Insurance Pricing Boosts Captive Recovery

In a press release issued in early May, the American Council of Insurance Agents and Brokers announced the results of their first quarter survey. It showed rates rising significantly, with close to 90% of responding brokers suggesting that rates for the five commercial lines were already “somewhat hard” or “very hard”. In an environment like this, it is safe to predict sizeable growth in the alternative risk transfer (ART) market as companies try to find ways around firming prices. If captives managed to grab a significant share of the market share in the relatively soft 1990s, they should certainly come into their own over the next few years.

Premium growth in the North American alternative risk market has outpaced growth the traditional insurance factor in each of the past 12 years, according to data from rating agency, A.M. Best. By the end of 1999, the alternative market comprised nearly 40% of the total commercial marketplace. That number is expected to grow to nearly 50% by 2003. “Sustained price increases will only increase the likelihood that sophisticated insurance buyers will more seriously consider an alternative market solution over the mid-term,” said analysts in the 2001 edition of Best’s “Captive Directory”. The hardening market may drive many mid-size companies out of traditional insurance vehicles and into alternative risk funding programs. Once there, will they ever return?

An article published in CFO Magazine a few months ago is indicative of the current corporate mood. It tells the story of several companies that were “fed up” and decided to stop “paying through the nose” for insurance coverage. Explaining rent-a-captives in basic terms and positioning them as ideal structures for mid-sized firms paying $1 million to $2 million in premiums, the piece goes on to say that “with commercial property-and-casualty insurance prices up 5% to 10% this year, and headed for further increases, many alternative risk transfer strategies are being dusted off and reconsidered”. When chief financial officers have this sort of reading material in hand, insurers might start to look a little anxious.

Captive support

The numbers support the sentiment. There are now 4,458 captives listed in A.M. Best’s directory. 245 new captives were licensed in 2000 while 170 were liquidated, representing a net increase of 2.4% over the previous year. The top six captive domiciles remained the same, namely (in descending order) Bermuda, Cayman, Vermont, Guernsey, Luxembourg and Barbados. The British Virgin Islands displaced the Isle of Man, taking seventh place – this is due partly to their ability to compete on price, as the cost of establishing and maintaining a captive there is only half that of Bermuda and the Cayman Islands.

IRS gives way

William McCullough is Deputy Commissioner and Supervisor of Insurance for the British Virgin Islands, and he is also of the opinion that small and mid-size companies are driving the growth in captives. In a recent interview he said that he expected most growth to come from small captives, from a hardening workers’ compensation market and from innovative vehicles such as protected-cell captives. “There has been a considerable amount of interest in small captives, called C501s,” says McCullough. Companies who form C501s may apply to the IRS and deduct up to $350,000 of premiums from their taxes. The generation of juicy tax deductions, however, should not be the sole motivating factor when making the decision to form a captive.

A partner and head of captive insurance at law firm McDermott, Will & Emery in Chicago, Tom Jones warns that while a captive may have tax advantages for American companies, “that better not be the main reason why you take that route, or you’ll end up regretting it”. Although the IRS just issued Revenue Ruling 2001-31 in early June, officially abandoning its 24-year-old “economic family theory” basis for denying insurance status (and therefore premium/loss reserve deductions) for single parent captives, some uncertainty remains. A summary of the new ruling prepared by Jones explains that a captive “will remain in tax jeopardy if its parent directly or indirectly guarantees its or its policy issuing carrier’s obligations, or if the captive is undercapitalized and/or it operates in an ‘under-regulated’ jurisdiction”. The IRS ruling is a significant and promising sign for captives in the US, but Jones recommends caution rather than jubilation: “The likely long-term impact of this ruling is that, more than ever, intelligently structured captives will achieve tax success. But it will not permit tax-dodge captives to operate with impunity”

Black List

The “under-regulated” jurisdictions to which Jones refers have of late come under an increasing amount of scrutiny. In June of last year, the Organization for Economic Co-operation and Development (OECD), put together a list of 35 countries that engage in what the OECD termed “harmful” tax practices. In order to get off this black list, the OECD indicated that countries must “achieve transparency and effective exchange of information” and “eliminate any regimes that attract business without substantial business activity.” Some of those listed (such as Barbados, Guernsey, the British Virgin Islands and the Isle of Man) were, not surprisingly, also important captive domiciles. The OECD threatened to impose economic sanctions on those nations that failed to sign a Memorandum of Understanding within a year’s time.

The OECD’s edict may have dampened growth in offshore captives over the last year, but a change in U.S. government may help to bring an end to the uncertainty. While the Clinton administration had embraced the proposal as a way to fight tax evasion, the Bush White House has been less than enthusiastic. U.S. Treasury Secretary Paul O’Neill came out swinging, saying that he was “troubled by the underlying premise that low tax rates are somehow suspect and by the notion that any country, or group of countries, should interfere in any other country’s decision about how to structure its own tax system”.

Some cynics believe that it is not a question of principles, but of profit, that is at the heart of the Bush administration’s concerns. The U.S. government is said to be worried about the harm the OECD proposal may do to the growth of the U.S. financial services industry. Whatever the case, recent developments suggest that the U.S. may have managed to scuttle the initiative entirely. At a series of meetings in Paris in early June, the OECD finally succumbed to U.S. demands, and the parties reached a tentative agreement. The OECD would stop trying to punish so-called “tax havens” for offering financial incentives to foreign companies and investors, and the U.S. pledged support for an international campaign to force disclosure of account information in specific cases of suspected tax evasion. The global chill on offshore captives may be coming to an end.

