M&A Roundtable: Things to Consider Before Establishing a Captive

Intro (00:01):
You are listening to the Alliant M&A Roundtable, providing insights and expertise on the unique risk management needs associated with private equity firms. Here is your host, Jonathan Gilbert.

Jon Gilbert (00:20):
Alright, well thank you, and welcome to another edition of the M&A Roundtable podcast. Today we're joined with Seth Madnick, who leads Alliant's Captive Resource Group, and Katie Murphy, who is a senior member of the M&A team. We're going to talk a bit about what it means to have a captive when you're considering a private equity transaction, both first-time private equity investors, as well as considerations upon exit and generally what the benefits are to a captive. With that, I'm gonna turn to Katie to start the dialogue with Seth.

Katie Murphy (00:49):
Thank you, Jon. A part of the focus of our conversation today wants to be a little bit on healthcare. So to start off, the healthcare industry has evolved over the last two years and continues to evolve due to M&A activity. These healthcare industry mergers, consolidations and divestitures require consideration on the best way to effectively manage the cost of risk through both risk retention and risk transfer. Captives can be effective solutions for the healthcare industry, in that they can be used to help healthcare groups mitigate some financial risk. So, Seth, can you tell us what companies should be considering when evaluating if a captive arrangement is appropriate for their risk?

Seth Madnick (01:30):
Sure, and I appreciate participating in today's discussion. The issue in captives really focuses a lot on their appetite or their ability to fund risk and the size or the amount of premium or dollars that are going into the exposure. When you set up a captive, you're really setting up a specialty or niche insurance company, and especially for the healthcare side of it, for medical practice groups or hospital groups, their ability to have the balance sheet to fund risk is a key component. And then looking at the size of the premium dollars, you need certain critical mass of premium dollars going in to fund the risk and also cover the frictional costs of running a captive. So as a rule of thumb, we typically look at premiums in excess of a million dollars and above. The more - higher than that is always preferred, but as a floor, we look at least at a million dollars in premium going in for that segment.

Katie Murphy (02:24):
That's great, thanks Seth and what are some of the advantages and disadvantages to setting up a captive?

Seth Madnick (02:30):
With any industry group, captives are a way of financing risks. So the advantages are that you can essentially fund your premium based on your projected loss cost plus expenses. So you step away from a standard commercial insurance market and you’re funding the risk yourself based on the loss experience of your own healthcare practice group or hospital group or other business. That's an advantage on the price side. You also get direct access to the reinsurance market for buying extra capacity or risk holding or laying off risk. Many clients look at captives as a way to capture underwriting profit and investment income. There is a lag between the paying of premium and the paying of claims, and insurance companies invest that money and make a yield on that. And captive owners, for the portion they're participating in, also can invest their funds and earn interest yield on that. And if there's underwriting profit, that's a big driver of that, that the dollars that are being paid going into the captive and anything left over not needed for claims, comes back to the captive owners. The flip side is always the disadvantage, which is that if losses exceed the projection, then the captive owners need to be able to fund that exposure and to capitalize and make sure there's enough money to cover the ultimate losses in the captive. So there is a funding requirement and also, it's a long term strategy, so there's a need to, you know, participate in the operation with advisors and the oversight of the capital, making sure it's adequately funded in managing the risk dollars over the long term.

Katie Murphy (04:00):
Seth, can you tell us why captives are attractive to private equity firms?

Seth Madnick (04:04):
Private equity firms, we've worked with a few on captives and really part of it is a couple of things. One, they're looking at a way to enhance their investment. If you think about it, there's a certain ROI that the private equity firms are looking at from an investment side, but if the private equity firm has ability to capture an underwriting profit and investment income from the insurance purchase of the investment, that enhances the scope or the return for the investors. And we have several clients who have experienced that, and in fact, one in particular, after they sold the asset, kept the captive because they were capped and it was a long term exposure and they wanted to capture the underwriting profits and keep that for themselves. So it's really a way to enhance the investment and also provide for some clients, to provide insurance capacity or a vehicle to have insurance capacity for that.

Jon Gilbert (04:56):
And Seth, just to add on to that, is there certain tax advantages that even a private equity-owned company could take advantage of by having a captive?

Seth Madnick (05:04):
Well, the interesting thing is when you take a captive, for example, if there's a cluster of investments, they really can create a group captive or a brother-sister captive, depending on the structure, for their own investments. Now, what that does is that it allows them to capture those profits and if it's structured properly with their tax advisors, it can be deemed insurance and so that effectively becomes an underwriting profit center for them. Now, tax-wise, when it comes out, typically it's just ordinary, it's dividends, but it's really more of a capturing of the underwriting profit on the tax side. There was a push a few years ago to use micro captive or small captives with the underwriting income comes out tax free. But there was such abuse of that, that the IRS set up those micro captives on the dirty dozen list and there's been reform to try and clean that up. It's more on the capturing underwriting profit and investment income side.

Katie Murphy (06:01):
And Seth, going back to a comment you made earlier about a company choosing to keep their captive in place through sale and just given that the M&A group works with private equity companies specifically, what consideration should be taken into account, as any given investment will have a finite life, such as tail issues that may arise at an investment exit.

