As the hard market continues, Nigel Allen examines the impact on captive insurance.

The current hardening of the insurance industry shows little signs of abating. A well-documented combination of poor investment returns, lack of capital, heightened market volatility and greater risk exposures continue to delay any return to a soft market. As with previous hard markets, the knock-on effect of this extended cycle is a greater reliance upon alternative risk transfer (ART) arrangements and the use of alternative carriers. ART has long formed a reliable means of combating the sky-high premiums that populate such a market and countering the impact of withdrawal by traditional re/insurers from litigation-strewn sectors. A recent study carried out by Swiss Re, entitled The Picture of ART, states that the ART marketplace accounted for approximately $88bn in 2001, and there's little sign of its use waning. Indeed, AM Best claims that the ART market will account for over half of the US commercial market by the end of 2003.

While the range of alternative carriers expands, the captive remains the stalwart of the market. The captive is in danger of losing its 'alternative' status, with 2002 proving another record-breaking year for the establishment of such entities. As the premium rates of traditional re/insurers soar and policy coverage in certain sectors becomes so restricted as to be worthless, the way is left clear for the captive. Swiss Re report that in 2001, approximately $25bn gross premiums were written by captives, accounting for 10% of the global commercial lines business, with almost $140bn in assets being invested. In fact, so dominant a force has the captive become in recent years that its success, it has been suggested, could further extend the run of the present hard market. Whereas in the last hard market, captive usage was limited to liability risks, this time around the captive is being employed on a broader risk basis. The market has also witnessed the introduction of the protected or segregated cell captive in recent years, which has facilitated the entrance of small to medium enterprises, so expanding the entity's appeal.

The AM Best special report Sizing up the captive market: growth in the number of active captives remained flat in 2002 provides a comprehensive breakdown of this record increase in captive formations for 2002. In total, the report shows that 462 new captive insurance companies were formed last year, an increase of 46% on the previous year. This rise was not unexpected, and regulators are already indicating that 2003 will continue this trend.

However, the report is quick to counterbalance this record-breaking statistic with figures showing a continued rise in the number of captives liquidated. As of year-end 2002, 311 had been liquidated, resulting in an active captive total of 4,526 for the year. This is an increase of 53.9% on the number of captives liquidated for the previous twelve months, and results in a net increase of only five captives compared with the active figure for 2001 (see table 1).

Captive consolidation
That the number of captives going into liquidation continues to increase is not wholly unexpected. The myriad accounting scandals such as Enron and WorldCom have had a negative impact on the market, resulting in a number of captives going into run-off and liquidation. A second factor is that many risk managers have sought to consolidate their risk management portfolios in an effort to improve overall efficiency, pooling capital in a single captive and liquidating those deemed surplus to requirements. For example, following the merger of Exxon and Mobil, both companies' Vermont-based captives were combined to form a supercaptive to facilitate administrative efficiency. The liquidation figure is further compounded by the continuing medical malpractice crisis. The medmal sector has contributed greatly to the burgeoning captives market, as companies seek to plug the gaps left by traditional insurers withdrawing in droves. However, by filling these holes, captives have now been placed in the litigation firing line and are beginning to feel first-hand the effects of the crisis which has forced so many re/insurers to pull back.

That the net figure for captives formed in 2002 is 'flat' is somewhat misleading. Though the net figure has remained virtually unchanged from 2001, the use of existing captives has broadened, with more capital being provided and more risk being written. Retentions within captives have shot up over the last 12 to 18 months. According to Mike Driscoll of ACE: "People are taking more and more risk on board... What we are seeing with established captives is a willingness to take bigger risk retentions and this is not just price driven."

The amount of premium volume under management also rocketed during 2002, with many of the dominant captive domiciles reporting premium increases of between 20% and 30% for the twelve-month period, as corporations seek to exploit established captives more and more in the present hard market.

A lack of front
With unprecedented numbers of new captives being formed, so the demand for fronting arrangements and reinsurance mounts. While reinsurance capacity remains at an acceptable level, continued price hikes are causing concern, reducing the economic feasibility of such coverage. However, Mike Driscoll claims that in the current climate, "captive managers have become very focused on the security of any reinsurance, perhaps more so than the general market, and are becoming actively involved in approving all of the reinsurers, which is good to see."

