Captives Gain New Shine

The number of captives formed globally during 2001 grew by 6% to 4,723 companies, more than double the annual growth rate experienced the year before, according to the A.M. Best 2002 Captives Directory. Notably, net written premiums channeled through captives in 2000 jumped by 29% year-on-year to US$50.2 billion.

A report released by the Insurance Information Institute (III) notes that self-insurance within the U.S. is now an annual US$100-$130 billion industry, amounting to roughly half of all commercial risk dollars. The III report drew focus to A.M. Best research indicating that the move of commercial risk dollars to alternative risk transfer (ART) has grown from 30% of the total in 1996, to 40% by the end of 2000, with this trend likely to maintain impetus to reach 50% by 2003. “Interest in alternative mechanisms, which dampened during the 1990s when commercial coverage was plentiful, revived as insurance rates began to rise in 2000, an upward spiral that accelerated in the wake of the 9/11 terrorist attacks.”

While captives are only one facilitating form of ART – and due to setup costs tend to be a long-term final solution – the dramatic growth in new formations last year suggests that large corporate insureds are exiting traditional insurance, says Carole Pierce, author of the A.M. Best Captive Directory. She says last year’s increase in captive formations is a 10-year record. While captive growth was evident throughout last year, the pace accelerated markedly in the fourth quarter as insurance rates spiraled upward in wake of the terrorist attacks.

In total, about 316 new captives were formed globally last year, with Bermuda attracting more than a third of the total number, representing about US$24 billion in net written premiums (reflecting year-on-year premium growth of 36.6%). Perhaps the biggest captive-related item in the media this year was the announcement that the North American airline industry through the Air Transport Association has established a Vermont-based captive – “Equitime” – which will handle third-party liability claims for its members. This self-insurance move was motivated by a fallout between the airlines and insurers over cover pricing in the post-9/11 environment. A similar move is afoot in Europe, which ultimately could result in billions of dollars being lost to the traditional insurance market.

A.M. Best is currently compiling 2001 premium and surplus values for captives, however, Pierce is confident that net written premiums directed through these vehicles last year will exceed the 27% annual growth rate recorded for 2000.

Pierce expects 2001’s growth in captives is just the tip of the iceberg, as these numbers mainly reflect formations that had been in the works before 9/11. Part of the momentum behind captive growth is also coming from within the insurance industry, she notes, as brokers and insurers follow the “premium trail” in providing special risk solutions. Overall, this year and 2003 will likely show a dramatic jump in new captive formations, she predicts. “There is more activity now in ART and captives than the hard market of the 1980s. Risk managers are a lot more aware of what is available [other than traditional insurance] to them.”

CANADIAN DEMAND

The A.M. Best 2002 Captive Directory suggests that the number of Canadian-owned captives declined marginally last year to 145 entities compared with 149 from 2000. Nearly 60% of Canadian captives are registered in Barbados (see chart), which has a tax treaty in place with Canada. Although some of the tax advantages available to Canadian companies registering a captive in Barbados have been tightened up over recent years, specialty risk solution consultants note that the financial incentives available through the domain are still very attractive for corporations.

Does the decline in Canadian captives for 2001 indicate that corporate insureds are less interested in self-insurance? Hardly, the specialty risk solution consultants say in pointing out that the handful of entities shut down in 2001 resulted mostly from corporate mergers and acquisitions. Last year saw a significant number of mergers and acquisitions just in the oil/energy sector alone, which is a major source/user of offshore captives, notes Bill Chan, vice president of alternative risk solutions at AON Reed Stenhouse Inc.

Chan says significant interest is being shown by corporate clients in captives, as well as in ART solutions in general. This interest had been gathering steam before 9/11, he notes, as insureds began looking at their coverage options in anticipation of the hard market. The sudden turn in market conditions after the terrorist attacks really opened the doors, he adds. That said, Chan believes there is a changing mind-set in the risk management community from being reactionary to anticipating. Risk managers and corporate management are a lot more knowledgeable of what ART represents and can do for them beyond just being an insurance tool. “Whether it’s a hard market or a soft market, companies are beginning to think in terms of a long-term strategy. They want to get off the ‘insurance roller-coaster’.”

Although captive and ART queries are up, this activity has not yet translated into new captive formations, Chan says. Initiating a feasibility study and taking it through to implementation is a two to three stage process, he explains, with much of the time taken by risk managers to convince senior corporate management to “buy in” to the value. “I think many companies are now at this stage.”

