In the Spotlight: The Use of a Captive Insurance Company By a Commercial Tenant

In a typical commercial lease, a landlord will require a tenant to carry a minimum amount of general liability insurance (e.g., $3 million per occurrence and $3 million general aggregate) and will also require that the insurance carrier meet certain standards, such as a minimum policyholder rating and financial size (as rated by an agency such as AM Best). In many cases, the tenant will agree to obtain the required insurance from a commercial insurance company. However, there are tenants that will request the right to “self-insure” or to insure through the use of a “captive insurance company.” This article addresses what it means for a tenant to self-insure or obtain insurance through a captive, and how a landlord and tenant can modify their lease accordingly.

Self-Insurance

What is self-insurance? It simply means that a tenant has set aside a reserve of cash to cover potential future losses. As claims arise, a tenant will use those funds to pay the claims. In some cases, a tenant may elect to insure through a combination of self-insurance and commercial insurance. Typically, the most predictable losses of the risk are retained and self-insured, forming a first or “working” layer of cover, and a stop-loss or stop-gap policy is purchased from a commercial insurance company. The commercial insurance company then pays for losses above the specified self-insurance limit per loss, thereby stopping the cost of losses to the self-insured above the retained values. Effectively, the losses paid for by the insured before the stop-loss policy pays becomes the deductible layer. Some risks, including Workers' Compensation and auto liability, cannot be self-insured without being approved by the state in which the risk to be insured is located. General liability may be self-insured without state approval.

Captive Insurance Companies

Captive insurance companies, on the other hand, are those established with the specific objective of financing risks emanating from their parent group or groups, although they sometimes insure risks of the group's customers as well. Using a captive insurer is a risk-management technique by which a business forms its own insurance company subsidiary to finance its retained losses in a formal structure. A “single-parent captive,” which insures the risks of its non-insurance parent or affiliates, is essentially a form of self-insurance, as the captive insures only the risk of the insured and its affiliates. In many instances when a captive is set up, a “fronting agreement” will also be in place.

A fronting agreement is one between the captive and a commercial insurance company, licensed in the state where the risk to be insured is located, under which the insurance company agrees to issue a policy to the insured. Under the fronting agreement, also known as a reinsurance agreement, the risk is then transferred from the fronting company to the captive. The end result is that the risk of coverage lies with the captive, but the insurance policy is issued on the paper of the commercial insurance company. Essentially, claims against the insured are covered by the captive, and the fronting company acts as a backstop to cover amounts, up to the limit of the policy, in excess of what the captive can cover. When the captive has entered into a fronting agreement, a landlord will get an insurance certificate or duplicate copy of the policy showing the commercial insurance company as the carrier, even though the risk is really covered by the captive. In those instances, provided the third-party carrier meets the requirements set forth in the lease, the landlord should be satisfied that the required coverage has been obtained in accordance with the terms of the lease. If no fronting agreement exists, the captive will issue the policies and certificates in its own name as the insurer.

Landlord's Concerns

While the use of a self-insurance plan (“SIP”) or a captive may have its advantages from the tenant's perspective (i.e., lower premiums, more control by the insured over its insurance program and more efficient claims management), it raises certain concerns for a landlord, all of which should be discussed with the landlord's risk manager or insurance adviser. The major concern for a landlord is the financial risk taken by the tenant (and/or guarantor, if any), particularly when the tenant does not obtain a commercial insurance policy (either a stop-gap policy in connection with an SIP or a reinsurance policy in the case of a captive). When a tenant purchases insurance from a third-party carrier, there is typically a deductible associated with the policy. The amount of the deductible is the maximum amount that the insured would have to pay in connection with any claims, thereby limiting the financial risk borne by the insured.

Ideally, a landlord would also like to limit the financial risk assumed by a tenant that self-insures or insures through a captive. However, if a tenant self-insures without a stop-gap policy, or sets up a captive without a reinsurance agreement, the tenant (or its parent company) is essentially self-funding the entire insurance amount and thus is at risk for the entire amount of any claims, not just the amount of the deductible or self-insured retention. In those situations, the landlord should be particularly concerned about the financial strength of the tenant and/or the entity funding the captive, as the case may be, and whether or not the SIP or captive is sufficiently funded to cover any potential claims brought against the insured. Thus, the landlord should carefully review financial information for the insured (including the SIP), the captive and the entity that funds the captive, be it the tenant, the lease guarantor, if any, or another entity.

