The failure of rates to harden means that captive formation remains stable, but interest in risk retention is on the rise, explains Jonathan Groves.

The growth of captives is often associated with a hard insurance market. Rising premium rates strengthens the financial logic for retaining more risk; hence an increase in the number of captive formations. Equally, the theory applies to the increasing participation of existing captives within risk financing programmes. While the perception is that captive use is increasing, each year the facts tell us that the total number of captives barely moves - either positively or negatively. This year is no different.

The total number of captives is currently estimated at around 4,900, up from approximately 4,800 this time last year (a move of barely 2%). Total premium income paid to captives in the major domiciles, also commonly used as an indicator, is currently estimated at $54.7bn, down from $55bn last year. This contradictory picture is reflective of the market in general.

The significant losses arising from hurricanes Katrina, Rita and Wilma appear, at least temporarily, to have created separate hard and soft markets. Given the reliance on global reinsurance capacity and in line with other events that have significantly impacted such markets the consensus was that, globally, the market would collectively harden or at least stabilise. At present, this does not appear to have occurred. Property rates in North America, particularly those with Gulf of Mexico exposures, have seen significant increases while in Europe, for example, rates remain highly competitive.

From a casualty perspective, the market remains competitive across North America, Europe and Asia. Apart from property cat, rate hardening is not having a major impact. More difficult to discern is whether these large losses have created a floor below which rates will not fall. The "Limits of Liability Survey 2006", that Marsh is due to release next month, will provide more insight from the 7,000 plus clients that participated.

Captives around the world

In Europe, we are seeing reinsurers take a far more active interest in engaging with captive owners. This has been evident in the management of gross retentions enabling captive owners to achieve optimal placement results tailored specifically to their needs. Accordingly, we see this continuing to develop, particularly as it provides access to additional, highly rated capacity.

It will not have gone unnoticed that the number of US states either enacting or revising existing captive legislation continues unabated. Twenty-two states now have specific captive legislation with Ohio currently drafting legislation for consideration. Locations such as South Carolina have seen amazing growth over a very short space of time; it now has over 150 captives. With much of the legislation proving to be very similar, both in terms of application and cost, deciding on which state is increasingly based on convenience and ease of access.

From a European perspective, locations such as Malta are proving increasingly popular with companies seeking to operate a captive that can write into all EU countries on an admitted basis. Indeed, it is rapidly catching up with locations such as Gibraltar in terms of captive numbers. Malta now has 13 licensed captives, showing that its accession to the EU has helped it expand in this area.

The benefits of being able to migrate from another domicile into Malta have also played a role. Previously, disposal of an old captive would often have involved a lengthy run-off period or an attempted sale of the captive that was rarely successful, being both problematic and time-consuming. Migration effectively deals with these issues by providing for a smooth transition.

Further afield, locations such as South Africa and Australia continue to provide an effective infrastructure for the needs of indigenous companies.

From a legislative perspective, there was anticipation that the validity of protected cell company (PCC) structures might be tested during 2006 given the dispute surrounding an insurer in the Isle of Man and a PCC in Guernsey. Ultimately, this was substantially settled out of court. What has become apparent to the market is that while cell-to-cell protection is regarded as robust, the use of additional specific limited recourse agreements is advisable in PCC structures between the core and each cell. With the development of incorporated cell companies (ICC), no doubt commentators will be looking to see how this structure holds up to any legal challenge.

The mature but innovative nature of the captive market means it continues to adapt to both changing markets conditions and the needs of its owners. This ability to be flexible means that captives continue to remain attractive for 2007 and beyond in both hard and soft market environments.

- Jonathan Groves is leader of Marsh's UK Captive Consulting Practice.