[Bharat Harne is a IV year student at the National Law School of India University, Bangalore]
On 3 December 2022, the Department of Financial Services invited comments on a host of proposed amendments to the Insurance Act, 1938 and the Insurance Regulatory and Development Authority Act, of 1999. One of the proposals is to add a definition of ‘captive insurer’ by adding section 2 (4B) to the Insurance Act. Globally, due to rising premium costs and a lack of coverage for risks in niche sectors, corporations have resorted to alternative risk transfer (ART) solutions/mechanisms. One of the most famous alternative risk transfer mechanisms is the use of ‘captive insurers’. Simply put, a captive insurer is an insurance company that is owned by the insured itself. In most cases, it is a wholly-owned subsidiary of the insurer company and underwrites risks exclusively for its parent company. In other cases, it can be owned by several entities and underwrites the risk of its owners. Captive insurers are mainly set up to reduce premium costs. Unlike traditional insurance companies, captives are not obligated to generate profits for their owner, which results in a lower premium. Even if the captive ends up making underwriting profits, it goes back to the owner. Additionally, the owner of the captive also gets returns on the investments of the captive. Thus, in the long run, it is believed that incorporating a captive is cheaper than traditional insurance.
Other Advantages of Captive Insurers
There are several reasons why a business would want to avoid the traditional insurance market (other than captives being cheaper in the long run) and set up a captive such as –
1. Accounting and tax rules
If a company were to retain surplus funds for financing future losses with itself, then it would have to pay tax on those funds even though it will not be able to use them (unless there is an actual loss). On the contrary, the premium paid for insurance is available for deduction for the calculation of income tax liability. Thus, rather than creating reserves or paying exorbitant premiums in the commercial insurance market, the business might choose to incorporate its insurer who would underwrite policies for its owners.
2. Control over management and investment decisions
The insured exercises no control over the premiums paid to commercial insurance companies. It is up to insurer as to how to invest (subject, of course to regulatory norms) those funds. However, in the case of captives, through its ownership in the insurer, the insured can exercise greater control over the investments of the insurer and can potentially make better and more prudent investment decisions.
3. Tailored risk management solutions
If the traditional insurance market does not underwrite a particular type of risk that a business faces, the business might be exposed to that risk without any insurance. However, since a captive insurer is essentially owned by the insured, such niche risks could be insured.
4. Direct access to the reinsurance market
Usually, insurance companies themselves insure themselves for situations where they cannot pay out their claims. Only insurance companies can access the reinsurance market and business owners cannot directly approach them. However, since captives are owned by the insured themselves, commercial insurers are circumvented and the reinsurance market can be accessed without them.
5. No information asymmetry
Traditional insurance is characterized by information asymmetry between the insured and the insurer. This usually leads to moral hazard and adverse selection, the two main market failures in the insurance market. In the case of captives, since it is (so to speak) an extension of the insured itself, there is no information asymmetry between the insured and the insurer and therefore no moral hazard or adverse selection.
Changes Proposed and their Implications for Captives
1. The recognition of captive insurers under section 4(B)
The proposed amendment adds section 4(B) to the Insurance Act, 1938 which defines a captive insurer as-
“An insurer carrying on the class of general insurance business or any of its sub-classes exclusively for its holding company or its subsidiary company or its associate company, as defined in clauses (46), (87) and (6), respectively of section 2 of the Companies Act, 2013”.
Ideally, a definition of captive insurance should answer two basic questions (for reasons that will be explained below) – first, who can (and cannot) own it, and second, whose risks can it underwrite? It is important to define ownership norms of captives because ambiguity surrounding them can result in misuse. In the United States, a family-owned business would set up a captive that would be owned by their children. The underwriting profits of the captive would be reaped by these owners of the captive. However, the idea behind captives is to reduce the premium costs of the company/entity that is setting up the captive which will happen when the underwriting profits go back to the company itself rather than related entities. The definition does clarify that the captive can underwrite the risks of its holding companies, meaning that the captive can be owned by a company whose risks it is underwriting. However, to avoid misuse, IRDAI will have to come up with clear ownership norms so that related parties of the promoter/holding company do not end up owning the captive.
