Fiona MacLeod reviews the development of the captive concept and captive domiciles during the 1990s and looks to the future.
During the 1990s, the captive insurance market continued to grow at a significant rate. By 1998, worldwide captive premiums had reached over $21 billion, investable assets were over $124 billion, and insurance management fees of around $200 million were generated. There is no doubt that the industry has entered the mature stage of its life cycle and, indeed, some would argue that it has reached saturation point in the United Kingdom, United States and even in parts of Europe. What is indisputable is that the expansion of the industry over the last decade has seen the concept spread to most of Europe, Australasia, the Far East and South America and that there remain significant further growth opportunities.
Part of the growth of new captives in recent years has emanated from countries whose insurance market has been deregulated. The trend towards privatisation has also created further opportunities for the captive industry where, for example, governments require evidence that adequate financial provision has been made for certain liabilities. While this process is most prevalent in the world's emerging economies, where captives can be seen to have become attractive risk retention vehicles, it is also evidenced in other countries, such as the UK for example, where the privatisation of the formerly government-owned utility companies has also created such opportunities.
However, in recent years we have begun to see the traditional insurance market responding to the loss of premium share to captives. Increased threats to captive business have also emerged from financial institutions and capital markets seeking better returns by diversifying into insurance and offering financial solutions to problems that would historically be viewed as insurance issues.
The effects of increased global consolidation in a number of sectors have filtered through to the captive industry, as newly merged, and de-merged, companies re-evaluate the use of their captives in order to ensure they achieve the optimum risk financing programme for their requirements. Furthermore, as captives mature and develop balance sheet strength, parents/sponsors undertake reviews to ensure that these significant subsidiary companies provide them with a satisfactory return on the capital employed.
Whatever the motivation behind the re-evaluation, this has often led to the captive being given a notably different role in the risk finance programme of its parent than in the past. Frequently as part of such re-structuring, an alternative risk transfer (ART) arrangement is put into place with the captive playing an integral role in the structure and working of the arrangement.
Many captives have also become involved in multi-year, multi-line programmes, and are writing numerous new classes of business, including employee benefits, customer-related risks, credit and political risks, weather and brand name protection. New captive structures have also evolved which have developed wider opportunities for the industry by making the market accessible to a broader base of companies, most notably the development of protected cell companies (PCC).
Tax and legislative developments
Throughout the last decade there has been a hardening in the attitude of tax authorities towards the use of captives. Controlled foreign corporation (CFC) legislation has been introduced in a number of countries and tightened in countries like the UK, Sweden and Australia.
The developments in the UK clearly illustrate this process. In 1995, the UK government took further steps to reduce the tax benefits of carrying on insurance business in low tax domiciles. It was thought at the time that, for many parent companies, this would signify the end for their captive. However, on closer examination, those established for sound risk management reasons survived, as the avoidance of tax had not been their primary raison d'être. Indeed, this was also a blessing in disguise in some instances, as it again led to a re-evaluation process, and, often as a result, a more effective use of the captive.
Another aspect of taxation which inhibits the use of captives is insurance premium tax (IPT), as it still attracts this tax despite being a risk retention vehicle. Rates across the globe continue to be anything from 1%, (health insurance in Austria) to 40%, (in Mexico). Even in the European Union, where moves towards the harmonisation of insurance law, accounting and taxation continue in earnest, differences still persist with premium taxes varying from between 1% and 30%. While IPT adds an increased frictional cost to the management of risk retention through captives, the introduction of accounting standards such as IAS37 and FRS12 in the UK pose barriers to “on balance sheet retention” by parent companies.
In Europe, the Third Non-life Insurance Directive had notable implications for non-EU captive domiciles. The directive introduced the single licence system, enabling an insurer licensed in one member state to carry on business in any other member state without needing to seek authorisation from the regulatory authorities of the individual host countries. This has been a major factor in the growth of Dublin registrations and the re-entry of Gibraltar into the captive arena.
The development of the domiciles
The 1990s have witnessed a significant expansion in the number and development of captive domiciles. However, principally due to the changing attitude of the tax authorities, a trend towards onshore captive formation has emerged, demonstrated particularly by the success of Vermont in the US. Vermont has experienced a growth rate comparable to that of Dublin, and has established itself as the world's leading onshore domicile by far.
By the mid point of the 1990s it was clear that five main domiciles had emerged as leaders, namely, Bermuda, Barbados, Cayman, Guernsey and Vermont, with Bermuda entering the 21st century as the world's largest and most developed domicile. It has established itself as a major property catastrophe insurance centre, although it also has an increasing volume of excess liability providers, with a significant amount of finite risk and financial reinsurance also being written. More recently, its rapidly expanding reinsurance capacity has been a particular enticement, with the notable arrival of a number of highly capitalised reinsurers as well as capital market players.
