Alternative Risk Transfer: CAPTIVES GAIN GROUND

Growth in the formation of captives for self-insurance and the facilitation of alternative risk transfer (ART) transactions is expected to rise by 5% per annum through to the end of 2005, according to rating agency A.M. Best Company. Specifically, the rating agency expects the current hardening of commercial insurance rates across North America to add impetus to this drive with a greater number of mid-sized companies withdrawing risks from the traditional insurance market. And, despite the almost record weakness in the average level of commercial insurance rates of last year, new captive formation and the flow of premiums through these vehicles remained robust with the number of new Canadian-sponsored captives outstripping the global formation growth rate by almost double. Should Canadian insurers be worried by this development? Yes and no, say the experts.

The number of new captives formed globally last year rose by 94, or 2.5%, to a total of 4,355 captives, according to rating agency A.M. Best’s Captive Directory 2000. The annual survey — which is carried out in conjunction with research agency Tillinghast-Towers Perrin — indicates that the formation of new Canadian-sponsored captives last year grew at a considerably faster pace of 5.4%, or 10 new captives, to a total of 155 (see chart).

Last year’s growth in captive formation was achieved despite the extremely soft commercial insurance market in North America, the rating agency observes. And, the growth recorded in last year’s numbers extends further to show a 15.2% rise to US$28 billion in the level of net written premiums channeled through captives. The capital and surplus held by captives also rose by nearly 30% year-on-year to US$70 billion with invested assets rising by 11% to US$137.5 billion, according to the report. “Contributing to 1999’s strong captive premium growth is the continuing trend of adding third-party business to single-owner captives and increased captive participation from small middle-market companies, especially rent-a-captives,” says A.M. Best author Carol Pierce.

Pierce, as well as several other commentators in this article, believe that the interest in captives will increase in coming years as the traditional insurance rate cycle turns. However, the demand for captives is also being driven by increased sophistication of the global corporate world and new risk coverage opportunities opening up through ART programs. In that respect, opportunities exist for insurers and brokers to participate with insureds in managing captive risk programs. “While I expect to see further contraction of the traditional commercial insurance market as captives continue to grow, there is definitely a lot of action by the brokers wanting to get in — this will enhance the attraction [of captive growth],” Pierce notes.

However, the over-riding drive behind captive growth is the desire by corporations to gain long-term pricing stability with regard to their risk programs. While many of the upper-tier corporations switched to captives in the 1980s during the liability rate crises, most medium size enterprises remained within the traditional insurance market — which worked to their advantage during the most recent “12 soft years” insurance cycle. The stimulus for future captive growth will largely come about from a broad movement by these mid-sized enterprises into alternative risk funding (ARF) programs requiring relatively high retention levels. “Due to the competitive global business environment, low-risk companies today form captives to defend against the negative financial effect of even moderate premium increases. An example is seen in the U.S. workers’ compensation market, where commercial insurers have reported rate increases of up to 25% in response to the unfavorable loss-cost trends over the past three years,” Pierce observes.

According to the A.M. Best Captive Directory, the British Virgin Islands saw the highest number of new captive formations with 51, while Vermont and Cayman each recorded a 40% increase in premium flow. Barbados, which is still the most popular Canadian domicile, remains a fairly small market — although it did account for nearly all of the new Canadian-sponsored captive formations of last year. There are now 89 Canadian captives located in Barbados.

Overall, the top four captive domiciles are (in order) Bermuda, Cayman, Vermont and Guernsey — accounting for over 60% of captives globally. The A.M. Best report also shows that of the 4,199 active captives of last year, 21.5% of them are group owned, 77% are single parent captives, and 1.5% of them are “unclassified”.

New perspective on risk costs

“The [U.S.] property and casualty insurance market is unquestionably beginning to increase the pricing of nearly every commercial insurance policy,” notes William Granahan of Boston-based risk management consultants Milliman & Robertson Inc. In addition, Granahan adds, “What is even more disturbing to the buyer is that they are also increasing selected retentions and deductibles, reducing some coverage, and even denying or non-renewing certain classes of risk”. As a result Granahan is forecasting U.S. property premium hikes this year of between 15% to 20%, and liability and umbrella-type policy rate increases of 10% to 20%.

Against this backdrop, the risk management consultants are expecting a shift by corporations from traditional insurance to self-insurance programs. ARF programs, which usually entail the establishment of a captive, will likely increase in popularity, they predict. However, Granahan notes, “while most ARF programs include a substantial retention level, it is normally only a partial transfer of risk that includes elements of a traditional insurance program and the use of reinsurance”. The expected growth in ARF should therefore be seen as an opportunity by insurers and brokers, comments Mike Wills, leader of Royal & SunAlliance’s (Canada) Specialty Solutions division. By participating in the management of these programs, insurers can tap into a multi-billion dollar market, one which is growing far more rapidly than the traditional insurance sector, he adds. “I think if a company is going to consider establishing a captive, the risk manager(s) will be looking for underwriting expertise of insurers and brokers. As we see further integration of traditional and non-traditional risks, or non-tangible and tangible risks, market opportunities will open up.” An area likely to receive attention in the future is insuring against cyber-related risks which the market pricing of premiums in the traditional insurance market is currently seen to be excessive.

