Bermuda may have started the captive trend but, as Ronald Gift Mullins reports, the competition from the US is hotting up
Once, there was just Bermuda. There, on that tiny island in the Atlantic, its first captive insurance company appeared in 1962. For nearly 20 years, the industry flourished as hundreds of companies, usually giant ones, set up offshore captives to take advantage of this creative means of allocating risk.
The considerable revenue generated from the fees paid by the captives and the ancillary services they require benefited greatly the Bermudian government and population. Lenient tax treatment by the Internal Revenue Service of the profits from these captives made them attractive to US corporations. And, of course, corporate risk managers considered it prudent to check on their captives in Bermuda and while there, why not enjoy the island's lovely beaches, plentiful shopping and a round of golf, or two.
In the US, a few states made tepid legislative efforts to entice companies to set up captives. Colorado passed enabling legislation in 1972, followed by Tennessee in 1978 and Virginia in 1980. But few captives were formed.
In 1981, the Product Liability Risk Retention Act became law in the US.
This act permitted a limited type of risk retention and purchasing groups to form to write product liability coverage. Seeing a choice opportunity to enter the captive market, Vermont approved its Special Insurers' Act in 1981, which offered appropriate regulation and taxation for the formation of captives. Other states followed Vermont, but still there was no rush to establish captives in these states.
States eye millions
The hard liability insurance market in 1985 prompted passage of the Liability Risk Retention Act 1986. These two events sparked a growth in captives in the US. (New captives licensed in Vermont jumped from 10 in 1985 to 36 in 1986 and 51 in 1987.) This act allowed all kinds of liability coverages to be insured by US captives. Also, written into the law was an obligation that profits from offshore captives had to be accounted for in the US parent's results and taxed accordingly, or risk being heavily fined.
Following this development, additional states, eyeing the millions of dollars in fees, taxes and additional employment from servicing these captives - management firms, auditors, claims handlers, consultants, lawyers and banks - began to actively promote their states as the ideal domicile for a captive.
In the almost 20 years since 1986, besides the pure captive which does business only as a reinsurer or as a direct writer; and association or risk retention group captives, a variety of captives have been developed - rent-a-captive, agency captives, cell (sponsored) captives and others.
Captives insure about everything from the mundane property risk to the exotic, such as animal feed contamination. Increasingly, domestic captives have issued terrorism insurance policies for their parents. These captives have legal standing with the Terrorism Risk Insurance Act.
Clean, pollution free
Len Crouse, the craggy, ebullient Vermont deputy commissioner, captive insurance division, discounts any notion that it is better to set up a captive in a US state than in Bermuda. Then, undercutting his impartiality, declared, "It depends on the corporation. Many US companies were off shore before Vermont had a captive presence, and now they can choose to be on shore, in Vermont." He did accede that without Bermuda and its immense reinsurance market, "we would not be able to handle the Vermont captives' demand for reinsurance."
However, Bermuda may be coming to Vermont. In August 2004, ACE USA of The ACE Group of Companies, Hamilton, Bermuda, opened ACE Captive Solutions in Burlington, the first such reinsurance company to do so.
Premium taxes and fees from captives in Vermont bring in close to $21m yearly, an important contribution to the state's budget. Further, each captive is required to have an annual meeting in Vermont, which is a boost to hotels and restaurants. Also, in August there is a captive conference that draws more than a thousand risk managers.
"Captives bring in a lot of money for our small state. It is a great industry for Vermont," Mr. Crouse exclaimed. "Clean, no pollution and gives thousands of our citizens full-time jobs."
Vermont has a tiered premium tax structure that caps at $200,000. South Carolina has a cap of $100,000. Arizona has no premium tax at all on captives, but a $5,500 annual renewal fee. Captives formed in Bermuda pay no premium, income or profits tax, withholding tax, capital gains tax, capital transfer tax, estate duty or inheritance tax. There are filing and considerable renewal fees based on share capital.
Premium tax has not been a primary determinate in deciding where to set up a captive, said Nancy Gray, executive director, Aon Insurance Managers (North America). "It is certainly looked at," she said, "but Vermont, for instance with its $200,000 tax cap, has the reputation, infrastructure in place, a proven captive domicile, these have helped fuel the growth of captives in the state."
"It is not black and white as to which place is better to set up a captive," said Rory Gorman, managing director, Marsh Management Services (Bermuda) Ltd. "A lot of it is the personal touch of the regulator in Bermuda or one of the states. How they get along is very important."
One unarguable advantage Bermuda has over any state is its knowledgeable and extensive infrastructure - reinsurance companies, captive management companies, auditing firms, law firms, banks and investment houses, consultants - all clustered within a very small area.
"The availability of services at a location can be important for determining where to place a captive," said Mr Gorman. "If you're a risk manager looking for specific excess health care coverages, you may already have a roster of companies, and there are several in Bermuda, so you go there to discuss coverages and terms. This ease of doing business is a prime advantage for Bermuda and it has a quality reputation. It is a smooth process."
Each individual company has its own unique requirements for organising a captive said Philip Barnes, managing director, Aon Insurance Managers (Bermuda).
