By Roger C Gillett, Senior Vice-President, Johnson & Higgins (Bermuda) Ltd
CAPTIVES are formed in hard markets, right? Wrong. According to statistics, the popularity of captive insurance company vehicles is not necessarily contingent on the condition of commercial insurance markets.
All right, fewer captives are formed in soft markets, right? Wrong again! Despite a continuing soft market, 278 new insurers were registered last year in what are considered to be the world's major captive insurance domiciles.
Admittedly, not all the 278 were what could be traditionally defined as captives, but it would be safe to say that other insurers being incorporated in these domiciles were in the minority. Add to this the fact that more interest than ever before is now being shown in expanding captives' activities and it is clear that something of a sea change has taken place in the captive insurance industry.
Programmes placed in new captives and new programmes placed in existing ones are of a much more diverse nature than we have seen previously. The traditional property and casualty programmes continue but no new trend is apparent in these areas. Companies are, however, taking a more aggressive position with regard to tax in the home country, whether that be by structuring the captive to shelter profits for catastrophe reserves from home country taxation or, with regard to the US, taking a deduction for all premiums paid into the captive as a business expense.
Hand in hand with this more aggressive tax posture is the development of innovative schemes designed to smooth profits for the purposes of taxation and accounting. The popularity of these has increased, with a large variety of risks being written into the captive as a consequence.
An interesting aspect of these programmes is that they are not what might otherwise be considered insurable risks and often more akin to business risks which the company faces. What is also apparent is that despite the soft market, companies are taking a long-term view regarding increased retentions, with the ultimate aim of removing transactional costs involved in risk transfer at the lower levels of loss.
Driven by the need to compete in their respective industries we are seeing a large number of captives formed to leverage its relationship between itself and others with whom the firm does business. In particular, captives are being used to provide insurance of many types to the customers of the corporation using the existing distribution system.
The unique advantage they gain is that by using the existing distribution system, costs are kept low to make the insurance provider competitive and they are able to replace products at cost rather than at retail prices, enabling the cover to be very profitable. These programmes include credit life, extended warranty, home owners' insurance, vehicle insurance, all risks on certain types of product and even disaster recovery where the equipment such as computers are an essential part of the company's environment.
Along with the varied uses of captives, we have seen in the last two to three years that it is not just the largest of companies forming captives. It has been commonly believed in the US that it was necessary to have primary casualty premiums approaching $2m to make the captive worthwhile, but with the varied uses, especially those orientated towards a profit motivation, this benchmark becomes irrelevant. What is clear is that companies of all sizes are looking to gain the benefits provided by a captive and are forming them even though for many the benefits will not be recognised in the short term.
Many other companies, not able to find sufficient justification to form their own captives, are attracted to association captives, group captives or rent-a-captive schemes. Association captives have for the most part been formed on an industry-specific basis to address the particular needs of companies in that industry. They are more commonly formed during hard times when insurance for a particular class of risk becomes unobtainable or very expensive. They are often sponsored by the industry association. During soft market conditions it is less common for these competitors to co-operate in the formation of an insurance vehicle for their common use, however, those that were formed during times of need have for the most part continued to perform their intended role.
Group captives are similar in nature to association captives but are formed by groups of companies whose affinity is something other than an industry association. This may be companies operating in a certain region or even the clients of the specific broker or agent. In both group and association captives there can be a varying amount of risk-sharing. Of all the decisions made by companies participating in such ventures the question of sharing others' risk is the most critical and most difficult.
In certain programmes features are included that limit the amount of risk sharing to certain layers or attempt to make corrections for adverse experience on a prospective basis. The structures are more sophisticated than they were in the early days of association captive creation. On the other hand, formulae and methods relating to the distribution of future profits need to be clearly laid out.
Unlike the association and group captives, the rent-a-captive programme is designed to transfer no or minimal risk to the rent-a-captive vehicle itself. This has been achieved by indemnity agreements or retrospective rating features, supported by letters of credit or other acceptable security, all designed to leave the rent-a-captive in a no-risk position. These schemes are popular as the expense of participation is less than the ownership of a single parent captive and also in most cases requires no capitalisation by the parent.
Quite often such programmes are used by companies to enter the alternative risk financing arena, with accumulated profits being used to capitalise their own captive in the future.
Many of the rent-a-captives today are simply designed and leave many unanswered questions relative to the tax advantages which are commonly claimed for them. With much of the research groundwork now having been done, it can be anticipated that a new style of rent-a-captive will soon be introduced that will include significant risk transfer.
One thing the existing rent-a-captives and those of the future provide is a lowering of the threshold for firms wishing to participate in the alternative risk financing market. Demand these types of programmes is at an all-time high.
This information is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances. The information was correct in December 1998.