Dean Cox, vice president of alternative risk transfer at Zurich Canada confirms that integrated risk thinking is bringing about heightened interest in captives. “A lot of companies now have an appetite for retentions and this will add to the growth in captive formations and ARF programs. However, although people [companies] will keep moving in this direction, I don’t think the shift will be dramatic.”

From a Canadian perspective, Cox says few companies operating offshore captives have embarked on underwriting third-party business, unlike the trend in the U.S. which has seen an increasing number of single-owner captives taking on outside risks. The difference between the Canadian and U.S. use of captives is largely a result of tax consequences, he surmises. However, Canadian captive owners are adopting a broader vision to their corporate risk exposures, with many of them bringing in non-traditional risks such as human resource business into the captive, Cox observes.

Lance Ewing, a member of the Risk and Insurance Management Society’s (RIMS) executive council, concurs that a hardening insurance market will spark further interest in captives. “Certain industries will look at captives, particularly through pooling [group captives]”. Also, he notes, “some companies ‘mothballed’ their captives during the soft market cycle, and I think these will be dusted off if premium rates continue to rise”. Furthermore, he points out, when the insurance cycle turns,
there tends to be a “creative rush” by risk consultants and insurers to develop alternative risk financing solutions — this will likely see further growth in ARF and ART programs if the commercial insurance market really does turn this year.

However, Ewing believes that much of the growth in captive use of last year has to do with global mergers and acquisitions. He does not believe that premium rate increases so far seen in the North American market have been that much of a driver. “The first issue in every risk manager’s mind when considering self-insurance options is to look at the bottom-line loss control. I think we will see large deductible options through traditional insurance emerging before companies turn to captives — that is the last resort.”

That taxing issue

Qualifying for tax deductibility is the biggest issue facing the captive industry, comments Derick White the assistant director of captives for the Vermont Department of Banking, Insurance Securities and Healthcare Administration at the recently held Vermont Captive Insurance Association Conference.

The significant shift of corporate capital to offshore captive domiciles over recent years has attracted the attention of the U.S. congress as well as the Organization for Economic Cooperation and Development (OECD). An U.S. congressional investigation is underway in an attempt to block certain U.S. reinsurers with local subsidiaries but operating through Bermuda-based captives to continue shielding their premium inflows from taxation. The OECD also recently issued a list of 10 “tax havens” believed to be engaged in harmful tax practices which, unless these domiciles bring their tax structures into line with that of OECD members, they will ultimately be subject to economic sanctions. Guernsey and Barbados are the largest domiciles on the OECD’s black list. And, discussions have been underway between the Canadian federal tax department and the Barbados government for several years now with the view of tightening up against tax loopholes.

Overall, most of the commentators in this article believe that the “uncertainty of tax dangers” will suppress any significant growth in offshore captive formation. Ewing does not believe, however, that current attempts by the U.S. legislator to block offshore captives will be successful. Between the various lobbyist activists, he expects the business clout of the Fortune-500 corporations will hold sway in maintaining the status quo.

The U.S. tax issue has, however, spurred a greater number of captive owners in Bermuda to take on third-party business, says Scott Bradley, director of Swiss Re New Markets in Bermuda. And, as White notes, “if you can have enough unrelated business in your captive, then what you own is a regular insurance company, and you can deduct your own premiums to your own captive in addition to other premiums that other people are paying to your captive”. This has been a major driver in the recent restructuring of U.S. captives, although the tax issue is presently less of a risk to Canadian captive owners. From a Bermuda perspective, Bradley says new captive formation and establishment of ARF programs remains robust despite the uncertainty on the taxation front. “Through this growth, we are increasingly seeing risk sharing between insurers and insureds through captive programs.”

Barbados uncertainty

“There is presently a lot of uncertainty in the Barbados market on the tax front,” comments Vinston Hampden, principal officer for AON Insurance Managers (Barbados). Essentially, there are two factors undermining confidence, the OECD “tax haven” list and negotiations underway between the Barbados authorities and the Canadian government. A double tax agreement exists between the two countries, hence the attraction the island has for Canadian companies. However, the Canadian government introduced amendments to offshore tax legislation in 1995, tightening up many of the qualifying requirements on the tax deductibility of premiums flowed through an offshore captive. Since then, the Canadian tax authorities have openly stated their intent to further limit the tax deduction qualifications. Latest rumors on Barbados suggest that such changes will be introduced by the end of this year, Hampden says.

As for the OECD report, Hampden adds, “I’m hoping the impact will be limited. The Barbados government is already involved in discussions with the OECD and I expect a satisfactory conclusion will be reached before the organization’s compliance deadline of next year.”

Nicholas Crichlow, principal officer of Marsh Management Services, is also fairly optimistic of a quick and satisfactory conclusion to the OECD discussions. “Although the government [Barbados] has not yet issued a clear statement to what they intend doing in the short-term, I expect to see some action shortly and believe that the domicile will continue to offer attractive business incentives while meeting the OECD’s requirements.”

And, despite the tax uncertainty, Crichlow says the island has experienced ongoing growth in captive formation, with much of the demand coming from smaller and mid-sized companies. “There has certainly been an increase of smaller companies participating in rent-a-captives.” That said, as Cox of Zurich Canada observes, “gaining clarity on the tax front will definitely enhance the growth possibilities of captives”.