Captives Go Mainstream

With the almost overnight hardening of the commercial insurance market following the 9/11 terrorist attacks, captives became a hot topic at risk management gatherings. Almost every corporation currently seems to be undertaking a captive feasibility study, and senior risk managers regarded as captive veterans have been bombarded with questions about what is involved in setting up this alternative form of risk transfer, they say.

Recently the “captive movement” came to Toronto, with the Strategy Institute’s “Captive Insurance Strategies” conference. The growth of captives in 2003 was dramatic, as alternative risk transfer (ART) plans developed through the recent hard market came to fruition. Worldwide, there are presently over 5,000 active captives, with about one-fifth of these domiciled in Bermuda, notes Kate Westover, vice president of Innovative Captive Strategies Inc.

According to a survey by the U.S.-based publication Business Insurance, total captive numbers in the top ten domiciles grew by almost 5% to 3,992 entities in 2003 from 2002’s 3,807 entities. The leading captive domiciles behind Bermuda are Cayman Islands, Vermont, Guernsey and the British Virgin Islands (see Chart 1). But, for Canadian organizations, Barbados is still the domicile of choice – 55% of Canadian-parent captives are domiciled there, notes Richard Ince, senior consultant with UI Management Inc.

The growth in captives seems a natural response to an insurance market where commercial buyers have faced steep price increases and limited availability of certain covers. In fact, growth in captives has largely occurred “wherever there’s a crisis in the standard market”, says Henry Witmer, managing senior financial analyst with A.M. Best, in interview. Such lines as medical malpractice and professional liability have been dominant in new captive formations, “because of the very public problem of a number of [insurance] companies in St. Paul leaving the market”, notes A.M. Best vice president John Andre.

But, perhaps the greatest change is one of “attitude”. Captives have become a standard business practice, says Robert Davis, senior vice president for ACE Captive Solutions. “They are becoming just as traditional as traditional insurance.”

Captives are less about a solution to the hard market than a long-term solution to weather the market and exercise loss control. Most corporations now take the approach of establishing a captive and using it as the market demands, notes Andre. “Having them [captives] available is just good business practice,” says Witmer. “If rates do soften, you have a period to build up capital.”

U.S. BELLWETHER

The U.S. provides a snapshot of the global captive explosion that has taken place since 2000. There has been an flood of captive legislation in the U.S. in recent years, with 25 states having captive legislation on the books currently, according to Leonard Crouse, director of captive insurance for the Vermont domicile.

Vermont is currently the leading U.S. domicile, recently marking its 700 license. But significant growth has also been seen in states including Hawaii, South Carolina and Washington. S.C. recently notched up its 100th captive license, while Arizona, just two years old as a domicile, just wrote its 33rd license, with Washington, which passed legislation in 2000, now having 32 captives.

Over the five-year period ending 2003, domestic U.S. captives saw net written premiums rise 45% year-on-year, with “admitted assets” increasing in value by 29%, according to an August 2004 report by A.M. Best (see Chart 2). At the same time, loss reserves grew annually by 35%, while surplus levels rose 2%. The rating agency had expressed concerns a year earlier about the economic state of captives – despite growth in new global captives in 2002, the demise of a large number of captives caused the market to remain flat. In the U.S. captive market, the loss ratio for all lines had risen to 62.2% in 2002, but “a significant turnaround occurred in 2003, where nearly all lines of business showed an improved pure loss ratio”, according to Witmer, the report’s author. He notes that many captives did increase premiums and become more selective about risks, mirroring trends in the traditional market. Despite the onset of softer market conditions in the traditional market, Witmer sees many corporations maintaining a commitment to their captive. “Over the next several years, if commercial insurance rates continue to decline, captives might lose a share of their business and will need to respond with lower rates or product enhancements. Nonetheless, with effective risk management and loss control programs, many will be more than able to maintain the commitment of their parents and sponsoring organizations who view their captives as the more appropriate means to insure their risks for the long term.”

LONGER-TERM

The “classic captive” is established by the parent corporation as means to “smooth out the peaks and valleys” and deal with high frequency-low severity losses, explains Harold Chmara, vice president of tax & risk management for Hudson’s Bay Co. Beyond the ability to transfer risk during a hard insurance market, Chmara says the captive can also act as a bargaining chip. Referring to the HBC captive in B.C., he notes, “just having that domestic captive in place does give a bit of a tool in negotiating with insurance companies”.

But, sources agree that captives cannot be a “knee-jerk reaction” to temporary insurance market headaches, primarily because of the high cost associated with setting up a captive. “If you get into a self-insurance program of any sort, it is essential to have a long-term commitment by your corporation,” stresses Peter Kelly, Western regional director for Willis Canada. “The benefits are rarely short-term.”

That said, Kelly is a big proponent of captives, and says that for “expected losses” they are preferable to commercial insurance. “If you have a group of losses you can put a handle on, finance them, don’t insure them.” He adds that given the timidity of insurers concerning “the next big oops” or unexpected risk which could blow up in insurers’ faces, “I don’t think we’ll ever get back to a real soft market”. Insurers may be somewhat behind the times in terms of what risks they are prepared to handle, he adds. “Business risk has become more complex and less bricks and mortar focused. The insurance industry is still insuring bricks and mortar.” Kelly notes the most public corporate failures have resulted from risks that were not concerned traditional insurance territory.