The Cayman Islands has also developed significantly in recent years, and appears to have become a magnet for healthcare captives in particular, although more recently it has seen the establishment of captives to underwrite workers' compensation and employers' liability risks. However, last year the domicile also saw a notable increase in the establishment of special purpose vehicles, (SPVs), for securitisation structures. It has passed legislation allowing what the domicile calls segregated portfolio companies, (SPC), elsewhere known as protected cells, which has proved to be such a successful marketing strategy for Guernsey, the first to establish such laws and regulations.
The main domiciles favoured by European organisations have emerged as Guernsey, Isle of Man, Dublin, Luxembourg and, although less so than in the past, Bermuda. Guernsey is now established as the largest European domicile, reaping the benefits of positive marketing, such as its risk conferences which are held every two years, and the development of new concepts, such as PCCs.
It is, however, Dublin which has seen the most dramatic growth of any captive domicile. Its success can be attributed to a number of factors, including direct access into the EU and its network of double taxation agreements. Recent changes in the Irish Republic's tax rates have demonstrated its government's commitment to maintaining Dublin's position as a low tax environment, with the overall corporate tax rate being progressively and dramatically reduced, to reach 12.5% by 2003.
Luxembourg, favoured by continental Europeans, mainly for the establishment of reinsurance captives, has seen new registrations slow to a trickle. The number of captives in the Isle of Man has remained almost the same for nearly five years. The introduction of re-domiciliation legislation resulted in some captives re-locating. However, Guernsey quickly introduced this legislation to eliminate the advantage.
Furthermore, while the statutory reserve had been a distinct advantage for attracting captive business to the Isle of Man, particularly from the UK, the changes to CFC rules as regards the acceptable distribution policy removed this benefit. Both Guernsey and the IoM have been reducing their dependency on the UK as the market for their captives. Guernsey, to date, has had more success in this regard.
One particularly significant development as regards captive domiciles in the last year was the admission of captive underwriting syndicates at Lloyd's. Captive syndicates do offer a number of advantages, including the ability to write insurance business in over 60 countries thereby avoiding fronting costs etc. However, there are also a number of significant disadvantages, which include relatively high costs, A+ required security rating and the inability to transfer existing business into the captive.
Lloyd's believes captive syndicates will compete directly for the large captives with existing offshore domiciles, in particular, Bermuda and Guernsey. However, the 1.1% levy on premium as part of the Lloyd's Reconstruction and Renewal, (expected to fall away by the end of 2002), removes the advantage of the savings in fronting fees in some cases. To date, only one captive syndicate has been established and, with a likely market of 50 or 60 candidates worldwide, it will never be a threat to the established domiciles as regards number of registrations.
Strategic risk management and the future role for captives
Although there have been no real tax advantages to the establishment and running of a captive for a US parent for some years, growth of US parented captives has continued. With the tax advantages now being eroded for European parented captives, we are yet to see if this pattern will be followed in Europe. The reason for this is primarily the use of captives beyond the traditional areas of insurance.
Today most corporations recognise the need to consider operational and business finance related risks alongside traditional property/casualty risks and that those who understand these inter relationships and develop superior risk management strategies can gain a competitive advantage. Therefore, as the process of risk management has developed from a compartmentalised approach to a more integrated and strategic approach, corporations' use of captives has developed. Inevitably, the optimisation of the financing mechanisms available to larger organisations today does extend beyond traditional insurance and the use of captives, and many large organisations recognise that there is a clear need for innovative financial engineering. However, many such programmes will continue to utilise captives, although for reasons far different to those which initially motivated captive formation.
Recent developments in the captive industry, in particular the attitude of the tax authorities, serve to emphasise the frequently expressed caution that a captive is not a short-term commitment. Through CFC legislation and penal tax regulations, governments have created disincentives for any corporation whose motives for setting up a captive may be at best marginal. The significance of the captive industry will continue in the future as there remains a business case for the establishment of a captive for those corporations who intend it to form an integral part of their overall corporate risk management strategy. However, it is also true that it is likely to become increasingly difficult in many cases, although not impossible, to find purely financial reasons for forming a captive.
Many have argued that the days of the captive are over, although the increasing number of new captive formations, in spite of the persistent soft market and the entry of more competition for captive-type business, seems to suggest otherwise. What is indisputable is that, because of the attitude of tax authorities, the reasons for setting up a captive and the role of the captive within a company's risk management strategy have changed. Corporations are increasingly adopting an holistic approach to risk management, and in the future, captives will only be formed when there exist sound risk management reasons for doing so.
The future of the captive insurance industry remains bright, because captives are still one of the most effective ways of keeping risk premium and attributable investment income within an organisation. What will change in the future, however, is that corporations will have to regularly re-evaluate their use of their captive, in order to ensure both that sound risk management reasons for retaining it still exist and that it is being used in the most effective manner. This change in focus, coupled with the increased emphasis on corporate governance in many countries, mean that the captive is no longer in the sole possession of the risk manager and is back where any strategically important activity should be, in the parent group's board room.
Fiona MacLeod is a consultant working within Marsh risk finance in London, and specialising in alternative risk transfer. Tel: +44 (0) 207 357 5823; fax: + 44 (0) 207 357 5810; e- mail: Fiona_MacLeod@sedgwick.com.