Another reason a landlord should require a fronting arrangement is the possibility that a large number of claims in any one year against the tenant entity (particularly if that entity has numerous leases around the country or is in a high risk business) could drain the captive of its assets, a situation less likely to occur when the tenant obtains coverage through a third-party carrier, given the presumed financial stability of the third-party carrier (barring a catastrophic event such as Hurricane Katrina). This is more likely to occur in cases where the captive provides multiple lines of coverage for the insured, such as liability, director's & officer's, auto and workers' compensation.

Drafting the Appropriate Lease Provisions

If the tenant obtains its liability coverage through the use of a SIP and a stop-gap policy is in place, the landlord should require a limit on the insured's self-insured retention. For example, if the landlord requires the tenant to carry $3 million of general liability insurance, the landlord may limit the self-insured retention to $1 million. That will cap the tenant's exposure at $1 million and the third-party carrier will cover the balance of the claims up to the policy limit. The landlord should also have the right to review documentation for the SIP from time to time to ensure that the SIP is being sufficiently funded.

If the tenant obtains its liability coverage through the use of a captive and a fronting agreement exists when the lease is signed, the insurance provisions of the lease should require that the fronting agreement remain in place throughout the term of the lease and that the certificates of insurance identify the commercial insurance carrier as the insurer. If the fronting agreement is terminated or expires during the term of the lease, the tenant should be required to obtain its coverage from a carrier that meets the criteria set forth in the lease.

If the tenant elects to self-insure and does not carry a stop-gap policy or if the captive does not have an agreement with a fronting company and will not agree to enter into such an agreement, the insurance provisions of the lease must be modified accordingly. One solution is to set a minimum net worth (or minimum capital and surplus) for the tenant (in the case of an SIP) or the captive, and a minimum net worth for the party that funds the captive. A determination as to the appropriate net worth should be made by the landlord after reviewing all of the relevant parties' financial statements. To confirm that the net worth/capital and surplus test(s) are being met, and that the SIP or captive is being adequately funded, the landlord must have the right to receive and review financial statements for the tenant, the captive and the party funding the captive throughout the term of the lease.

A sample lease provision, under which the lease guarantor funds the captive, is as follows:

Tenant shall have the right to maintain the commercial general liability coverage required above through an affiliated entity, a captive insurance company, XYZ, Inc., a __________ corporation (“XYZ”); provided that (i) XYZ at all times maintains at least _________ Dollars ($____________) in total capital and surplus and (ii) Guarantor at all times maintains a tangible net worth of at least ____________ Dollars ($________). In the event that (i) Tenant no longer obtains the commercial general liability insurance required above through XYZ or (ii) XYZ fails to meet the aforementioned capital and surplus test or (iii) Guarantor fails to meet the aforementioned net worth test, Tenant shall obtain such coverage through an insurer with a policyholder rating of at least A- and a financial size category of at least Class VIII as rated in the most recent edition of “Best's Key Rating Guide” for insurance companies. Within fifteen (15) days after delivery of written request from Landlord, Tenant will furnish XYZ's most recent audited financial statements (including any notes to them) to Landlord, or, if no such audited statements have been prepared, such other financial statements (and notes to them) as may have been prepared by an independent certified public accountant or, failing those, XYZ's internally prepared financial statements certified by an authorized officer of XYZ. Tenant and XYZ will also discuss XYZ's financial statements with Landlord, or Landlord's representative, as reasonably necessary.

Conclusion

When a tenant obtains its liability insurance from a third-party carrier, particularly one that meets the landlord's rating and size requirements, the landlord can generally be comfortable that the tenant will maintain the required coverage throughout the term of the lease, assuming the tenant pays its premiums. If a tenant requests or requires the right to self-insure its liability coverage, particularly the right to do so through a captive insurance company, a landlord must do its due diligence to understand the implications of allowing the tenant to do so rather than procuring such insurance through a traditional third-party insurance carrier. That due diligence should include a thorough review of the financial statements for the tenant, the captive and the entity that funds the captive. Given the specific nature of the issues involved, a landlord should also have its insurance broker or risk manager involved in the process as early as possible and, if necessary, in direct contact with the tenant and/or the tenant's insurance adviser to resolve any issues.

Brian J. Levin is in the Real Estate Department of Fox Rothschild LLP, resident in the firm's Philadelphia office. He focuses his practice on general real estate matters, including leasing, sales and acquisitions and financings. Levin can be reached at [email protected]. Phone: 215-299-2838.

