Despite statistics indicating business as usual, things are changing in the captive theatre, says Jenny Hill.

The US is a mature captive market and many of the domiciles that serve it are dependent upon it for continuing business, but there are other forces at work too that will determine which of them will be the success stories of the new millennium.

Macro factors
It is no secret that the OECD countries have considered the effects of e-commerce upon their own economies and are worried about the outcome. Capital will be truly mobile for the first time and the probability exists that it may come to rest in the most comfortable tax regime, that is, the captive domiciles. That means less tax collected by the OECD countries and they are gathering to attack. In fact, they have already launched the first salvo in the form of their report on harmful tax competition. It matters not whether they succeed in their mission. Simply by being aggressive, the OECD will force change in the way things are done in captive domiciles. The controlled foreign company (CFC) tax model is also being implemented by more countries.

The tax issue does not stop there. Transfer pricing rules have been in place for a long time, but the United States and United Kingdom have recently increased the intensity with which they are applied. Captive owners are now obliged to benchmark premiums to captive subsidiaries in a much more formal way. The end result of a general tightening in tax rules, and the loss of some measure of confidentiality, will be that some companies do not make the decision to set up or continue with their captive.

A further influence upon the direction of development in the Caribbean and Bermuda will be the recovery of the economies in Latin America. Many companies in this area are ripe for captive development, but the drag of slow legislative change and economic upheaval have delayed the implementation. With economic recovery now looking more likely we can expect more captives from the region.

Industry factors

Within the insurance industry itself, over-capacity continues, though there are some small signs that underwriters and shareholders may have had enough. This is not yet reflected in the statistics, though this is hard to judge, as the number of captives has increased year on year despite the harsh conditions. Perhaps because of this, the number of domiciles is increasing too - the latest being Washington DC.

The new or potential domiciles must think there is potential to succeed. Captives do seem to be the industry that refuses to die, but is the growth due to innovation or simply more of the same?

World figures for captives show growth (of net written premium) of 18%. It seems extraordinary that, in a prolonged soft market, there is only one year when net written premium (NWP) reduced (1997). Numbers of captives are growing at 4% or 5% while NWP increases have been anything up to 20% per year. In 1998, the latter was 18%, and this may suggest that the captives that are being set up now are bigger than their predecessors. Indeed, one would expect special situation captives to write more premium, because they are set up in those sections of the market where capacity is thin.

Cayman's results are certainly above average. It has romped away with a growth rate of 30% in NWP - partly due to a surge in segregated portfolio companies (SPCs) and alternative risk financing programmes, but also due to increased retentions in existing vehicles. The spread of activity remains in very much the same proportions, being dominated by workers' compensation and healthcare programmes.

One interesting aspect (especially in a soft market) is that the gross premium has risen by 62%. This could mean that the captives going to Cayman may be writing more of the programmes in which they participate, and that the markets are showing increasing flexibility when dealing with captives. Reinsurers are getting closer to their “client” by use of the captive. SPCs, rent-a-captives (RACs) and association captives have all retained less, while pure and group captives are retaining twice as much which may illustrate the differing needs of insureds who use third party entities rather than their own subsidiaries.

The breakdown of sponsor origin is also interesting. Of the total companies, 56 are now from neighbouring Caribbean and Latin American countries. It is difficult to see trends on one or two years' statistics, but this could be the start of a significant development. The expectation for some years has been that a lot of Latin American companies would set up captives. Once the economies of Colombia, Ecuador and Argentina recover, and Brazil deregulates, we should see this happen. There are early signs of merger and acquisition activity between European companies and those in Latin America that could accelerate this trend. On the other hand, recent events in Ecuador show just how fragile this region can be.

Bermuda has consolidated its position as a premier reinsurance market that can be flexible and innovative in risk financing. There is a growing tendency for companies in the US and the UK to take a “whole enterprise” view of risk - rather than purchase protection against hazard risks only, and if the markets in Bermuda continue to satisfy demand in this respect, the number of captives domiciled on the island must increase.