The company has to go through a feasibility study to determine if a captive will work. "In a way, it is very much a subjective view of the business niche you are in," Mr Barnes continued, "and how can your risk allocation best be met. If the risk manager requires some unusual coverages that are readily found in Bermuda, then the 'one-stop shopping' environment would be advantageous."
John Yonkunaz, Principal, Tillinghast, a business of Towers Perrin, suggests that there are a variety of factors that have to be considered before deciding on a domicile for a captive.
"Those are the cost of the infrastructure - captive management, banking, regulator fees, auditing. Second, the cost of the transaction - the filing fee, premium taxes, possible excise taxes in US and federal income tax.
What is the implication of selecting one domicile over another after considering the tax convention of the deal?
"Then, there are qualification factors, including the flexibility of laws relating to the line of insurance of the captive, requirements for meetings, so forth.
"Finally, there is a personal preference, such as the geography. If you operate out of Boston why go to Hawaii or Bermuda, when Vermont, New York or South Carolina are so close? "One other item to consider is the regulatory environment, the people you are dealing with in your domicile. Are they accessable, knowledgeable, do they understand your needs?"
Basically there is no longer a great difference between captives in Bermuda and in one of the states stated Gary Osborne, president, USARisk Group.
Starting in 1986 the US government has chipped away at the tax advantages of having offshore companies. The reason companies go to Vermont, it's the old story, there is experience and risk managers are like other people, they go where the comfort level is high. With almost 25 years of service, captives feel welcomed in Vermont.
A state that has changed its attitude toward captives is New York. It did have a spotty record of welcoming captives, Mr Osborne said, "but not anymore." There are tax opportunities for establishing a captive there, and profits at the captive can be loaned back to the originating company, or to buy treasury stock.
New York had 28 captives as of early 2005, a record 14 new captives were formed in 2004, said Mike Barry, director of public affairs, New York Insurance Department.
"There are two reasons New York has aggressively entered the captive market," Mr Barry said. "One is that a New York captive is close to the New York headquarters of major corporations. There's no need to travel out of town to conduct business.
"And the other reason is that the New York insurance department has developed an efficient means of licensing, usually in 30 days. New York definitely wants more captives."
In early 2005, the state licensed its first group captive - an insurer owned by 14 financial institutions to provide coverage for wealthy clients if one of them loses more than $500,000 from bad investments. Insurers which did provide such coverage have withdrawn from that market.
Leery of offshore
One factor that has had an influence on US companies' decision to establish a captive onshore is that captives owned by publicly-held companies now have to comply with all the regulatory compliance and governance requirements stipulated by the Sarbanes-Oxley Act.
Further, Ms Gray observed that the importance of corporate governance issues and the demand for corporate transparency post-Enron had made management of US companies somewhat leery of informing its board of directors and shareholders that it has a presence in a captive offshore rather than one onshore, that it set up a captive in Bermuda or the Caymans or Barbados rather than choosing a US state.
"I think for the industry as a whole, it is beneficial that there are more venues for captives," said Mr Gorman. "This competition creates more information and understanding, more opportunity for new ventures."
He does admit that Bermuda's share of the captive market has declined somewhat, "but this is more the coming softening of the market. Right after 9/11 when the market began to harden, there was an increase in captives," he said. But did say that a significant reason Bermuda numbers are going down is "because of the increasing number of states that welcome captives."
Mr Crouse of Vermont said, "I think the business will continue to develop in the coming years. There are enough mid-cap companies that need the captive market. The market will develop at a steady pace. Vermont is poised and ready. Bring on your captives."
In December 2004, the US Department of Labor gave tentative approval for Aloca to use its Vermont-based captive insurer to fund its US employee benefit risks. This new utilisation of a captive may lead to establishing other similar captives in the future.
With a 20-year head start, Bermuda remains the premier captive domicile for now. However, there is cause for concern - the biggest single source of captive business for Bermuda, more than 60%, comes from the US. It is apparent that a number of states by using aggressive campaigning and favourable regulations and fee structures are determined to entice prospective US clients and subsidiaries of foreign corporations to establish captives in their state.
The race to be the leading captive domicile in the next decade could see Bermuda's proud motto - The World's Risk Capital - being seriously challenged by one or more US states.
- Ronald Gift Mullins is a freelance journalist living in New York, USA.
CAPTIVES VERMONT - THE SECOND LARGEST
In the US, Vermont at the end of 2004 had 717; Hawaii with 141 is second, followed by South Carolina which in less than five years has licensed close to 125 captives.
At the beginning of 2005, 24 states and the District of Columbia are legally captive domiciles, though several have licensed no captives. The number of captives in the US now totals more than 1,100, which brings the country very close to Bermuda, and about 50% more than the 700 in the Cayman Islands. There are approximately 4,250 captives world-wide.
CAPTIVES BERMUDA - THE FIRST CAPTIVE DOMICILE
Today, Bermuda (where the term "captive" was first coined) has about 1,250 captives of all kinds, though from figures furnished by the Bermuda Monetary Authority, at year-end 2002, there were 878 companies under the heading captives and 398 under professional insurers/reinsurers for a total of 1,276. The same figures for 2003 were 857 and 410 for a total of 1,267. It is unclear if some professional insurers/reinsurers are captives and some not. Figures for 2004 were not available, though 77 new insurance incorporations were completed in 2004, but the number that liquidated or withdrew was not disclosed.