Second, it is important to define beforehand whose risks a captive can underwrite because a captive can be misused by underwriting risks of non-related third parties and using their premium money to subsidize the losses of the parent entity. This is precisely the reason why jurisdictions such as Bermuda limit the number of third-party risks that a captive can underwrite and also mandate that premiums from third parties be in a separate cell whose funds cannot be used to fund the losses of the owner of the captive. Having said this, the definition does clarify that at least in India, a captive insurer cannot underwrite third-party risks. Curiously, the definition states that a captive can underwrite risks (exclusively) of “itsholding company or its subsidiary company or its associate company”. From a bare reading, it seems to be referring to the captive itself. The captive can underwrite the risks of its holding company, so its holding company’ part makes sense. But the next two parts do not make sense because captives themselves are subsidiaries (rather than holding/parent companies) that generally insure the risks of its parent. They do not have subsidiaries or associate companies. Moreover, IRDAI regulations themselves do not allow subsidiaries to be a promoter of an insurer. Therefore, a captive insurer (which is itself a subsidiary) cannot insure the risks of its subsidiaries. It seems that the government wanted to introduce the concept of “pure captives” in India. Globally, pure captives insure the risks of its parent (i.e., the owner) and the subsidiaries and affiliated companies of the parent. To avoid unnecessary confusion and complications, the definition should be amended to convey that the captive can transact (exclusively) the business of its holding company or/and the subsidiaries and/or affiliates of the holding company.
2. Minimum capital requirements
Currently, the minimum capital required to transact general insurance business is Rs. 100 crores. This is a major hurdle for businesses to incorporate captives because captives are usually relatively small (in terms of capital) because they insure exclusively their owner. Setting aside Rs. 100 crores merely to insure business risks could be feasible only for large industrial houses such as the Tata, Reliance, or Adani Group. However, it is simply impossible for most medium enterprises. Fortunately, the amendments propose to do away with the minimum Rs. 100 crore requirement and allow the regulator to determine the minimum capital on a case-to-case basis. The idea is to give entry to relatively small and niche players in the insurance market. If accepted, this would be a major boost for companies looking to set up captives as they will not have to set aside Rs. 100 crores. The regulator, on the other hand, will have to show sufficient flexibility in assessing the minimum capital requirements of captives by taking into account several factors such as the size of the parent, the magnitude of risk, the frequency of loss, etc.
3. The Class(es) of insurance business
In Indian insurance law, any insurance company can only apply for the license of a single type of insurance business. The types of insurance businesses for which an application can be made are – general insurance business, life insurance business, reinsurance business, or health insurance business (regulation 4, Insurance Regulatory and Development Authority (Registration of Indian Insurance Companies) Regulations, 2000). In other words, an insurance company cannot transact general insurance business and reinsurance business simultaneously. The definition states that the captive can only transact ‘general insurance business.’ However, the risks that a typical business needs to insure are not limited to general risks (such as fire, flood, theft, etc.). A business needs to take out group insurance policies including group life insurance policies and group health insurance policies for its employees. If a company is taking the trouble to set up a captive to insure its risks, it would usually expect that captive to insure all of its risks rather than just general risks. Importantly, the captive may need to act as a reinsurer rather than a direct insurer. This is known as fronting and it is quite common in other jurisdictions. If a customer or a potential client or legal regulations require a business to get insurance from (say) an A-rated insurer, then a captive will not be able to meet this requirement. Fronting is the solution to this problem. Under this arrangement, a traditional ‘A’ rated insurer issues a policy and then cedes all the risk to the captive through a separate contract. In case of loss, the traditional insurer pays the amount and then gets the same amount back from the captive. In other words, the captive becomes the reinsurer. However, if the captive is not able to meet the loss, then the traditional insurer will have to pay up anyway.
Interestingly, the new amendments propose to allow insurance companies to acquire a license for one or more classes of business. This is a welcome development that will further pave the way for the setting up of captives in India. However, under Reinsurance regulations 2018 (regulation 3), fronting is prohibited. On the contrary, the regulations advise insurance companies to retain as much risk as possible and cede as less as possible. This might be a prudent approach to take for traditional insurance companies but it will have to change if captives are to be incentivized in India.
In addition to these changes, IRDAI should come up with a comprehensive regulatory framework for captives that is distinct from traditional insurers. This is the approach followed by jurisdictions such as Vermont and Bermuda. One of the areas where the IRDAI needs to be careful is the investment decisions of captives. Given the control exercised by the insured, the funds of the captive could be rerouted back to the insured through investment in the parent, thus resulting in a circular flow of money. Such misuse of captive structures was seen in the United States where the controlled funds of the captive were rerouted back to the insured in the form of loans.
Conclusion
Given the numerous benefits of captive insurers, the government has sought to recognize them in India. To that end, it proposes to add a new definition under section 4(B) of the Insurance Act, 1938. However, there are at least two issues that need to be addressed before captives can effectively function. First, the definition should be redrafted to address the concerns pointed out above. Second, re-insurance regulations should be tweaked to allow full cession of risk so that fronting arrangement with captives is possible. The proposed flexible minimum capital requirement and composite licensing will go a long way in promoting the setting up of captives in India. However, IRDAI should have a clear regulatory framework distinct from that applicable to traditional insurers.
– Bharat Harne