In a typical commercial lease, a landlord will require a tenant to carry a minimum amount of general liability insurance (e.g., $3 million per occurrence and $3 million general aggregate) and will also require that the insurance carrier meet certain standards, such as a minimum policyholder rating and financial size (as rated by an agency such as AM Best). In many cases, the tenant will agree to obtain the required insurance from a commercial insurance company. However, there are tenants that will request the right to “self-insure” or to insure through the use of a “captive insurance company.” This article addresses what it means for a tenant to self-insure or obtain insurance through a captive, and how a landlord and tenant can modify their lease accordingly.

Self-Insurance

What is self-insurance? It simply means that a tenant has set aside a reserve of cash to cover potential future losses. As claims arise, a tenant will use those funds to pay the claims. In some cases, a tenant may elect to insure through a combination of self-insurance and commercial insurance. Typically, the most predictable losses of the risk are retained and self-insured, forming a first or “working” layer of cover, and a stop-loss or stop-gap policy is purchased from a commercial insurance company. The commercial insurance company then pays for losses above the specified self-insurance limit per loss, thereby stopping the cost of losses to the self-insured above the retained values. Effectively, the losses paid for by the insured before the stop-loss policy pays becomes the deductible layer. Some risks, including Workers' Compensation and auto liability, cannot be self-insured without being approved by the state in which the risk to be insured is located. General liability may be self-insured without state approval.

Captive Insurance Companies

Captive insurance companies, on the other hand, are those established with the specific objective of financing risks emanating from their parent group or groups, although they sometimes insure risks of the group's customers as well. Using a captive insurer is a risk-management technique by which a business forms its own insurance company subsidiary to finance its retained losses in a formal structure. A “single-parent captive,” which insures the risks of its non-insurance parent or affiliates, is essentially a form of self-insurance, as the captive insures only the risk of the insured and its affiliates. In many instances when a captive is set up, a “fronting agreement” will also be in place.

A fronting agreement is one between the captive and a commercial insurance company, licensed in the state where the risk to be insured is located, under which the insurance company agrees to issue a policy to the insured. Under the fronting agreement, also known as a reinsurance agreement, the risk is then transferred from the fronting company to the captive. The end result is that the risk of coverage lies with the captive, but the insurance policy is issued on the paper of the commercial insurance company. Essentially, claims against the insured are covered by the captive, and the fronting company acts as a backstop to cover amounts, up to the limit of the policy, in excess of what the captive can cover. When the captive has entered into a fronting agreement, a landlord will get an insurance certificate or duplicate copy of the policy showing the commercial insurance company as the carrier, even though the risk is really covered by the captive. In those instances, provided the third-party carrier meets the requirements set forth in the lease, the landlord should be satisfied that the required coverage has been obtained in accordance with the terms of the lease. If no fronting agreement exists, the captive will issue the policies and certificates in its own name as the insurer.

Landlord's Concerns

While the use of a self-insurance plan (“SIP”) or a captive may have its advantages from the tenant's perspective (i.e., lower premiums, more control by the insured over its insurance program and more efficient claims management), it raises certain concerns for a landlord, all of which should be discussed with the landlord's risk manager or insurance adviser. The major concern for a landlord is the financial risk taken by the tenant (and/or guarantor, if any), particularly when the tenant does not obtain a commercial insurance policy (either a stop-gap policy in connection with an SIP or a reinsurance policy in the case of a captive). When a tenant purchases insurance from a third-party carrier, there is typically a deductible associated with the policy. The amount of the deductible is the maximum amount that the insured would have to pay in connection with any claims, thereby limiting the financial risk borne by the insured.

Ideally, a landlord would also like to limit the financial risk assumed by a tenant that self-insures or insures through a captive. However, if a tenant self-insures without a stop-gap policy, or sets up a captive without a reinsurance agreement, the tenant (or its parent company) is essentially self-funding the entire insurance amount and thus is at risk for the entire amount of any claims, not just the amount of the deductible or self-insured retention. In those situations, the landlord should be particularly concerned about the financial strength of the tenant and/or the entity funding the captive, as the case may be, and whether or not the SIP or captive is sufficiently funded to cover any potential claims brought against the insured. Thus, the landlord should carefully review financial information for the insured (including the SIP), the captive and the entity that funds the captive, be it the tenant, the lease guarantor, if any, or another entity.

