Originally published in June 2003
As the tally of Cayman Island captive insurers sails through the 600 barrier, Anthony Menzies of Hunter & Hunter goes back to basics in explaining why the captive option remains so enduringly popular.
With no end to the hard market in sight, it seems nothing can stop the onward march of the captive insurance industry. The demise of two of the main fronting carriers, Legion Insurance Company and Reliance National, and the withdrawal of many others from the market, have certainly created an almighty headache for the industry, but the problem is surmountable, or so it would seem. New innovations are in the offing, including at least one initiative by a group of blue-chip captive owners to establish their own shared fronting facility, and all the while the number of captive incorporations in the established offshore domiciles continues to increase.
As the world’s second largest captive domicile, the Cayman Islands are currently benefiting more than any from the sustained interest in self-insurance. Globally, more than 20% of all new captives formed in 2002 were established in the Cayman Islands, the highest tally of any domicile1 At the time of writing, there are 610 captives incorporated in the jurisdiction, writing almost $4.5bn in premiums and with some $18bn of assets under management. Almost every class of business is now considered suitable for insurance in the Cayman market, from the traditional healthcare portfolio to property and marine and aviation.
So why does captive insurance remain such a popular choice, and why do most captives continue to gravitate to a small number of offshore jurisdictions?
Clearly, difficult conditions in the traditional market remain a primary factor in encouraging insureds to examine the captive option. It is no coincidence that historical growth in the captive industry has tended to match periods of hard market, although it is also true that the object is not always lower premiums per se. Insureds who find that their needs are not met in the traditional market will inevitably look elsewhere, and this is just as likely to do with coverage terms as with premium rates. The formation of a captive allows the insured to tailor the insurance product to suit its own needs, and to procure terms that might be difficult or impossible to find otherwise.
If anything, the captive option can sometimes prove more expensive during periods of soft market, but what it does provide is a degree of insulation from the volatility of the traditional insurance cycle. Many insureds value, more than anything, the ability to establish a reliable, long-term budget for cost of risk.
There are, however, many other factors involved in the decision to go the captive route, and which have nothing to do with the vagaries of the traditional insurance cycle. It is often said, for example, that the risk averse insured has the most to gain from the captive model. In most cases, premiums in the traditional market will be negotiated according to the insured’s claims history, and in this way the premium will, to some extent, reflect the insured’s ability to control its own losses. Nevertheless, it is still true that an insured with an exemplary claims record will find itself subsidising less well-managed companies whose risks are insured in the same market, many of whom may well be competitors. The captive option enables the properly managed company to retain for itself the benefit of its own successful risk control strategies. Premiums are geared according to the claims experience of the parent or group of companies insured by the captive.
The captive option also allows insureds to gain direct access to the reinsurance markets and to a range of products not available at the primary layer. By pooling risks from the insured group, the captive achieves better leverage, and hence better rates, than if each of the risks had been placed in the traditional market separately at the direct level.
It is also a fact that traditional insurers fund profits only partly through premiums. The balance of their income (for many, indeed, most of their income) is derived from investment of capital and reserves. In the captive model, interest and other investment income accrues to the benefit of the captive and its parents, thereby turning a cost centre into a profit one.
And what of the tax advantage? The common misconception is that captive insurance operates primarily as a tax avoidance scheme, but in most cases the tax benefits of the captive model are largely incidental. Rarely will fiscal considerations be the primary reason for captive formation, as against traditional market insurance, but in certain specific instances there will be important tax implications to be taken into account. For those companies, for example, who have already found themselves forced out of the traditional insurance market, the captive option can bring appreciable benefits. Most companies will find it prudent to reserve against uninsured contingencies, but reserves are not usually tax efficient. Where premiums are paid to insurers, on the other hand, these can be treated as a business expense and hence deductible in arriving at taxable profits. If the insurer concerned is a captive, the effect is that the group overall will have no more (nor less) funds to meet a loss than it had before the transfer of premium, but it will have accrued the benefit of a deduction from taxable income which it would not have enjoyed had the parent merely retained the risk under reserve.
The precise tax situation will depend upon the rules existing in the insured’s home domicile, but in most cases the payment of premium to a captive will be treated as a bona fide expense, so long as the premium is in fact due and paid and is at an arm’s length rate. Even the US, which has traditionally applied a conservative approach, now accepts tax deductibility in most instances.
So why offshore? Once again, tax is the big myth. Captives domiciled in a jurisdiction such as the Cayman Islands will pay no tax locally on premium income, nor on investment returns. However, in most cases they will be required to make an acceptable (ie. taxable) distribution back to the parent, failing which their profits will be taxed in the hands of the onshore parent as a controlled foreign company. In the case of a UK parent, for example, the offshore captive must remit to the parent a dividend equivalent to at least 90% of its chargeable profits if it is to escape a controlled foreign company assessment. If follows that, while certain tax advantages are still to be gained by incorporation offshore, they are usually marginal.
The greater draw of the offshore domiciles is in their expertise. A few of them, namely Cayman, Bermuda and Guernsey, have a long history of captive insurance management, during which they have developed a solid infrastructure and a formidable body of industry know-how. There are, for example, some 25 captive insurance management companies operating in the Cayman Islands, including branches of all of the world’s major broking houses. They, in turn, are serviced by the big four international accounting firms, each with a local specialist captive insurance practice, as well as experienced local insurance attorneys. Each of the leading offshore jurisdictions has legislation specific to captive insurance, and almost every innovation in the captive industry has originated in one or other of them. The latest example is the Segregated Portfolio, or "Protected Cell", Company, an idea first introduced in Guernsey and quickly adopted in Cayman. It has more recently spread to Bermuda.
It is also true that each of the three main captive jurisdictions happens to be a British Overseas or Crown Dependent Territory, in which the local company and insolvency legislation largely reflects respected UK models, and where (at least in Cayman and Bermuda) English common law principles of insurance law apply.
It is these factors, much more than tax advantages, that continue to attract insureds to the captive option, and continue to bring that business offshore. In the meantime, captive insurance is still aggressively expanding its customer base. Previously the preserve of a few big players with the resources to finance their own structure, the captive option has become increasingly available to small and medium sized companies through participation in rent-a-captive and segregated cell programmes (only two years after their inception, segregated portfolio structures now account for 11% of the Cayman market). With speculation of new fronting carriers entering the market, and reports of new innovations to overcome the short-term shortage in fronting capacity, there is every reason to expect the growth in the captive industry to be sustained, particularly while the hard market endures. Having recently enjoyed one of its most successful 12 months on record, the Cayman captive market will undoubtedly play a dominant part in that continuing success.
1 Source: A.M. Best Special Report, 14 April 2003
The above article was first published in Lloyd's List Insurance Day on 10 June 2003.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.