Arthur G. Koritzinsky explains why the North American captive market continues to flourish.

In the midst of an extraordinarily prolonged soft market, the growth in the number of new captive insurance companies continues to surpass all expectations. When the statistics are finally tallied for 1999, it is expected that over 300 new facilities can be counted in the start-up column. And even though there will be some deletions from the roster due to liquidations, mergers, consolidations and programme redesign, by all indications the net increase in captives during 1998 will still exceed 200.

The emergence of the “risk centre”
As risk financing strategies continue to evolve from single to multiple line insurance programmes, captives are likely to see a bigger role. New approaches that combine multiple types of hazard risk as well as financial and operational risks will help to drive this trend. As different types of uncorrelated risks are consolidated in a single insurance programme, the predictability increases and the variability decreases. The resulting risk financing arrangements typically have larger retentions, which serve to reduce the cost of risk transfer products.

Higher retentions coupled with increased predictability can yield increased efficiencies on a corporate-wide basis, but also may create the need for more sophisticated internal risk financing systems. Captives have provided the means to help global organisations fulfil internal funding of corporate retentions for nearly 30 years. In many large organisations that have several operating companies, captives are used to help strike a balance between the parent organisation's desire to retain risk and achieve economies in the purchase of insurance and a disparity in the ability to retain risk among the operating units. In these instances, the captive is deployed to buy back the difference between business unit deductibles and the overall corporate retention. The captive acts as the internal “shock absorber” allowing business units to smooth the impact of unexpected hazard losses.

These same principles are being applied to financial and operational risk. The captive, or “risk centre,” acts as the clearinghouse for interest rate, foreign currency, and commodity risk, etc. By accepting risk that individual business units do not want to or are unable to retain, in exchange for a premium, the risk centre becomes the corporate facility in which all risk of this type resides. The risk centre can then determine how much risk to retain and purchase aggregate-stop-loss insurance to protect the organisation's overall results.

Third party business
The use of captives to underwrite third party business, with its potential risk management and financial benefits, has also helped to fuel their continued growth. The assumption of additional risk from outside the organisation can reduce variability by adding unrelated business and uncorrelated risks to the captive's portfolio. Additional premium received in this manner can contribute an independent stream of profit. On the other hand, these arrangements can also result in losses if the unrelated business is not properly underwritten and understood by the captive. The disastrous results of some captives that wrote third party business from the 1960s through the 1980s without the appropriate underwriting due diligence still resonate throughout the industry.

In a growing number of industries - particularly healthcare, retail and financial services - captives are being used to provide benefits to customers. In many cases, the products and services being offered can be expanded to include insurance services. The common element found in these situations is a client base already doing business with the owner of the captive insurance company, an understanding of the nature of the risk being underwritten, and pricing that is competitive as well as profitable.

Captives that lack access to related third party business now can investigate a number of pools and risk-swap arrangements. One such arrangement, the Green Island Reinsurance Pool, allows captives to cede and assume premiums and losses among a group of captives. Losses are limited to the first $100,000 of workers' compensation, general and automobile liability. The pool is not an entity or captive, but simply a formalised series of reinsurance agreements between the participants. All governance issues are well defined in the participants' agreement.

The pool works as follows:
1. A common actuary is used to set premiums.
2. Assume that Captive A has a premium of $25 million and all participants have a premium of $200 million. This means that A has a participation percentage of 12.5%. The same calculation is performed for all members.
3. Captive A cedes $25 million to the pool. This is accomplished under the terms of the pooling agreement in which all pool participants assume their respective participation percentage of each member.
4. Captive A assumes 12.5% of each of the other participant's premium. This results in a total assumed premium of $25 million.
5. Each quarter, loss payments are reconciled. Each participant receives 100% of their own paid losses while paying 12.5% of the pool losses. This settlement procedure continues until all losses are paid.
There are currently 15 participants in the pool, which generate in excess of $120 million in annual premium.
The goals of the pool are to provide a source of third party business, which has minimal transaction costs, low variability and a high degree of comfort that the ultimate results will be within expectations.
Substantial case law that has emerged over the past several years supports the position that related business may qualify for favourable tax treatment if supported by the proper amount of third party business.

Update on popular domiciles of North American firms
In addition to broad trends in risk financing and captive utilisation, developments in each domicile are having an impact on captive growth. Here is a brief overview of key trends and developments contributing to the growth of captive incorporations in the major domiciles used by North American corporations and governmental entities.

