David Alexander reviews some of the methods adopted by captives when seeking their exit solution
As premium rates throughout most of the re/insurance world hardened during the last few years, there were countless reports and articles about the boom in captive company formations, and the increasing desire of risk managers to seek out alternative vehicles for risk transfer. During 2002, 462 new captive incorporations were reported worldwide. Bermuda, the world's largest captive domicile, had approximately 17% of this market with 77 single and multi-owner captives licensed during 2002, with a similar trend through to the third quarter of 20032. Other captive jurisdictions have seen comparable growth, particularly in the Cayman Islands with its reputation for healthcare captives, as well as new domiciles such as Vermont and South Carolina. However, hidden behind this boom has been a corresponding increase in the number of captive liquidations, with 311 reported during 2002(1).It is only on examination of a detailed profile of the captive market that one begins to understand why many have recently been looking to wind up their operations, or in some cases have been forced into insolvent liquidation. Taking Bermuda as a representative example of the market as a whole, there are approximately 1,600 captive companies registered.Of these, single parent (class 1) captives constitute 23%, multi-owner (class 2) captives make up 27%, and captives writing third party business (class 3) make up 27%. However, it is estimated that 10% to 15% of these captive companies are either dormant or in run-off.Why so many? With the soft market conditions prevalent during the end of the last decade, many risk managers returned to the commercial market, leaving these insurance cells in stasis, in anticipation of the next hard market. When that hard market materialised, many of these captives were reactivated, although a significant number remained in run-off. This was largely because the captive had become superfluous to the parent company's needs, or the parent found itself with duplicate ART vehicles in multiple jurisdictions - perhaps because of an earlier corporate merger, or rationalisation.Furthermore, many of the run-off companies derive from long before the last soft market, having been in run-off for perhaps 15 years or more, and often are encumbered with old asbestos or pollution exposures. In addition, establishing a captive in an offshore jurisdiction is a relatively easy and low-cost process. Something rarely considered by the parent at the time of incorporation is the exit decision that may ultimately need to be taken, and the time and cost associated with it.
Historic impedimentsHistorically, these companies have struggled to find ways of bringing the run-off to an end. Indeed, many factors were conspiring against them doing so. Simply getting a parent company to the point at which the decision for dissolving the captive could be made was perhaps the biggest hurdle to be overcome.The first stumbling block probably lay at the feet of the captive management companies where there was relatively little knowledge about the exit solutions available beyond that of an aggressive commutation plan.But there were also other factors at play:- the uncertainty over the long-tail nature of the exposures;
- a desire to retain an ART vehicle for future use (even if it meant retaining an old and inefficient run-off);
- an inability to focus on the needs of a captive that was immaterial to the parent; and
- a conflict of interest for the management companies that would lose a revenue stream once the captive achieved an accelerated wind-up.
Despite these factors, the market has begun to realise that taking a proactive approach to managing the wind-up of these companies can offer a very cost effective and efficient alternative to continued run-off.One reason why this has become more of an issue for risk managers - especially in the case of dormant and run-off captives - is that the low investment returns achievable in recent years have not been enough to fund the captive operating expenses, slowly eroding capital.In a jurisdiction such as Bermuda or the Cayman Islands, the variety of tools available to achieve that finality is wide and diverse. There is no single exit solution suitable for every captive, and its own circumstances need to be carefully considered when making such a move.
Dissolution processOften the first step taken on the road to dissolution is an aggressive commutation plan. This will be a relatively simple exercise for a class 1 or class 2 captive, as there should be relatively few policyholders to deal with, and they will likely have a common strategic goal. Reinsurers of the captive, on the other hand, may not be so cooperative, and may be required to actively participate in the inwards commutation proposals before agreeing to settle reinsurance balances as part of the commutation plan. This will be particularly difficult to achieve when the balances are very small, or relate to long-tail exposures such as asbestos. However, on the assumption that all open contracts have been commuted, the captive can then take the relatively straightforward step of de-registering with the regulator, and dissolving the company.Unfortunately, many class 3 captives find they cannot complete such commutation plans as they simply cannot engage all their policyholders in sensible discussions, possibly because balances are so small, or because of indeterminable latent exposures.However, alternative approaches are available. A tool used in Bermuda is the solvent scheme of arrangement, which can similarly be viewed as a mass commutation plan, but with the advantage that it becomes legally binding on all policyholders once it has been voted in by 50% of those policyholders in number and 75% in value. Although viewed as a more expensive route to finalisation than pure commutation, it helps circumvent the frequent scenario where there are a minority of dissenting or uncommunicative creditors and achieves the desired result in a shorter time frame. Ultimately this may well lead to a more cost-effective result for the parent company, captive and any other shareholders.
Single scheme innovationOne of the more interesting innovations seen recently is when a group of captives with a shared underwriting stamp participate in a single scheme of arrangement to wind up all their affairs. The cost-sharing aspect of this makes it a much cheaper and effective tool. Another variation is when the scheme is applied to a single book of business, allowing the company to continue its current underwriting business, whilst eliminating the risk of deterioration of the older risks. The scheme is extremely flexible, and no scheme is the same as another, so it is important that companies consult closely with their advisors before making a decision to enter into such a procedure.One issue for a captive owner in considering an exit solution is the tax liabilities that may emerge in the home jurisdiction when surplus assets are released. This may vary depending on the country involved, the circumstances of the parent company owner, and the captive's financial position at the time of exit. However, there have been situations where a differential between the gross and net value before and after tax costs has been exploited to achieve an exit via disposal. In such circumstances it can provide a win-win situation where a differential exists between the buyer's and seller's tax positions.For captives that have been in run-off for many years and have little exposure left on their books, a scheme of arrangement may not be a cost effective approach to take. In the last year there has been an increasing number of such captives commencing members' voluntary liquidations, and appointing their own members as the liquidators. This novel approach is possibly the cheapest way to dissolve the company's affairs, but it is not without its risks and can only be undertaken in exceptional circumstances.As liquidators, the members take on personal liability for the debts of the company, therefore there must be an extremely high level of certainty about the solvency of the company, and great care must be taken in the final steps of dissolution of the company. Again, consultation with the company advisors is an important part of the process.Finally, mention should be made of insolvent captive liquidations. Whilst representing only a fraction of the total liquidations, they are nevertheless high profile, and have repercussions for the rest of the reinsurance market.In general terms, class 3 captives are most at risk of failure, as there is the added risk of writing third party business with which the company is not familiar. Indeed, it has been said that some failed class 3 captives had a total lack of understanding of the nature of the risks they had assumed.Recently, there have been particular solvency problems for medical-malpractice captives, with a number entering run-off or liquidation as a result of the continued increases in claim costs and claim frequency impacting the direct writers. The aviation sector also saw its fair share of captive failures, most notably Carolina Re, which accepted very high layer aviation risks from the Fortress Re aviation pool. Carolina Re was exposed to massive losses resulting from the World Trader Center terrorist attack that, combined with an overstated balance sheet position and allegations of fraud, has left significant exposure for the company's creditors.In summary, the recent increase in captive liquidations has arisen in response to the large number of captives that are dormant or in run-off, taking advantage of an increasing array of methods available to help them find a cost-effective way to wind up their affairs. As this knowledge continues to spread, and risk managers become comfortable with the options available, there will most likely continue to be a large number of captive liquidations during the coming years.
References(1) Data taken from AM Best report "Sizing up the captive market: Growth in the number of active captives remained flat in 2002" (April 2003).(2) Data taken from the Bermuda Monetary Authority 2002 annual report, and the 2003 quarterly reports.