Typically, the creation of a captive from drawing up a feasibility study through to actual setup takes about 12 months, says Chan. As such, the increased attention shown toward the end of 2001 and this year will likely show up in new formations in 2003. “My guess is we will see a slight increase in Canadian captive numbers this year, but there will be a big jump in 2003.” Chan notes that premiums moving out of the insurance market into long-term self-insurance mechanisms like captives seldom move back to traditional coverage.

“We’re seeing a lot of enquiries into captives, although this has not resulted in that many new captives being formed,” comments Karen Gillespie, specialist of alternative risk transfer at Zurich Canada. Most of the enquiries have been made by corporations with annual revenues of over $300 million, she adds, with many of them having foreign exposures.

A big driver behind the current interest in captives is the lack of cover in certain specialty lines as insurers have withdrawn capacity in the new hard market era. Although interest in captives was on the rise before 9/11, and very much so post the terrorist attacks, Gillespie believes that the current activity in new formations began with risk managers anticipating the turn in insurance pricing. “Companies [insureds] want more control over their claims, and they are looking for stability in pricing.” She says that, just based on Zurich’s experience, a number of Canadian companies have been engaged in captive feasibility studies and are now ready to proceed. “I know of at least three companies doing so.”

NO ALTERNATIVE

“I think there will be a move of premium from the traditional insurance market [into ART programs],” says Mike Wills, manager of specialty solutions at Royal & SunAlliance Insurance Co. of Canada. Royal & SunAlliance moved out of ART services about two years ago, he notes, to focus on core insurance activities. However, he believes opportunities do exist in the ART field based on current insurance market conditions. “I’ve seen through discussions with risk managers that there is interest [in ART and captive solutions] because of where the [insurance] market has gone. People [insureds] are looking for stability and permanence in their cover.”

Furthermore, Wills notes that the restricted coverage limits, and sometimes complete lack of cover options, has left insureds with no alternative but to look at self-insurance mechanisms. “Just because there’s no cover doesn’t mean that the risk is just going to go away. Insureds have to react somehow. ” There is also a sense that there is a certain “permanence” to the hard market, and risk managers are looking at their risk cost in the long-term, he adds.

“Because of the current [insurance] market situation, the number of captive enquiries has gone through the roof. Many companies are carrying high risk retentions,” comments Edouard Moreira, vice president marketing at Willis Canada. Much of this activity is the result of insureds being forced to carry higher retentions which, relative to the price of cover, does not offer value. In some incidences, there is simply no cover available, he adds.

Moreira says he is already dealing with three Canadian companies close to actually forming captives – in other words, the process has gone “beyond discovery”. And, he adds, “there’s more committed clients in the process. I think next year’s captive formations will rise substantially as feasibility studies are put into practice. We should start seeing a dramatic increase from about mid-2003 through into 2004.”

Moreira notes that the shift to self-insurance and captives is not limited to just top-tier corporations. Typically, corporations interested in single-owned captives hold retentions of between $2-$3 million, he explains. A captive feasibility study costs money and ultimately requires time to implement, which means that any company moving forward is doing so with a long-term commitment. But, there are a lot of insureds out there looking for a more immediate and short-term solution to outride the hard market. Many of these companies lack the capital resources to meet regulatory requirements for establishing a captive. This has sparked interest in other ART solutions, as well as “protective cell captives” and “rent a captives” which do not require the same capital requirements as single-parent entities. Essentially, these hybrid type captives and other ART instruments are a “channel” enabling ensureds access to non-traditional coverage and risk sharing arrangements. Overall, Moreira comments, “smaller companies [insureds] are also temporarily moving out of the traditional insurance market into ART solutions.”

Moreira believes that the current interest shown in captives and ART is greater than during the 1980s’ liability crisis. This he attributes to a more sophisticated corporate insurance buyer, as well as broader advantages seen in forming a captive. “I went through the early 1980s [price] crisis, and there was a large shift in premium out of the traditional insurance market. Now, with the ‘enterprise risk management’ approach being applied by companies, captives are seen as being more than just a replacement for insurance.”

Although current statistics do not reveal the real demand for alternative insurance solutions, “I believe there is a push toward ART programs in Canada,” says David Westberg, a consultant at Tillinghast Towers-Perrin. At this point, he observes, most of the activity by risk managers has been focused on investigating options before them. As a result, not many companies have taken the ultimate step of committing to a long-term self-insurance program through a captive. “At the moment, insureds are looking at higher retentions and higher deductibles to contain insurance costs. However, if things are going to change, then it’s likely to happen in this market.”