Barbados: A long-standing tax treaty between Canada and Barbados offers significant advantages to the Canadian shareholders of insurance companies domiciled in Barbados. Recent amendments to legislation allow captives to be licensed under the Insurance Act (domestic) legislation or the Exempt Insurance Act (offshore). If a captive is licensed under the Insurance Act, the tax advantage is maintained for Canadian-owned captives that write non-Canadian business, i.e. a 2.8% income tax, with the remainder repatriated to the shareholder on a tax-free basis. Canadian corporations that operate globally will continue to organise in Barbados and will generally avoid other domiciles such as Bermuda (with no corporate tax) and the US (which has a tax rate in excess of 35%). US based captive owners can be found among the roster of Barbados insurers, however, many were formed as a result of a short lived Federal Excise Tax treaty which existed for a short time in the early 1980s. At present, Barbados has not seen its share of the growing number of South American captives, but it is geographically closer to the continent than other domiciles.

Bermuda: The oldest and most popular domicile continues to attract captives from all of the Americas other than Canada for the reasons already mentioned. The well developed excess liability markets are rapidly expanding to underwrite other lines of coverage, such as property, aviation and financial risk. In addition, Bermuda based insurers are strategically expanding on a global basis by creating branch offices and by acquisition. Investment by Bermuda based insurance facilities into Lloyd's and the recent purchase of CIGNA's non-life business are two examples of this trend. These initiatives affect captive formations in Bermuda in a number of ways. They solidify perceptions of Bermuda as a global insurance centre, have attracted many of the best and brightest in the insurance business, and make it easy for US organisations to have “one-stop shopping” for all risk financing needs. Notably, the Bermuda insurance market is able to serve captive owners by offering large amounts of creative insurance capacity.

Dublin: As Europe continues to unify many financial functions on a cross-border basis, the ability of a Dublin captive to operate on an admitted basis is a key strategic advantage in any domicile comparison. Global organisations with substantial EU exposures are one of the beneficiaries of this strategy. Many organisations use Dublin as a home for a second captive, which can issue policies on a direct basis and then reinsure the exposure with their primary captive. The use of captives to underwrite employee benefits is gaining the interest of corporate financial, risk management, and human resources executives, and may represent the next growth area for Dublin based captives.

Cayman Islands: New rent-a-captive legislation was recently enacted, providing further support to the popularity of these once arcane risk financing arrangements. The Caymans also are home to new captives whose sole purpose is to support capital market financing of insurance programmes. Innovative uses of these special-purpose companies includes residual value coverages and catastrophe property programmes. The growth of healthcare related captives continues, but it is slowing as the impact of mergers and acquisitions reduces industry activity. Many heterogeneous group captives are organised in the Caymans. Membership in these facilities is slow but steady. As middle market organisations continue to have interest in captives, rent-a-captive arrangements as well as heterogeneous group captive facilities in the Cayman Islands will be a direct beneficiary of this new trend.

Hawaii: Known as the US offshore alternative, Hawaii has seen slow but steady growth since its captive law was enacted. Organisations based on the US west coast continue to take advantage of Hawaii's commitment to captives. The Hawaii Insurance Department will be establishing a dedicated unit to further expedite the regulatory process and will increase accessibility to those responsible for supervising captives. Healthcare organisations are considering Hawaii for new formations and “redomestication” of non US captives.

Vermont: Vermont continues to be the most popular US domicile. For many US based captive owners, Vermont and Bermuda are the two domiciles usually considered. The unique regulatory infrastructure, as well as a developed group of service providers, including management companies, lawyers and auditors, provides captives that locate here with a world class environment. Although the income tax advantages of other domiciles cannot be found here, premium payments are not subject to excise taxes and only nominal state premium taxes of no more than 40 basis points apply. As Vermont continues to liberalise its insurance regulations, there are fewer objective differences between domiciles. Vermont has become the domicile of choice for residential mortgage lenders who are setting up single parent and group facilities that underwrite private mortgage insurance.

Overall, the growth of captive formations has generally remained steady across all of the major North American captive domiciles. With an increasing number of businesses in this region embracing new risk financing strategies, captives will continue to flourish as risk management executives find a host of new applications for these versatile risk management tools.

Arthur G. Koritzinsky is senior vice president, J&H Marsh & McLennan.