Another development is the increase in the number of captives set up for profit generation, rather than cost containment. These relate to the lucrative practice of leveraging a customer base in order to sell on insurance products. Financial institutions are a case in point. They have large customer bases, on which they already collect a lot of data, making insurance products an obvious cross-sell. Significant profits can be captured by the captive, and recent start-ups show the growing popularity of this type of captive.

Recently, the new cell structure has attracted business more usual in the capital markets. For example, some cells are being set up for use in derivative transactions. Others are used to separate “own protection” programmes from the “customer insurance” programmes mentioned above.The more traditional business is behaving as one would expect in a soft market, with premiums and retentions declining slightly where insureds take advantage of low cost options in the open markets. This is offset slightly by new business emanating from Latin America - Bermuda now hosting half of all captives originating from the region. The island should benefit from the recovering economies as the tried and tested always appears to be the more popular choice.

US onshore
What of the onshore US domiciles? More and more states are enacting legislation that will enable captives, but so far Vermont appears not to have felt the heat of competition, licensing 70 captives in the past 24 months (to December 1999). There the growth has come, once again, from financial institutions insuring customer risk or, indeed, their own credit decisions in the form of mortgage guarantee insurance. Either way, the customer pays the premium and the institution reaps the rewards. A captive is a handy way of segregating the funds.

Vermont has also seen the first establishment of a branch of an offshore captive. More and more companies are looking to warehouse their employee benefit funds in a captive to capture the significant cash flow involved, and one way of complying with the fearsomely complicated regulations is to establish an entity onshore.

Other than that, the growth has come from traditional lines, although there are early signs of an appetite for enterprise risk programmes. Losses have occurred through merger and acquisition activity; it is not unusual for a sponsor to find itself with three or four captives these days. Some sponsors, unfortunately, have become casualties in the fast changing economic environment and their captives have sadly vanished with them.

Hawaii has seen good growth, from both domestic and overseas companies (10 in 24 months). The Japanese, like the Latin Americans are going through a process of deregulation and privatisation and are a likely source of new business for captive domiciles. There is a great deal of interest in Hawaii - and why not? It is beautiful, an island and easy to get to from Japan. It also enjoys the right tax structure to attract Japanese companies.

The best of the rest
Other domiciles have not fared so well and growth has been negligible. Panama has been active in promoting itself as a captive domicile, and the BVI have attracted at least 10 new captives from North America, but the smaller islands have remained static. Competition is fierce between captive locations and new business must be chased hard. Where there is no differentiator, a sponsor company will inevitably chose a domicile with a wide and respected reputation.E-commerce may be the differentiator of the future. The domicile that invests in high quality communications will have an edge over its rivals as more and more traffic migrates to the internet. High definition output at destination is essential when data is to be included in differing programmes and spreadsheets, and this will be a watershed for domiciles. Bermuda has invested already in the Bermuda Insurance Data Service (BIDS), so the race has already begun.

This year has seen the consolidation of the larger domiciles with good growth in some areas of the industry. Customer risks have been a good source of captive clients and SPCs have become a popular choice of captive type. Traditional captives have suffered in the soft market conditions, but domiciles have benefited from using them in innovative ways. The tightening of domestic tax regimes of the dominant US market has led to the disbandment or mothballing of marginal captives and merger and acquisition activity has also taken its toll.

OECD initiatives have caused at least one domicile to increase its regulatory requirements to comply, making life a little less comfortable for the captives there. The plethora of new “domiciles” has not affected growth in the larger locations but has made competition at the lower end of the market that much more intense. Still, the strategy may be right. If a hard market is round the corner, it will be too late to instigate captive legislation now. Only those already in the frame will be the beneficiaries.
Jenny Hill leads the captive practice in Willis and is based in London. Tel +44 20 7975 2096. Fax +44 20 7975 2726. Email