Captive & Art Growth: Corporate Retentions Rise in Wake of the Hard Market

The number of new captives formed globally during 2002 rose year-on-year by 32% to a record 462 entities, according to data collected by rating agency A.M. Best. Just as importantly, the captives tracked in A.M. Best’s “Captive Directory 2002” show a 20.7% increase to US$61 billion in net premiums written for 2001 compared with the previous year’s US$50.5 billion. The rating agency notes that the growth in premiums for 2001 is unlikely to reflect any significant rise in corporate retentions as is expected to be the case for 2002 and this year in response to the capacity shortage and hard market pricing that gained a firm hold within the traditional insurance industry over the same period. “A.M. Best doesn’t believe that increased retentions contributed significantly to the net premiums written and invested asset growth that occurred during 2001. For most captives, their 2001 reinsurance programs were in place before the fourth quarter when the reinsurance market tightened considerably. A.M. Best expects this situation has changed dramatically for 2002 and 2003,” says Carol Pierce, author of the A.M. Best Captive Directory 2002.

As such, the rating agency has affirmed its statement made in 2002 that by the end of this year roughly 50% of total U.S. commercial risk dollars will have migrated from the traditional insurance sector to the global alternative risk transfer (ART) market. This compares with approximately 40% of total U.S. commercial risk dollars for 2000, and about 30% of the total for 1996. A report released by the U.S.-based Insurance Information Institute (III) in October this year points out that, based on research by Swiss Re, the global market for “alternative carriers” (self-insurance, captives, risk retention groups and pools) reached US$88 billion in premiums for 2001. The reinsurer expects that this alternative market will grow by about 10% annually through to 2005. Notably, Swiss Re’s total estimate for 2001 premiums breaks down to US$44 billion for “self insurance” and US$38 billion for “captives”.

Global captive growth

Although 2002 saw a record number of new captive formations, the net increase in total active captives by the end of that year grew by a moderate 1.1% to 4,526 entities compared with the 4,521 active entities at the end of 2001, according to A.M. Best (see chart: “New captive formations vs. liquidations”). Pierce ascribes this almost “flat growth” to the demise of several captives owned by corporations caught up in the “big name” financial scandals that emerged through 2001 and 2002. “The captive industry was by no means immune to the problems of Arthur Andersen LLP, Enron Corp., Tyco International Ltd., and WorldCom Inc. Each of these companies had one or more captives that went the way of their parent, thereby increasing the number of captives put into runoff and eventually liquidation during the year [2002].”

However, Pierce observes, “…regulators in the major domiciles advise that they continue to see a significant number of new [captive] applications in 2003”. A major driver behind new captive growth in 2002 was the greater availability of “segregated cell” entities. Cell captives operate on a similar concept to “rent-a-captives” in that the entity is owned by a third-party (usually the large commercial brokerages) and its use is provided to numerous participants for a fee. The main advantage with rent-a-captives is the reduced overhead cost associated with single-parent captives. Cell captives have an additional advantage in that the assets of “each cell” owned by the various participants are protected from liability of the other “cells”. Such innovation in the captive market has expanded access to smaller corporations, she notes. “Continued developments in captive structures via segregated-cell companies is expanding captive’s reach even further.”

Cell captives are estimated to have grown by 20% year-on-year for 2002, Pierce says. Notably, the III report notes that, “such mechanisms [cell captives] accounted for some 10% of new captive formations last year. Overall, the number of segregated-cell companies increased 20% in 2002, with Guernsey and the Cayman Islands recording a combined growth of 45.8% [for 2002].”

The increased availability of cell captives through the Cayman Islands, combined with the domicile’s perceived expertise at dealing with healthcare and medical malpractice insurance (which saw a dirge in traditional insurance capacity last year), resulted in the domicile recording the highest growth rate in new captives for 2002, Pierce notes. The Cayman Islands saw its new captive formations rise by 21% year-on-year for 2002, followed by Bermuda at 17.1%, Vermont at 15.2%, Guernsey at 10.6% and the British Virgin Islands (BVI) at 9.7% (see chart: “Top 10 domicile locations of new captive formations”). In response to the demand for cell captives that emerged in 2002, A.M. Best says, “A.M. Best expects that the captive industry will continue to reinvent itself. A.M. Best also expects the continuation of the flow of insurance risk from the commercial market that has occurred steadily over the past three decades.”

