It is almost a quarter of a century since I first started working with captives, which I have been doing in one capacity or another ever since, and I cannot recall a time when someone was not predicting their demise. They were dismissed as a passing fad; as being tax-driven or only working when based in very obliging but questionable offshore jurisdictions.
Of course, the conventional insurance market was never going to be keen on an idea that was essentially an indictment of its performance, and that includes the broking community which even today remains ambivalent about the value of captives. Tax authorities, quick to define a benefit as a motive, were Pavlovian in their reaction and wasted much effort in pursuing specious arguments and, as a result, were distracted from more fundamental issues concerning the real reasons why captives were attractive at all.
What is sure is that the appeal of captives as risk financing vehicles and more general risk management tools has never wavered and their number has continued to grow. Indeed, if Cayman's experience is reflective of the overall market, the demand for captive solutions, and the ability of captive structures to meet that demand, is today stronger than ever.
Irrespective of who has been attacking captives and why, their usefulness to risk managers has not waned. Captives have proved to be largely immune to the insurance cycle (as we once called it), and they have continued to be formed and their usage extended in all market conditions. There are no signs that saturation point has been reached or that, in the right circumstance, the captive rationale is no longer compelling.
Along the way, the captive market may have suffered some casualties, as a few were closed down for reasons other than no longer serving a risk management purpose, but overall captives have withstood very successfully the various challenges they have faced.
However, it is now the third charge mentioned above, that captives only really work in a lax regulatory environment, which has revived the debate about their future. For the first time there is a concerted international attempt to make this point count.
This initiative, most commonly linked to the Organisation for Economic Co-operation and Development (OECD), began to gather momentum last year. It was, in fact, one of the reasons why I was attracted to becoming an offshore insurance regulator. I enjoy arguing a case, particularly when it involves a matter to which I have given much of my professional life, and I was confident that Cayman would provide a very strong fortress from which to repel these raiders.
What I did not quite appreciate then was the extent to which passing judgment on offshore jurisdictions would become a new international sport (possibly a blood sport), the rules of which are uncertain, often contradictory and certainly not based upon any concept of fair play.
The OECD has been joined in its mission by the Financial Stability Forum and the Financial Action Task Force, with the European Union also throwing the occasional firecracker into the ring. Not to be left out, the UK Government has commissioned an extensive review of the regulatory regimes of six British Overseas Territories, including the two main captive domiciles of Bermuda and Cayman. Apparently there is to be no end to these assessments, and perhaps it will only be a matter of time before the International Olympic Committee and Amnesty International somehow get involved.
The term “offshore” has acquired a pejorative meaning in certain circles and the very existence of offshore financial centres (OFCs) is being called into question by major industrialised nations. And insurance, although not a big part of the activities of most OFCs, has been caught up in this attack. In the last few months, therefore, captive business and how it is conducted and regulated has come under a very intense spotlight.
A broad agenda set by the G7 nations means that OFCs are being charged with abusing their powers to set their own rules for financial services business. It is asserted that the regulation of these activities is usually deficient according to international standards, either because the applicable controls are too weak or their enforcement is ineffectual.
These failings are deemed to be unacceptable for a variety of reasons. The Financial Stability Forum is concerned with threats to the international monetary system arising from capital flows that are driven (in part, at least) by the special features found in OFCs.
The OECD sees OFCs as a conduit through which a growing element of the tax base of its member countries is being lost. In fact, globalisation and internet trading are much bigger causes of tax avoidance but OFCs are an easier target. And the Financial Action Task Force has categorised OFCs as the weak link in the fight against money laundering.
These different but overlapping interests point to a concerted effort by the major nations to restrict the opportunities for OFCs to continue doing business in the way to which they and their users have become accustomed. Many OFCs have found themselves described as “unco-operative” and placed upon one or more blacklists, with the threat of sanctions if their financial regulation does not improve. The tests are being set, it seems, by Washington, DC and Brussels, albeit expressed in terms of accepted international standards.
The process of assessment is widely regarded as arbitrary (reportedly this has even been admitted within the OECD secretariat itself) and, certainly, it has not been based upon a careful and informed analysis of regulation as actually practised in the jurisdictions being named and shamed.
