One of the great tragedies for captive owners is when their annual meeting is handled perfunctorily, memorialized with something like a one page list of resolutions re-electing officers and reappointing service providers and maybe even reciting start and stop times that illustrate a mere 5 or 10 minute event.
During the annual meeting a captive owner should expect to see his board presented with completed copies or confirmation of completion of all of the captive’s material contracts, especially its insurance policies and any reinsurance or retrocession agreements. An owner should also expect to see prior year audited financials, current year unaudited financials, the prior year statement of actuarial opinion and current loss runs. ERC meeting organizers often shy away from producing all of this documentation, not because they do not want the captive owner to see it, but because they do not want to overburden or overwhelm the captive owner or present him with documents that he is not trained to understand. However, this view misses the mark for best practices by missing an opportunity to educate the owner and to allow him to confirm that these things were actually completed. The annual meeting is the moment when service providers should be demonstrating to the client that they have done their jobs over the prior year.\
Resident directors might be the most underutilized resource in the captive insurance industry. Especially for ERC owners, who typically have no experience with insurance companies at all, an experienced resident director can be a great asset. Best practice is to engage a resident director who is familiar with captives in general and ERCs in particular and can assist the owner in ensuring that the service providers have done their jobs, the captive is compliant with law and regulation, and the insurance program is implemented and operated sensibly.
To be fair, the resident director requirement in most states’ captive laws exists to support economic development and encourage the captive to contract with local service providers. Unfortunately, many captive managers and captive owners miss this great opportunity to bring a value adding resource into the captive equation.
Instead, they might contract with somebody’s cousin who lives in the state or with an accommodating registered agent, neither of which knows anything about insurance, but each of which meets the letter of the law. Considerably better, but still not ideal, is using a local employee of the captive manager. This can add insurance experience, but typically does not help add diversity of perspective. The resident director should not be viewed as a box to check, but instead as a chance to bring more experience and diversity of opinion to the team.
Conflict of interest disclosures
Most states require some form of annual, written conflict of interest disclosure to be provided by each director, officer and key employee. Typically, the disclosure is presented at the annual meeting in the form of a single page that recites the captive’s conflict of interest policy and includes a blank space for the signer to identify his actual or potential conflicts. Almost invariably, the blank stays blank or is filled in the word “None” or the all-purpose shorthand “N/A.”
I am always interested in this result because almost every party at the table in a captive insurance board meeting has some actual or potential conflict of interest. For example, where representatives of the captive manager are serving as directors or officers of the captive, the potential exists for a conflict of interest.
In fact, because the quintessential captive is an insurance company that is owned by its customers, captives are conflicted transactions by definition. Rather than ignore these conflicts as irrelevant or “not applicable,” best practice is to embrace the reality of these actual or potential conflicts of interest and use them to educate the captive owner on how to think about the health of his captive and protection of the captive.
While we in the industry may be entirely familiar with the conflicts and able to conduct our business with an ongoing background awareness of them, the typical ERC owner does not understand enough about how captives work to appreciate the actual or potential conflicts and their possible impact on key decisions like whether and when to bring a claim, how a pool might view the same claim and what happens when the captive manager is stuck in the middle. The conflict of interest disclosure is a perfect opportunity to discuss these concerns with the ERC owner.
Everyone agrees on the importance of financial controls for any business enter rise, and captives are no different. For ERCs, there seem to be two prevailing strategies. Many people believe the captive owner should always have exclusive access to the captive’s checkbook and assets, and the captive manager should never have access. Others believe the captive manager should always have as much control as possible.
The problem is that both are wrong, and the best solution involves balancing control. Best practice for ERCs is for the captive manager to have easy access to the amounts of cash necessary to pay most claims and invoices, and also to be included as a required signature for any significant withdrawal of captive assets
In the structure I would consider ideal, the captive has an operating account with the captive manager as the sole signatory, and the captive owner has real time access to statements. The balance of the captive’s assets are in an investment account with the captive owner as the sole signatory for all purposes except withdrawals, which require the additional signature of the captive manager. The operating account controlled by the captive manager allows the ERC to smoothly and easily conduct its business, with no worry about chasing around unavailable or uncooperative owners. Meanwhile, the investment account controlled by the captive owner, but requiring the captive manager’s signature for withdrawal, allows the captive owner to manage his own investments while preventing assets from leaving the captive without the captive manager’s knowledge.
This design is a balanced set of financial controls that allows the captive owner to have the investment freedom he usually wants and allows the captive manager to easily pay operating expenses, but still protects the captive’s resources and minimizes the potential for theft or fraud. Independent service providers
The Holy Grail for ERC captive managers is the true turnkey solution. There are dozens of managers in the space who advertise their offerings as turnkey. What they all seem to be trying to sell is convenience and one-stop shopping – the captive manager takes care of everything, including arranging for the other required service providers.