Serious doubts have been raised about the ability of fronting carriers to absorb the record number of new captives. A combination of M&As, a number of companies pulling back from fronting arrangements and others dropping out of the market completely has resulted in an overall decline in the number of available carriers. The pressure on the remaining carriers is further enhanced by those captives previously using now defunct carriers seeking to establish new fronting relationships.

As a result, fees have increased substantially, with some captive managers questioning the economic viability of establishing or even maintaining current fronting arrangements. In a fronting survey of 91 captives predominately domiciled in the US, conducted by the Captive Insurance Companies Association in conjunction with the Vermont Captive Insurance Association, the statistics revealed an increase of 9.3% in the average fronting fee between 2001 and 2002.

A further financial pressure is imposed by carriers demanding ever more stringent security requirements before agreeing to a fronting arrangement. While the advantages to a captive of harnessing itself to a well-established carrier are clear, such reductions in overall margins are proving a major stumbling block.

In such a depleted environment, some companies are seeking to overcome the fronting deficit by turning to direct writing captives, particularly in the case of large US corporations. Dublin, a leading domicile for the establishment of direct writing captives, has witnessed rapid growth in direct writing as opposed to reinsurance captives, and specifically in relation to US companies operating European subsidiaries.

In general terms, while the number of Dublin-based captives has remained steady, the sector has witnessed a marked increase in the volume of business being written. The hard market has forced many captives to focus on the more traditional lines of business, including property and general liability, and to pull away from sectors such as employee benefits and extended warranties, areas that hold more sway in the captive market during a soft cycle.

Ireland has recently implemented a flat rate corporate tax of 12.5%, as of

1 January this year. Although captives set up prior to 1998 will retain a 10% tax rate until 2005, the new standard rate applies to all captives established after that date. While some believe this may have a negative impact on the market, moving to a standard corporate tax rate opens up the possibility of triggering double tax treaty provisions previously excluded due to the special tax status. There are, however, challenges being posed by the UK government which are proving troublesome to the Dublin-domiciled UK-owned captive community, as they face tax bills at the British rather than Irish rate.

Tried and trusted
The traditional captive domiciles of Bermuda, Cayman Islands, Guernsey and Vermont have further enhanced their dominant market positions by hosting the majority of new captives (see tables 2 and 3). This is of little surprise, particularly as many of those companies establishing new captives are doing so for the first time. According to Carole Pierce of AM Best, such companies are keen to exploit the experience afforded by the established domiciles, enabling them to effectively "hit the ground running".

Leading the pack, Cayman accounts for 21% of the total number of new captives formed, almost 4% ahead of Bermuda. Cayman has long been a favoured domicile for captives writing hospital and medical malpractice coverage, a factor which has clearly contributed to the dramatic rise in the number of captives formed in 2002 when considered in the context of the current crisis in medmal capacity. Approximately 50% of new licences issued in 2002 were healthcare related. According to figures released by the Cayman Islands Monetary Authority, as at 31 March 2003, there were 196 healthcare captives, equating to 32.5% of the captive market. When one also takes into consideration that Cayman retains a percentage of the US captive market second only to Bermuda (519 of the 603 captives licensed in Cayman on 31 March were of North American origin), the jurisdiction has found itself in a win-win situation over the last few years.

According to statistics compiled by the Bermuda Monetary Authority, the number of new captives formed in Bermuda fell slightly in 2002. There are a number of possible reasons for this decline. The jurisdiction has been at the sharp end of much negative publicity in the US concerning the issue of 'corporate inversions', which although not directly linked to the captive market has tarnished the island's reputation as a financial services location. Bermuda has also had to play second fiddle to the Cayman Islands on the medical malpractice front, a key driver in the formation of captives in 2002. A further factor is the slowing down in the setting up of new captives following the initial post-September 11 formation frenzy. However, this slight decline is not seen as cause for alarm, as the jurisdiction witnessed a massive increase in the amount of premium volume, with retentions within captives rising dramatically.

