Captives must adapt and change in order to remain competitive. Dominic Wheatley examines the changing environment in which captives operate and suggests how they can respond to it.

Captive experts will tell you that captives should be regarded as a medium-term strategic tool and not a short-term fix in a hard market. This is true as in many cases, in the early stages of captive establishment and development, the costs can accrue more quickly than the benefits.

However, the pace of change in the modern international business environment is such that the prevailing circumstances at the time of establishing a captive cannot be relied upon to continue to generate benefits. It follows therefore that in order to continue generating benefits and justify the initial investment, captives need to adapt to new circumstances and respond to new challenges as they arise. That they do is borne out by the continuing commitment of captive owners over decades of captive operation, although the source of value of their captives changes significantly over time.

There are a number of drivers of change for captives - including the insurance cycle, regulatory and governance scrutiny and the business environment.

The insurance cycle - It is a common misconception that captives are most cost effective in hard markets and that interest in captives, therefore, follows the insurance market cycle with new formations in hard markets and captives being wound up, or mothballed, in soft markets. People often point to the significant number of new captives established during the hard markets of 2003/2004 as evidence of this. However, a closer examination of the empirical evidence suggests that this correlation is weak at best and that the number of captives in the world has grown fairly steadily throughout both hard and soft markets. Given the high front-end costs of establishment, it is perhaps not surprising that short-term market conditions drive the formation of many new captives. At best they may affect the timing of establishment rather than being the raison d'etre.

However, the state of the market has a profound affect on the way in which a captive is used and in the source of the value that its use creates. Additional sources of value arise in a hard market, such as access to reinsurance markets and the ability to fill gaps in the programme, either where 100% cover is not available or where terms vary or cover is denied for specific risks.

Regulatory pressures - Hardly a week goes by it seems without some new international or domestic initiative seeking to restrict the operation of insurance companies generally, or captives in particular. Accounting rules, the core principles of the International Association of Insurance Supervisors, UK Financial Services Authority, tax authorities, the European Union, the International Monetary Fund and the Financial Action Task Force have all introduced recent challenges for captives. The list of rules and regulations impacting captives either directly or via their parent group is nigh on endless. Thankfully, much of this so-called progress involves little more than the documentation of best practice and can safely be left to competent insurance managers to administer and comply with. However, changes that directly impact the operation of the captive programme need more careful consideration.

For instance, in recent times changes in EU directives, particularly when "gold plated" by local regulatory authorities, have seriously affected captives' access to markets, levels of capitalisation and running costs. In some cases this has been enough to undermine the value of the captive, leading to its closure or transfer of captive operations to a more sympathetically regulated jurisdiction.

A recent example of this is the EU Reinsurance Directive which may encourage well-run reinsurance captives to move offshore. Similarly, the implementation of Solvency II will penalise EU captives for their lack of spread of risk and increase their regulatory capital requirement.

Business environment - Perhaps the fastest rate of change comes from captive owners themselves as they evolve and respond to their own market and business environment. Restructuring, mergers & acquisitions, listing, delisting, changes in strategy, new markets, new products, new management; all of these and more have direct and often profound effects upon the operation and role of the captive and on the risks it insures. To keep the strategy of the captive firmly in line with the objectives and strategies of the parent group, and to constantly ensure the group derives maximum value from it, is perhaps the toughest challenge of all.

Captive but not trapped

It is, perhaps, a good reminder at this point that the basic technology available has not fundamentally changed since the advent of protected cell companies in the 1990s and the sources of value remain the same, although their relative significance has certainly changed. The strategic, operational and financial advantages of captives are illustrated in figure 1. The possibility of a loss must be weighed against these advantages, potentially exacerbated by the limited spread of risk in most captive programmes, and the costs in terms of operational costs, capital, and management time.

All captives generate value through some combination of these value sources and it is through the recognition of the optimum combination of location, corporate structure, programme and management & governance infrastructure that the optimum value from the captive in all the prevailing circumstances, and in line with group priorities and objectives, will be delivered. The obvious question then is: how does a captive owner go about achieving such an optimal, value-generating captive?

The most fundamental requirement is a clear understanding of the group strategy and objectives. These will drive the setting of captive value priorities against which performance can be assessed. Secondly it is important to have an objective means of assessing the benefits derived, even where this is not measurable in financial terms. It is only by examining of these together that the overall value generated can be determined. This process should be undertaken regularly to ensure the continuing feasibility of the captive.

To ensure the most value, the parent group must be constantly challenging the captive to address the risk issues it faces. All kinds of insurable risks are potential sources of additional value, whether retained by necessity or where the captive operates in competition with conventional insurance operations.

Effective consideration of potential lines of business for the captive involves a team effort on the part of the group risk manager, the broker and the captive manager. This highlights the need for all these parties to fully understand the role and value potential of the captive, and to work together openly to achieve it. Obviously it helps to have brokers experienced in working with captive programmes, and to have insurance managers with wide experience and expertise, preferably across a range of different captive structures, programmes and domiciles.

High quality governance infrastructure and, in particular, a strong and competent captive board will provide effective scrutiny of proposals and oversight of implementation. All too often the value of strong, knowledgeable non-executive captive directors is overlooked. Communication is obviously critical amongst all parties. The more there is, the better.

Finally, flexibility should be designed into every aspect of the captive. This should include:

- Domicile selection - where attention should be paid to the style and substance of regulation, the availability of company migration, market access restrictions, capital requirements and the availability of potentially useful corporate structures such as protected cell companies and incorporated cell companies;

- Programme design - where contracts need to reflect the possibility of changes in the underlying risk, and enable early cessation through commutation and/or cancellation clauses; and

- Capital and structure - where care should be taken to ensure that capital can be adjusted up and down to suit current needs as these evolve, and shareholding arranged to provide the least restrictive possible consolidation, both accounting and tax.

Benjamin Franklin once said, "In this world nothing is certain but death and taxes". However, in the modern world, and particularly that of business, change and the need to adapt should be added to this list. Only by responding quickly and positively to change can captives reliably generate net benefits in the medium term.

- Dominic Wheatley is managing director of Willis Guernsey.

Captives Figure 1 - Sources of captive value

STRATEGIC VALUE

- Flexibility and control over the insurance programme in terms of both coverage and claims management;

- Optimise programme design - risk retention/risk transfer at both strategic business unit and group levels;

- Supplement to conventional markets - specific or unusual covers including new risks without claims history; and

- Corporate governance.

OPERATIONAL VALUE

- Reinsurance market access;

- Holistic risk management control and coordination; and

- Expert advice and access to specialist delivery systems.

FINANCIAL VALUE

- Market leverage as an alternative to conventional markets;

- Reserving of claims, especially incurred-but-not-reported and incurred-but-not-enough-reported;

- Reduced administration costs through outsourcing to specialist administrators;

- Cash flow/investment returns;

- Efficient capital use;

- Tax deductibility of premiums; and

- Other fiscal benefits subject to parental controlled foreign company restrictions.