Barbados treaty

Despite this global warming, the weather for captives in Canada remains comparatively frosty. British Columbia in particular has attempted to make itself attractive to non-residents, providing captives who insure non-resident risks with an exemption from provincial income taxes, thereby reducing the effective income tax rate to about 29%. That may sound grand to a Canadian accustomed to this country’s taxes, but it does not stand up very well against a “0% rate” on offer in Barbados.

Barbados, with which Canada has a tax treaty, is home to the majority of Canadian offshore captives. In the past, insurers were able to repatriate earnings to Canada without taxation because, generally speaking, income earned in Barbados was already subject to local income tax. The Canada Customs and Revenue Agency (CCRA), however, caught on to the fact that zero percent was not much of a local tax and decided to apply a less favorable interpretation of the treaty, insisting that Barbadian earnings be fully taxed once repatriated to Canada.

Hoping to keep its preferred position, Barbados introduced legislation to tax captives. There is still a zero perc ent tax for the first 15 years, but that is followed by a 2% tax per year from that point on, capped at an annual maximum of $5,000. In return for this onerous 2% tax, the government of Barbados waives the annual license fee – which, oddly enough, is also $5,000. In an advanced ruling addressing the issue, the CCRA saw through the move and bluntly dismissed the legislation “an attempt to disguise an annual license fee as an income tax in order to allow captive insurance companies to treat their income as exempt surplus”.

Big brother

Barbados is not the only loophole to have been closed. The “Foreign Accrual Property Income” (FAPI) rules have been tightened, meaning that income earned by all offshore captives is now subject to tax in Canada. A brief from the British Columbia Captive Insurance Association (BCCIA) explains that “insurance or reinsurance of Canadian risks will be caught in the FAPI net”, meaning shareholders will be required to report offshore income in their own taxable income calculations on a current basis. According to the BCCIA, “the insurance or reinsurance of non-Canadian related company risks will also be caught in the FAPI net, unless the captive employs six or more full-time people and its business is conducted principally with arms-length persons”.

David Louis, a prominent tax lawyer with Minden Gross Grafstein & Greenstein in Toronto, believes that the government is only starting to take action on the foreign reporting issue. “In the last few years, the CCRA has developed a formidable array of information-gathering tools, which can be kicked into high gear with powerful computer techniques”, warns Louis. ” I have heard that the CCRA has recently beefed up its personnel who will monitor these returns – big time. My prediction is that, in coming months, there will be heavy scrutiny on foreign reporting”.

Overcapitalization

Taxes are not the only area of concern for captives. At an IBC European Captive Convention that took place in London last year, one speaker explained how captive insurers could put themselves at risk by mismanaging capital. Ken MacDonald, the director of IRMG Risk Advisory Services in Europe, explained that many captives have a tendency to overcapitalize. “Holding excess capital in a captive can be very, very costly.”, says MacDonald. “Often captives have built up funds over the years, and their level of capital needs to be re-evaluated.”

A fear of overcapitalization and a drive for profits helped to push Lloyd’s of London out of the captive market altogether. In May, Roger Sellek, commercial director for the Lloyd’s market, said that captives (which often have tax considerations as a primary purpose) may not be as tightly focused on profitable underwriting as the for-profit syndicates that comprise the bulk of the Lloyd’s market. Unwilling to expose Lloyd’s “Central Fund” to additional liabilities by growing the market’s captive business, Lloyd’s decided that the best course of action was a quick exit.

Opportunities

Lloyd’s may be leaving, but others are gearing up for business. The A.M. Best survey predicts that traditional rent-a-captives will come back into fashion in 2001, creating opportunities for insurers and reinsurers alike. Rather than negotiate the minefield of risk, taxation and capital management on their own, many companies will opt for a rent-a-captive instead of trying to form their own corporate-owned captive. This allows them to have more control over losses and access to underwriting profit, but with a minimum amount of capital and management effort.

John Foehl, of Tillinghast-Towers Perrin, describes the rent-a-captive as “an affordable and profitable opportunity for middle market agents”. Foehl says that those trying to establish themselves as trusted advisers can not go wrong by bringing alternative risk transfer strategies to clients, as it is “the quintessential win-win situation”. A broker is not only able to offer additional value to clients in the transition to risk manager, but it is also an opportunity to build solid relationships by allowing them to share in the control of their risks. Of course, he also points out that working with a rent-a-captives is a potentially lucrative source of new revenue.

It may be some time before ART and captives gain widespread acceptance in Canada, but as the markets harden, brokers will be challenged to develop cost-effective solutions. Rising prices may well be the push to innovation that the industry needs. Tom Hopkinson, CEO of Canadian operations at Guy Carpenter, the reinsurance arm of Marsh Inc., “acknowledges” the dearth of Canadian alternative risk transfer (ART) activity at the moment. He believes, however, that “intermediary-driven products, creatively designed with client advocacy at the forefront, have considerable momentum”.

Worldwide captives locations

32% Bermuda

12% Cayman

9% Vermont

8% Guernsey

6% Luxembourg

5% Barbados

4% British Virgin Islands

4% Ireland

4% Isle of Man

9% All other Non-US

7% All other US

Source: A. M. Best