Reasonably, the captive managers want to make it easy for the ERC owner, and frankly, ERC owners are responsive to turnkey programs. But turnkey does not mean the same thing to everyone. Some turnkey solutions involve the captive manager helping the ERC owner identify and engage the right service providers. Other turnkey solutions focus on in-house staff and involve the captive manager’s having as many services as possible delivered by his own employees. Between these two extremes is a spectrum of arrangements, all advertised as turnkey, all providing the ERC owner with some measure of a one-stop shop, and very many of them being quite competent and well organized operations.
But some of them lack independence, and a lack of independence can be dangerous. All other things being equal, best practice for ERCs is to draw services from as many different independent service providers as possible.
Independence works to the benefit of the ERC owner in that independent service providers answer to the captive owner and not to the captive manager. Because they have their own practices and their own reputations to consider, independent service providers are more likely to say what they really think instead of what they think they are supposed to say. In-house employee service providers, on the other hand, can find themselves pressured to adopt practices, reach conclusions or take actions that are not consistent with their view of best practices.
In-house arrangements are not necessarily bad in and of themselves, and in fact many are very good. But inhouse arrangements are much more vulnerable to pressure to engage in less than ideal practices. So, as far as best practices for ERCs, independent service providers are the right way to go.
Take this one with a grain of salt because I am, after all, a lawyer, and certainly have a bias in that regard. But I have also seen a lot of problems arise in ERCs that would not have arisen if experienced captive counsel had been included.
Of all the professionals who frequently work on captive transactions and ERC structures, the one most likely to be excluded from an ERC’s team of service providers is the lawyer. Often, it is a simple matter of cost – lawyers are expensive, and forming the company, running the board meetings and drafting and issuing the policies would all be less expensive if someone else did it. Sometimes, the ERC owner or the captive manager believes that the lawyer does not add enough value. Sometimes, no one even thinks about bringing in the lawyer. However, excluding the lawyer, for whatever reason, is frequently a mistake.
Best practice for ERCs is to ensure that a lawyer is involved in all aspects of the ERC’s activity. When everything is said and done, when the claims are long since paid and the policy year has been closed, when the examiner or the IRS come knocking at the door, the only thing the captive has to show for itself is its written record. Nobody appreciates this, or plans for it or anticipates it more than the lawyer.
At the same time, lawyers provide an immediate value in the checks and balances column by thinking differently from everyone else about how the captive can and should operate, and chiming in when it is headed in the wrong direction. I have seen all manner of ERC improprieties, from illegal dividends and unauthorized investments to flatly incorrect policies and defective corporate actions, that could have been avoided if a lawyer had been at the table to speak up. Maybe lawyers are just a subset of independent service providers, but including them is definitely a best practice for ERCs.
Benefits of Following Corporate Governance Best Practices
The benefits of corporate governance best practices are difficult to quantify. But for ERCs, there are three primary benefits that should be important to everyone. The upshot of following these ERC corporate governance best practices is a well-informed and engaged owner, a well-protected captive and a well-documented program.
Well-informed and engaged owner
Captive owners should all be working to be as well-informed as they can be. But ERC owners, often being inexperienced with insurance and focused on running their operating businesses, frequently don’t know what they don’t know and don’t know how to inform themselves about their captives. So they rely on the captive manager. By insisting on and implementing corporate governance best practices, the captive manager pushes information to the ERC owner, puts the ERC owner in a situation where he can focus on that information and provides the ERC owner with the resources to explain and digest the information. When that happens, the ERC owner becomes informed, and informed owners are much more likely to be engaged owners. Of course, engaged owners are much more likely to fully appreciate the value of the captive and to seek new ways to exploit and benefit from captives in their risk management programs – which is a win for all involved.
ERCs that follow corporate governance best practices will necessarily develop the policies and procedures that keep the captive compliant with regulation and that protect the captive’s assets from mismanagement or fraud.
Owners and directors of these captives will ensure the adoption of appropriate financial controls and will have appropriate awareness of conflicts of interest. A captive that has these policies, procedures, controls and awareness is a well-protected captive. Of course, a well-protected captive is much more likely to safely accomplish its business purpose. Well-documented program
Finally, ERCs that follow corporate governance best practices will end up with a thorough and organized record of their activities. That record will include contemporaneous documentation of business purpose, detailed documentation of board activities and resolutions, complete and fully executed contracts and insurance agreements, and timely filing of regulatory reports. All of this adds up to a well-documented captive, and a well-documented captive is much more likely to withstand the scrutiny of a regulatory examination or an IRS audit.
For ERCs, corporate governance best practices can seem unnecessary or burdensome, but they really are simple procedures and decisions that maximize the value of many of the things captives are statutorily required to do. What’s more, they pay off with owner engagement, protection of the structure and a strong written record that helps defend the captive in the long run. If you follow ERC corporate governance best practices, you too can give your client an experience that ends with them saying, “I’m so glad we did this!”