Furthermore, Kelly says risk managers he has spoken to are concerned by more than just price and availability with regard to the traditional insurance marketplace, and are turning to captives out of frustration with insurer service levels. “I can’t tell you how many risk managers I know who are seeing renewal decisions being made at four o’clock the day before expiry.” And, he observes, “they are tired of the inconsistent claims philosophies of insurers”.

Claims control is a major factor tempting corporations to establish a captive. Kelly refers to cases where self-insured mechanisms have allowed organizations to put 92 to 95 of every premium dollar toward paying claims and implementing better risk controls.

TAX HAVENS?

Traditionally, captives have been viewed as a taxation reduction strategy, but sources say the potential tax benefits should never be the driving force behind captive formation. “Tax should not be the primary reason for forming a captive,” Ince stresses. “Tax benefits are only a day away in the legislature.”

An example of the ever-changing nature of tax structures occurred with the removal of the U.S. federal excise tax in the mid-1980s, a move which sparked significant growth in Barbados as a domicile for U.S.-parent captives. With the reinstatement of the tax in 1987, “we shifted our gaze to Canada” in terms of growth opportunities, Ince says, although Barbados again has its eye on the U.S. market. As such, Ince says in the last negotiation of Barbados’ tax treaty with the U.S., h e witnessed a “tightening of the loopholes”. Westover adds that this is part of an overall push for tax harmonization at the global level.

Many of the nation’s which are home to captives have come under heat from the Organization for Economic Cooperation and Development (OECD). In the 1990s, the OECD published its “Harmful Tax” paper, explains John Lawrence, director of financial services for one of the newest domiciles, Anguilla, just one month old. He says the paper looked at three key issues: “ring fencing”, disclosure and information exchange of external tax structures. “The sore point for us [as captive domiciles] was that the OECD seemed to be singling out offshore jurisdictions as tax havens, rather than member states of the OECD.” Specifically, this applies to the issue of “ring fencing” and the OECD’s contention that local taxes should be on par with those charged to offshore corporations.

The OECD pressure to regularize local and offshore taxes has become less intense, sources say. “The reason this issue has receded is because it tended to be raised by first world countries,” says Michael Oliver, director of insurance for the British Virgin Islands (BVI). The question became whether those member states of the OECD could demonstrate that their tax systems were more fair than those that were being targeted.

In Canada, the latest tax development is the foreign investment enterprise (FIE) tax. “People still don’t have a good idea about how this is going to work,” observes Chmara. While the Auditor General sees the program as a tax scam, other government departments see a value in having such treaties and paving the way for off-shoring, he says. The FIE is a tax based on accrued interest on capital, rather than on profits which are repatriated to Canada, explains Fred Borgmann, partner at Price Waterhouse Coopers. He notes that this system, if passed, could be beneficial in the case of protected cell captives, who are currently subject to the harsher foreign accruel property income (FAPI) tax.

GOOD FRONT?

Another key factor in forming a captive is the need for “fronting”. In the case of B.C., the inability of the domicile to gain recognition in other provinces means that risks outside the province transferred to the captive fall under the definition of unlicensed insurance and will face the punitive premium taxes some other provinces levy on such coverage. This has been one key force hampering the development of the B.C. domicile, which currently has 12 captives and five reciprocals, explains Douglas McLean, manager of provincial operations for B.C.’s Financial Institutions Commission.

Some coverages require a front, or an insurer who issues paper on risks covered by a captive so that they are deemed covered by an admitted carrier. From a regulatory perspective, some covers such as U.S. workers’ compensation or mortgages may require a local, admitted carrier on the paper. But, for some insurers, there has been a negative perception of fronting a captive. The thinking, Davis says, is “they’re taking business away from the traditional marketplace, [and the question is] ‘why should I aid and abet taking money from my own pockets?'”. But, this view is diminishing as captives become more accepted. “They are becoming just as traditional as traditional insurance.”

Fronting a captive can boost gross premiums and provide top-line growth for an insurer, and it is also a way of enhancing relationships with commercial clients, Davis adds. “Most of the ‘Fortune-1000’ companies have one captive or another”, he notes, which adds to the prestige factor of acting as a fronting carrier for such firms. However, there are also perils that fronting companies need to be aware of, he adds. This includes the effect of gross premium growth on the “net to gross” ratio, and the resulting boost to reinsurance recoverables, particularly in the current environment where financial analysts and rating agencies have a keen eye on recoverable levels.

The large-scale withdrawal of insurers in the traditional market following 9/11 was mirrored in the fronting market for captives – and the same was true for reinsurance and retrocessional markets which captives might have traditionally relied on for higher layers of coverage. “The fronting market didn’t dry up, but it was certainly restricted,” confirms Kelly. He says the biggest attraction for those still in the market is likely the opportunity to cover other risks in the corporation’s portfolio.

Notably, in a 2003 survey of captive insurers by the Captive Insurance Companies Association (CICA), fronting agreements were the top concern. That said, by 2004, reinsurance leaped forward to become captive owners’ biggest headache, according to the CICA. The absence of triple-A rated reinsurers, the cost and availability concerns, tightening terms and conditions, and the exodus of reinsurers from the domestic U.S. market are all challenging captive managers.

Despite these issues, Chmara says reinsurers are attracted to captives for the very reason risk managers are – loss control. “I’ve had some captives say reinsurers wanted to stick with them through the long haul because of they have good, strong risk management and loss control.”