Seth Madnick (06:20):
The issue we've seen with private equity companies is really what happens when they exit the investment, and that's always a concern, about how to structure that. So, there are a few ways that clients have handled it. Some of them will sell the captive along. If it's a single parent captive tied to one investment, they'll sell that along with the investment. You know, let's say let the new buyer have the captive, that becomes another asset if you would, that they're selling as part of the package. Another area is to work with, essentially, keep the underwriting profit, structure what we call a lost portfolio or a buyout. So, the asset that they're leaving behind, they effectively buyout, you know, sell off the insurance exposure or tail coverage to the captive itself, and then the investors or whoever was tied with that asset are essentially paid off. And that usually involves getting our actuarial team involved and doing a loss projection and everybody agrees this is the projected losses and here's the dollar value for what's left over, and basically come to an agreement to sell off the liabilities to the captive and move on. So there's some form of a loss portfolio transfer or a sale. And there are also insurance companies in the loss portfolio transfer business. They have whole divisions who will buy off the asset, buy a book of business off. But one of the areas going in is perhaps, you know, pre-negotiating the buyout or the tail coverage terms in advance. So when they sell the asset, they know the structure if you would, of how it's gonna be valued and the exposure. And then the PE firm can continue to own the captive and essentially run it off and maintain the, you know, basically the concept is that they can close out the claims at or below the projected loss pick.

Jon Gilbert (08:01):
That's, that's very interesting, especially if you're able to cap the potential liability for any prospective buyer or as you said if a private firm fund would want to keep the captive, which they may not want to have happened as they usually want to close on those funds and get the monies back to LPs. But good to hear those interesting ways to handle all that and certainly taking the guesswork out of the liability at the time of sale related to the captive would solve a lot of concern and angst that maybe private equity firm buyers and sellers might have relative to the use of a captive vehicle, for sure.

Seth Madnick (08:34):
And what's interesting, there's been a growth in basically loss portfolio transfer companies lately. They're also funded by PE firms, which is interesting, but there's been a growth of companies that will come in and buy out your portfolio. And so companies can close out their liabilities captives and move on with that. So it's just negotiating the buyout and they look at it as a cash flow arrangement, what they're paying for, and then how they can take the funds and invest it and manage that. So there are vehicles in the insurance community to help, you know, manage that in addition to just if the client elects not to keep the captive running after they sell off the portfolio company.

Jon Gilbert (09:15):
Yeah, that's very interesting as well, and I would say the majority of times that we've seen a captive involved in an M&A transaction that it has survived closing at times we'll see it merge with another captive. The acquiring portfolio company, let's say if it was an add-on acquisition, had another captive, they would eventually look to merge the two, but, you know, by and large, all the ones that I can remember I’ve have been involved in the last, you know, 19, 20 years have maintained the captive through closing, which is kind of interesting, in that it's sold with the company as an asset and an entity acquired by the buyer.

Seth Madnick (09:49):
Which makes sense because you've created an asset. If you think about it, whoever started the captive has created a new company. They've created a niche insurance or reinsurance company. So they've created a new asset that's been capitalized and it has some experience with losses and premium and investment income. So, you know, the question becomes, what's the highest and best use of a valuation for the seller to either maintain it and run it off themselves or to get a multiple if they could, on valuation by putting the captive as part of the asset when they sell it.

Katie Murphy (10:20):
Seth, can you provide us with an example of a situation where you helped a private equity owned company establish a captive and tell us a little bit about the benefits that it provided?

Seth Madnick (10:29):
So we had a client who had provided payroll and other services to the entertainment industry. Every motion picture television show is a separate entity. And so they were highly automated. And the way that industry works is, for example, on workers' compensation insurance, the studios provide a fixed rate on the payroll to the company who's managing it, and then they go out and buy the insurance and manage that. And they were making money, effectively on the spread between what they were being paid and what the cost was. But by providing good management services, there was a tremendous amount of underwriting profit in the workers' compensation segment by providing good risk management. So the private equity firm that invested into the staffing company and payroll, essentially, we created a workers' compensation captive that took the first layer of risk. So the underwriting profit essentially was owned by the PE firm that was investing into the company, and it was highly successful and there was incentives for risk management and safety, and part of their acquisition investment, in fact, was capturing the profit and enhancing the valuation of the company. And interestingly enough, it was quite successful. And then when the company was essentially sold off, the PE firm retained the captive to manage the runoff and retain the underwriting profits on the workers' compensation side.

Jon Gilbert (11:51):
That's great. Anytime you can take an insurance solution and make it a profit center for our clients, that's a pretty exciting thing. And I bet our clients are pretty excited about that as well. So that's a great story, Seth.

Katie Murphy (12:03):
Seth, I wanted to touch briefly on the topic of jury awards. This has been a heavy point of focus throughout the insurance industry over the last couple of years because of the fact that things like nuclear verdicts have put so much pressure on the insurance industry as a whole. So as jury awards in certain jurisdictions such as Cook County, Illinois, Texas, and Florida continue to increase, do you see an increase in companies exploring a captive?

Seth Madnick (12:27):
The quick answer is yes. When you think about it, the marketplace is responding to the entire industry segment that's being stressed by the nuclear verdict. So a captive allows a particular business or entity to basically fund for their own projected losses plus cost of running the captive. So employers or businesses that have the ability or the financial strength to step out of the marketplace and fund their own risk are doing that. And we're seeing a growth because of that.

Katie Murphy (12:54):
Helpful, thank you.

Jon Gilbert (12:56):
Well, great. Well, thank you Seth and Katie for a very lively discussion around captives, particularly for private equity buyers as well as private equity buyers focused on the healthcare industry. So appreciate the dialogue and hopefully everyone here today enjoyed the conversation. For more information, please visit us www.alliant.com. Thank you.