For Vermont, 2002 proved a record year for captive formation, with a total of 70 new captives set up, far exceeding the previous high of 51 in 1987, and almost double the figure for 2001. Vermont has almost certainly profited from the US corporate inversion backlash against Bermuda. In general terms, the US is seeing a move onshore as corporations with offshore operations come under increasing scrutiny. Vermont has also, like Cayman, profited from the medical malpractice crisis, with a number of group captive formations in this sector. Figures released by the Vermont Banking, Insurance, Securities and Health Care Administration reveal the continued trend in the growth of written premiums for the twelve-month period, which is expected to be approximately $7bn, $1.9bn up on the previous year.

A bill containing a rewrite of the Vermont captives statute has been passed by both House and Senate and is currently awaiting Governor's action. The bill will also establish a Deputy Commissioner for the Vermont Captive Division and will affect the taxation of premiums.

However, it is another piece of US legislation which could well have a much more dramatic impact on the captive industry in Vermont and on US captives worldwide. The degree of uncertainty which surrounds the definition of 'insurer' in the Terrorism Risk Insurance Act (TRIA) of 2001 and whether it includes a captive has caused much concern. Treasury guidance states that section 102(6)(A)(i) does include both captives and risk retention groups. Mandatory participation in the programme could have major financial implications for the US captives market, and may make it impossible for corporations to maintain their captives. However, the Treasury has acknowledged that it is willing to reconsider the matter and some expect that an opt-out clause will be provided for such vehicles.

Overall, captive activity in Europe is lower than expected according to Carole Pierce, a fact which is put down to increased consolidation. However, Europe's leading captive domicile, Guernsey, has recorded an increase of over 50% in the number of new captives formed in 2002 compared to 2001. Increased capacity within Guernsey's captives resulted in a gross premium volume for 2002 of an estimated £2.71bn, up approximately £250m on the previous year.

In November 2002, Guernsey implemented two new laws, The Insurance Business (Bailiwick of Guernsey) Law 2002 and The Insurance Managers and Insurance Intermediaries Law 2002. The legislation includes the incorporation of the International Association of Insurance Supervisors (IAIS) core principles and amends the solvency requirements for captives, based on the captives' liabilities as opposed to premiums, which it is hoped will heighten the appeal of the island as a location for captives. The jurisdiction also underwent an International Monetary Fund assessment during 2002, which, while its findings have not been released yet, is expected to provide a positive appraisal of the island's insurance sector.

Entering the fray
The Bahrain Monetary Agency (BMA) issued a consultation paper entitled, Building a new insurance regulatory framework on 8 April 2003. Under the proposed framework, captive insurers would be permitted to establish in Bahrain. The move is seen as a means of plugging a gap not only in Bahrain, but also in the Middle East and South Asia as a whole. The BMA believes "Bahrain can offer an attractive location to regional companies looking to establish a captive close to their operations."

The proposals consider four captive categories:

  • single parent captives where none of the business is liability;
  • single parent captives whose business includes liability;
  • multi-owner captives insuring the risks of its owners or affiliates of the owners; and
  • single or multi-owner captives whole or partly insuring related third party business.
  • The first three categories are prohibited from handling any third party risk.

    The BMA also expects that these categories will allow the establishment of captives as Islamic insurers, requiring that they have a Sharia Board and, where necessary, that they be compliant with the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) standards.

    A combination of steady growth during the soft market period, followed by a dramatic rise in formations during the last 20 months has resulted in a captive-heavy marketplace. More and more domiciles are climbing onto the captive bandwagon, enacting legislation in an attempt to secure their piece of the pie. The flow of capital into established captives is fast becoming a torrent, but on the other side of the scale, the liquidation of captives is reaching unprecedented proportions. Reinsurance pricing continues on its upward spiral, while the number of available fronting carriers dwindles. The captive market appears delicately balanced.

  • Global Reinsurance would like to acknowledge the assistance of AM Best in providing source material for this article.
  • By Nigel Allen

    Nigel Allen is the Assistant Editor of Global Reinsurance.