These should be good times for the captive insurance sector and for other self-insurance arrangements. After the longest 'soft' market in recent memory (a time when insurance capacity exceeds demand and thus depresses premiums), the insurance and reinsurance markets have finally begun to turn and harden, with premium rates rising across most business lines. When insurance prices rise, large corporate insureds will look to contain their insurance spend by retaining more risk, including through the use of captives and other self-insurance arrangements.

Many of the key domiciles for captive insurers are offshore, with Bermuda, the Cayman Islands, and Guernsey being the leading jurisdictions. While these jurisdictions should be gearing up for a growth in captive formations, a mild chill has spread over the sector as a result of uncertainty over the impact of the European Union's so-called "economic substance" requirements. These requirements are designed to eradicate "harmful tax practices" in certain low or no tax jurisdictions, principally through the use of so-called "shell companies", whereby structures may attract profits but do not reflect real economic activity.

In response, and under threat of EU sanctions for non-compliance, the relevant jurisdictions (which include Bermuda, Cayman, and Guernsey) enacted economic substance legislation in late 2018. The legislation requires in-scope entities to have "adequate" substance within the jurisdiction, including "core income generating activities", to be managed and directed in the jurisdiction, and to have "adequate" physical presence, employees and operating expenditure within the jurisdiction.

The impact on captive insurers

Captive insurers are certainly not shell companies. Nevertheless, they are impacted by the broad substance legislation, being entities engaged in a "relevant activity", namely insurance. Thus, whether or not the EU had captives in mind when they devised their economic substance requirements, captives, like almost all offshore insurers, are unavoidably subject to the new substance requirements.

For most offshore insurance entities, the substance evaluation is straightforward: Bermuda's "bricks and mortar" insurance companies (with offices, underwriters, claims personnel and other staff on island), for example, will surely pass the test and demonstrate adequate substance under the new rules when they file their first returns by 1 July 2020.

But what about captive insurers? The limited need of most captives for dedicated staff or premises makes for a less obvious case on substance and requires a more nuanced and considered approach to demonstrating compliance with the substance requirements which place emphasis on matters such as the existence of staff and premises.

Of course, there is a range of different types and sizes of captive insurers. These include captives with multiple policyholders, such as industry group captives. Others write third party business, including to customers of the onshore parent (a sector that might be expected to grow under current market conditions) and thus require more intensive administration. These entities are, by their nature, more likely to have tangible substance such as dedicated employees and premises.

However, a typical captive insurer will have a single policyholder (i.e. its onshore parent) and will conduct its offshore operations exclusively through the use of a third party service provider in the form of a specialist captive management company. Typically, the manager will cater for almost all of the captive's needs, including handling regulatory filings, corporate formalities, accounting, receipt and investment of premiums, administration of claims and reserves, and the purchase of reinsurance. In most cases, there is no need for the captive to have much additional support, whether offshore or onshore, although a captive's board of directors will usually include employees or directors of the onshore parent.

For these captives, the substance review will require a more careful analysis. In addition, onshore tax and other authorities may need to be educated by industry groups on the role that captives play so they can understand that captives are in no way analogous to the shell companies.

It is true that there may be tax mitigation benefits associated with the use of some offshore captives; for example, the arrangement may enable the accumulation of untaxed reserves and capital. However, it would be a mistake to assume that tax mitigation is the primary driver of offshore captives and wrong to suggest that captives are engaged in activities that might fairly be described as "harmful tax practices".

Reduced insurance spend

The ability of large corporations, or groups of smaller entities within a similar industry, to self-insure to a tolerable level and to accumulate reserves and capital through the use of a captive insurer can result in significant reductions in overall insurance spend compared to what can be obtained in the commercial market. In times of rising insurance costs, such as we are now witnessing, this becomes increasingly important with captives performing a critical role within the overall insurance ecosystem, dampening demand that would otherwise be directed at the commercial markets.