The impression given is one of being guilty until proved innocent, and so far some most incongruous verdicts have been reached. The next stage is an appraisal programme being run by the International Monetary Fund (IMF). What does the IMF know about captives? Probably nothing, in which case how it sets about remedying this deficiency will be important.
The areas in which action is being demanded mostly concern access to client information by the regulators and the sharing of that information with counterparts in other countries. Secrecy (as distinguishable from confidentiality) will no longer be tolerated in this new world order, and for those OFCs where this has been the cornerstone of their financial industry a decline in business can be expected.
Captives as part of a global financial system
What does this mean for captives? Tax has long since been a less material factor of captive success, given the common application of controlled foreign company provisions and such measures that dilute the benefits of being located in tax havens.
As far as is known, there has been very little connection between captives and money laundering (in part thanks to the diligence of regulators who have declined several dubious propositions). Nevertheless, the insurance mechanism does lend itself to such activities, as has been demonstrated in some conventional (i.e. non-captive) markets.
Regarding international financial instability, insurance probably has the best record of all financial sectors, with the captive experience being better still. In any case, in terms of potential threat there are few captives that operate on a scale that would register on this particular radar screen. Indeed, perhaps only the collapse of the Bermuda market is a systemic risk that would count in this context. And such an eventuality could plausibly only be linked to natural catastrophes, which even the OECD might have difficulty in controlling.
However, in a sense this is irrelevant. OFCs are being judged in their entirety and exemplary insurance supervision will count for nothing if it is negated by shortcomings elsewhere. There is no intention to discriminate between different financial sectors, particularly when their boundaries are becoming more blurred.
OFCs will be acceptable to those who matter (the nations from which most captive business originates) or they will not.
If not, carrying on that business may become very difficult as various obstacles are placed in its way.
To be acceptable, OFCs will have to adopt and enforce regulations (including information access) that will be more onerous than currently apply. Most likely this will mean supervision to standards that are higher than prevail in any “onshore” jurisdiction. And cries of “Unfair!” will not be heeded.
Can OFCs achieve this? Of course they can, and Cayman has already enacted most of the necessary changes or has committed to do so. However, it will be more difficult for smaller OFCs that do not have the scale of business to diffuse the additional costs of supervision that will surely arise.
And out of adversity will come opportunity. Once OFCs are demonstrably world class jurisdictions, no longer open to the charges of secrecy or slack regulation, there should be no obstacle to their use. For OFCs that can attain this status (whereupon the “offshore” tag will be dropped), their share of international financial business should actually increase.
For the captive scene, the following developments may be expected:
Boom or gloom?
There is little doubt that these challenges to OFCs are part of a political crusade by the big nations. Some believe that the end game is nothing less than the extinction of OFCs, and the battle has hardly begun. One OECD official was quoted as describing the purpose of its review as to “close down islands in the sun”. This was later denied, but it is not difficult to imagine circumstances in which, as one set of tests is introduced and passed, so other more demanding criteria will be applied. In this scenario the OFCs will always be found wanting and facing ever more draconian sanctions.
However, the economic distress this would undoubtedly result in may have a political price that the G7 would not find palatable. That the tide may be about to turn is suggested by the views of Dick Armey, Majority Leader of the House of Representatives, in his call to the US Administration to disassociate itself from the OECD initiative. Also, there may come a point when some of these directives and ensuing penalties, which have no legal basis, will be challenged in the international courts.
Viewed from the vantage point of the Cayman Islands, the prospects for captive business are good. As a broadly-based international financial centre, we have the critical mass and service infrastructure to cope with the challenges of tomorrow's marketplace.
Cayman has already been independently assessed as being largely compliant with the core principles of the International Association of Insurance Supervisors, the recognised benchmark in these matters. The call for higher standards of regulation is one we welcome because we see it as an opportunity to enhance Cayman's competitive advantage. Some OFCs may be less optimistic, as might most onshore locations, but a market more focused on quality than quantity (which certainly does not need 50+ domiciles to accommodate it) is, in our view, to be encouraged.
Clive Thursby became head of insurance supervision with the Cayman Islands Monetary Authority in January 2000. For the previous 24 years he was an international risk management consultant, based in London. He is a Fellow of the Institute of Risk Management, of which he has also been a governor.