Vermont achieved the highest growth rate as an “onshore” captive domicile in 2002, with new captive formations topping 70 entities. Gross premiums channeled through the domicile also grew to a phenomenal US$7.2 billion for 2002 from the previous year’s US$5.1 billion, according to the Vermont’s department of “Economic Development”. Furthermore, Vermont reports that 37 new captives were formed in the first six months of this year compared with 26 new formations during the same period in 2002. Commenting at this year’s recently held Vermont Captive Insurance Association (VCIA) conference, Liberty Mutual Insurance Co.’s captive services unit president Scott Barry expects that interest in captives will diminish once insurance markets soften again. However, he believes that efforts by the various domiciles such as the VCIA and Hawaii to educate risk managers on the long-term benefits of forming a captive has created a more sophisticated pool of serious clients. “I think the captive industry will hold up well in the next soft market.”

Canadian captive growth

The number of Canadian-owned captives grew year-on-year by 2.8% to 144 entities by the end of 2002, according to the A.M. Best Captive Directory 2002. Notably, Barbados (which has a reciprocal tax agreement in place with Canada) saw eight new formations during 2002, reflecting a growth rate of 8.5% to 89 entities compared with the previous year’s 81 active entities. Overall, the percentage growth rate in Canadian-owned captives for 2002 is not only double that of the global growth rate, but comes of a decline shown for 2001 when several Canadian captives were liquidated (see chart: “Total Canadian captives worldwide”).

Although specific data relating to the premium income channeled through Canadian-owned captives was not made available by A.M. Best, it is notable that net premiums written by Barbados-registered entities rose by 35% year-on-year to US$7.3 billion for 2001. Canadian-owned captives account for nearly half of the total captives registered in Barbados, as tracked by A.M. Best.

Bigger Canadian pool

Canadian corporate interest in self-insurance mechanisms such as captives has not decreased this year in response to improved conditions in the traditional insurance marketplace, says Bill Chan, vice president of alternative risk solutions at Aon Reed Stenhouse Inc. “Buyers of insurance are more sophisticated [today] and don’t react as much to what they see as a ‘blip’ in the market. Forming a captive today has little to do with ‘hard market’ conditions, except that it’s easier in this kind of a market for risk managers to get the attention of corporate executives in floating the idea [of forming a captive].”

However, Chan agrees that this year’s fairly tight insurance marketplace, in terms of pricing, capacity and terms of coverage, has been a factor in the ongoing interest in self-insurance options. “There’s still good interest in alternatives to
traditional insurance, but not necessarily in captives.” Notably, much of the interest this year has come from smaller companies. “The interest has filtered down to smaller entities, companies that are too small to have their own captives.” Much of this activity has been in “mutual” captive arrangements, but specifically in “reciprocal arrangements”.

Reciprocals are not registered company entities, as is the case with captives, Chan explains, but rather constitute a legal agreement whereby the participants agree to cover each other’s losses. Since reciprocals are not companies and also do not offer tax advantages, many are registered domestically and therefore do not show up in self-insurance statistics, he notes. As a result, the growth in reciprocals over the past year is likely much greater than that reflected in captive numbers, he adds.

“Reciprocals are the ‘fix’ for the [corporate] mid-market,” confirms Dean Cox, vice president of alternative risk transfer at Zurich Canada. He agrees that the premium increases still demanded by traditional insurers is forcing a greater number of smaller companies to look at alternative options. The “mid-market” of commercial risks is where brokers have experienced the most problems in placing business in the traditional insurance marketplace, he adds. In response, the brokerages have promoted the idea of reciprocals and group captives, which Cox says could ultimately create instability as losses from some participants begin to emerge and therefore threaten the collapse of these arrangements.

From his perspective, Cox believes there has been far greater growth the past year in “retention programs” through indemnity agreements with insurers whereby the “risk” is ceded back to the insured. Although, he says there has also been a fair amount of interest in captives this year, mostly in cell captives. And, while growth in captives has not quiet met up to expectations touted about the market last year, Cox believes this has much to do with the fact that “insureds were caught unaware by the rapid pace and the extent of the price increases [introduced by insurers] during 2002. They didn’t have time to react. But, we are now seeing this activity – October and November this year has been busy as ever in self-insurance [enquiries].”

Most corporate insureds looking at self-insurance have opted for higher risk retentions by working with traditional insurers, confirms David Westberg, a consultant at Tillinghast Towers-Perrin. “It’s all about the amount of energy versus the cost,” he says in being the “deciding factor” that motivates companies to look outside of the traditional insurance marketplace.

However, the sharp reduction in coverage capacity available through traditional insurers over the last two years has fueled demand for alternative risk mechanisms, Westberg says. This has specifically been the case for certain industries like long-haul trucking, and generally within the liability lines of business. In some instances, certain business sectors have had little choice but to look at self-insurance group arrangements, he notes. Furthermore, while growth in captives during the liability crises of the 1980s was limited by the availability of cost-effective options for smaller enterprises, the situation today is different with the introduction of cell captives and rent-a-captives. “Then, there wasn’t any choice [to traditional insurance coverage], now there is.”