Captives as Tools for Supporting Private Equity Activities

This article originally was published on Captive.com and is reprinted here with permission.

The staggering amount of money flowing into the private equity (PE) sector has spurred significant increases in acquisition activity. Depending upon a PE firm’s plans for the companies it is acquiring and its timeline for investing in and eventually divesting business units, there may be opportunities to consider using a captive insurer.

The critical factor in determining when a captive strategy may be compatible with a PE firm’s activities is the anticipated timeline. Typically, private equity funds are structured with well-defined expectations and objectives for the companies they expect to acquire. That nearly always includes a specific timeline the PE firm will follow to acquire, grow, enhance, and divest investments to achieve the necessary rate of return for investors.

As an example, a PE firm may intend to hold an acquired company for 10 years. It may spend the first two or three years funneling capital into that company to achieve performance goals and profitability improvements and six or seven years to allow the company to grow. There will then be an expectation that the company will be brought to the marketplace by the end of the 10 years. Ideally, what they invest in the company will be returned in multiples through value creation.

The use of captive insurers is typically a longer-term strategy that requires significant upfront capitalization to fund the captive’s risk and operational expenses. Assuming the captive is well-constructed and coupled with loss-prevention activities, it will become financially strong enough to generate returns that can be reinvested into the company fairly quickly.

If a PE firm seeks a shorter timeline for improving what it purchases and divesting it quickly—say over a five-year timespan—then a captive may not align with the strategic objectives of the PE firm, given the upfront investment to establish and fund the captive operations and the risk of losses as that could reduce the investment returns. However, if the timeline is on the order of eight or 10 years, strategic use of a captive may generate worthwhile cost savings and return on invested capital—particularly if loss reduction efforts have reduced claims and created positive cashflow from the capital surplus built up in the captive.

There are situations in which the captive approach may be advantageous for a PE firm. One example involves situations where the PE firm intends to purchase multiple companies in similar businesses that carry similar risk profiles. Suppose a PE firm intends to purchase two dozen home services businesses like heating, cooling, and plumbing contractors. Covering some of the common risks through a single captive insurer and implementing across-the-board risk reduction efforts may allow those risks to be managed at a lower cost than what’s available to the individual contractors in the insurance marketplace.

When considering a captive, it’s important to determine whether the companies being acquired have demonstrated better-than-average loss experience that has led to mispricing from the insurance market. After all, establishing a captive involves assuming risk. That’s why companies whose loss history is worse than their average peers tend to be more well-suited for the traditional insurance marketplace.

One challenge associated with a captive insurer centers on the eventual dissolution of a PE fund and a captive’s lifecycle. The captive domicile’s regulator will determine whether to allow the captive to shut down and allow the capitalization and surplus to be returned to the fund’s investors. Even if the captive’s financial obligations have been eliminated, the regulator will require assurance that all claims have been paid out and no additional claims will emerge. This is where a captive consultant’s knowledge of domiciles and their expectations can head off problems.

Whether a captive is worthy of consideration for a PE firm depends largely upon the fund managers’ willingness to use risk management and insurance as levers to maximize the value of their portfolio companies. Successful private equity managers who want to use a captive insurer strategy must possess a clear understanding of inherent risks, a solid grasp of their investors’ expectations, and the target criteria for companies they intend to acquire. Bringing a strategic captive advisor into the process may identify cost-saving and value-creation opportunities they may not have considered. Even if the situation proves to be inappropriate for a captive, the discussion may create other opportunities to manage risk more effectively and economically.

The above information does not constitute advice. Always contact your insurance broker or trusted advisor for insurance-related questions.