Unlike the shell companies, offshore captive insurers are regulated and subject to solvency and other requirements in their domicile, which typically apply a 'risk-based' approach to regulation, with single-parent captives requiring less regulatory oversight than a commercial insurer. As it happens, these requirements have, for many years, at least in certain jurisdictions (including Bermuda), included a requirement for the captive to demonstrate a form of "economic substance" to the industry regulator.

Cognisant of this, Bermuda's economic substance requirements provide that, if a captive insurer is licensed by the Bermuda Monetary Authority (as all Bermuda-based insurers and captives must be), then it will be deemed to have economic substance for the purposes of the substance legislation, on the basis that it has already passed a substance test under Bermuda's insurance and companies legislation.

Nevertheless, perhaps mindful of the EU's watchful eye, Bermuda's Registrar of Companies has indicated that it intends to independently monitor the economic presence of captives. Accordingly, even though a captive may already comply with local substance requirements, having demonstrated compliance to the satisfaction of the insurance regulator, the captive must now also file a detailed separate declaration with the Registrar under the separate, EU-driven substance rules.

If remains to be seen if the Registrar will take a more inquisitive or stricter approach than the insurance regulator, or if the EU will take a specific position on captives. If so, what can offshore captives do to show a more meaningful economic presence?

Striking a balance

Obviously, there is a balance to be struck. It would be entirely artificial to hire dedicated staff and acquire (more) premises, not to mention that these moves would substantially erode or eliminate the cost advantages of managed captives. Indeed, in Bermuda, such moves are unnecessary under the current draft substance guidance, which recognises that regard will be paid to the "nature, scale and complexity" of the entity's business and permits core activities to be outsourced to insurance managers provided the activities take place substantially in Bermuda.

No doubt, captives will now be reviewing, and possibly reforming, the nature and extent of core activities conducted offshore. Captive managers will need to maintain careful time and other records to support the captive's annual economic substance declaration and to ensure that key meetings (including of directors) take place within the jurisdiction. In the case of Bermuda, the only offshore jurisdiction with a credible commercial insurance market, the captive's onshore directors may already visit the island frequently, not just for captive board meetings but also for renewal and claim meetings with the parent's Bermuda-based excess insurers or with the captive's reinsurers. In this case, the increased focus on on-island activities may not be especially burdensome and, indeed, may enhance Bermuda's attractiveness over jurisdictions that do not have a developed insurance market.

It would be alarmist to view the EU's substance requirements as an existential threat to the offshore captive industry and it is to be hoped that the EU will recognise that captives do not engage in "harmful tax practices". Indeed, forcing offshore captives to close may only lead to them relocating to Vermont and other jurisdictions not subject to the EU requirements. Likewise, if the EU takes the time to understand the role of captive insurers (particularly at this time of increasing insurance costs), and the offshore (re)insurance industry in general, it will come to appreciate that responsible offshore insurance jurisdictions perform a key function in the global allocation of risk and provide a direct benefit to the EU's members. This is particularly important now that EU-based businesses will be concerned about their rising insurance costs.

It is possible that the recent focus on the substance requirements may increase the attractiveness of group captives (where economies of scale justify dedicated employees and premises) or other alternative insurance arrangements such as mutual insurance, whereby the insurer is collectively owned and funded by the insurer's policyholders. We may also see an increased use of 'rent-a-captive' arrangements, whereby a captive's assets are allocated to an individual cell in a protected cell company operated by a captive management company. It is likely that such a company will be viewed as a single entity for substance purposes and thus should be able to sustain and demonstrate the required critical mass.

Finally, it is also worth remembering that the success of Bermuda's insurance industry derives, in large part, from the establishment of the insurers, ACE and XL, in Hamilton in the 1980s when those insurers were capitalised by US and multinational corporate policyholders – a form of self-insurance on a grand scale - who were in desperate need of liability insurance at a time of severely restricted insurance capacity. Perhaps, the consequences of the EU's economic substance initiative will not be negative for offshore financial centres, particularly for the insurance industry at this time when opportunities beckon.

This article first appeared in IFC Caribbean 2019

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances. Kennedys operates in Bermuda in association with Kennedys Chudleigh Ltd.