Another reason a landlord should require a fronting arrangement is the possibility that a large number of claims in any one year against the tenant entity (particularly if that entity has numerous leases around the country or is in a high risk business) could drain the captive of its assets, a situation less likely to occur when the tenant obtains coverage through a third-party carrier, given the presumed financial stability of the third-party carrier (barring a catastrophic event such as Hurricane Katrina). This is more likely to occur in cases where the captive provides multiple lines of coverage for the insured, such as liability, director's & officer's, auto and workers' compensation.

Drafting the Appropriate Lease Provisions

If the tenant obtains its liability coverage through the use of a SIP and a stop-gap policy is in place, the landlord should require a limit on the insured's self-insured retention. For example, if the landlord requires the tenant to carry $3 million of general liability insurance, the landlord may limit the self-insured retention to $1 million. That will cap the tenant's exposure at $1 million and the third-party carrier will cover the balance of the claims up to the policy limit. The landlord should also have the right to review documentation for the SIP from time to time to ensure that the SIP is being sufficiently funded.

If the tenant obtains its liability coverage through the use of a captive and a fronting agreement exists when the lease is signed, the insurance provisions of the lease should require that the fronting agreement remain in place throughout the term of the lease and that the certificates of insurance identify the commercial insurance carrier as the insurer. If the fronting agreement is terminated or expires during the term of the lease, the tenant should be required to obtain its coverage from a carrier that meets the criteria set forth in the lease.

If the tenant elects to self-insure and does not carry a stop-gap policy or if the captive does not have an agreement with a fronting company and will not agree to enter into such an agreement, the insurance provisions of the lease must be modified accordingly. One solution is to set a minimum net worth (or minimum capital and surplus) for the tenant (in the case of an SIP) or the captive, and a minimum net worth for the party that funds the captive. A determination as to the appropriate net worth should be made by the landlord after reviewing all of the relevant parties' financial statements. To confirm that the net worth/capital and surplus test(s) are being met, and that the SIP or captive is being adequately funded, the landlord must have the right to receive and review financial statements for the tenant, the captive and the party funding the captive throughout the term of the lease.

A sample lease provision, under which the lease guarantor funds the captive, is as follows:

Tenant shall have the right to maintain the commercial general liability coverage required above through an affiliated entity, a captive insurance company, XYZ, Inc., a __________ corporation (“XYZ”); provided that (i) XYZ at all times maintains at least _________ Dollars ($____________) in total capital and surplus and (ii) Guarantor at all times maintains a tangible net worth of at least ____________ Dollars ($________). In the event that (i) Tenant no longer obtains the commercial general liability insurance required above through XYZ or (ii) XYZ fails to meet the aforementioned capital and surplus test or (iii) Guarantor fails to meet the aforementioned net worth test, Tenant shall obtain such coverage through an insurer with a policyholder rating of at least A- and a financial size category of at least Class VIII as rated in the most recent edition of “Best's Key Rating Guide” for insurance companies. Within fifteen (15) days after delivery of written request from Landlord, Tenant will furnish XYZ's most recent audited financial statements (including any notes to them) to Landlord, or, if no such audited statements have been prepared, such other financial statements (and notes to them) as may have been prepared by an independent certified public accountant or, failing those, XYZ's internally prepared financial statements certified by an authorized officer of XYZ. Tenant and XYZ will also discuss XYZ's financial statements with Landlord, or Landlord's representative, as reasonably necessary.

Conclusion

When a tenant obtains its liability insurance from a third-party carrier, particularly one that meets the landlord's rating and size requirements, the landlord can generally be comfortable that the tenant will maintain the required coverage throughout the term of the lease, assuming the tenant pays its premiums. If a tenant requests or requires the right to self-insure its liability coverage, particularly the right to do so through a captive insurance company, a landlord must do its due diligence to understand the implications of allowing the tenant to do so rather than procuring such insurance through a traditional third-party insurance carrier. That due diligence should include a thorough review of the financial statements for the tenant, the captive and the entity that funds the captive. Given the specific nature of the issues involved, a landlord should also have its insurance broker or risk manager involved in the process as early as possible and, if necessary, in direct contact with the tenant and/or the tenant's insurance adviser to resolve any issues.

Brian J. Levin is in the Real Estate Department of Fox Rothschild LLP, resident in the firm's Philadelphia office. He focuses his practice on general real estate matters, including leasing, sales and acquisitions and financings. Levin can be reached at [email protected]. Phone: 215-299-2838.