Is it worth having a captive insurer? Does it add value? Jenny Hill looks at the continuing debate.

Is it worth having a captive insurer? Does it add value? Jenny Hill looks at the continuing debate.

Captives have been pronounced dead several times, but any real evidence of this has proved hard to find. The numbers of new captives listed in the Best's Captive Directory continue to rise. On the other hand so do the numbers of captives dissolved (156 in 1999 - Best). Some domiciles are having their best years ever. Others are suffering low or zero growth. What's really going on?

The fact is that the basic conditions for captive establishment have changed over time. The pace of change is also increasing. In those conditions, some captives will falter and fall. Others will thrive. The raison d'etre for a captive 10 years ago no longer applies. If it hasn't moved with the times, its days maybe numbered. However, the changing conditions have thrown up opportunities for different captives, where they provide a solution to a whole new set of variables. The numbers of these have been increasing.

Measuring the development of captives by numbers alone is not enough. Organic growth is also a factor. Net premiums written or investable assets may be better measures of the efficacy of the captive concept. These increased by 15.2% and 11.1% respectively between 1998 and 1999 according to Best. Although growth is occurring worldwide, the real engine is the USA where numbers were up 13% in 1999.

Market conditions
Ten to 15 years ago, companies were forming captives to write what today we would term "vanilla" business. It was safe, it was profitable and it was worth doing, given the market conditions at the time. The captive gave the risk manager additional status within his company, which, in turn, allowed access to the finance director and other decision makers. This was important in the evolution of risk management, giving risk financing a higher profile, and enabling the iterative process of implementation and financial reward to be more closely allied to real experience within the business units. The result was higher standards of risk management and a lower cost of risk overall for many companies.

Some years on, the picture was quite different. Market conditions had changed. The price cycle in insurance had elongated to the point where memories of hard market conditions faded and were almost lost. The shock of a perfect market suddenly acquiring cartel characteristics was something many practitioners had not experienced. Captives were finding it hard to justify their position in the light of external markets willing to write the business at suicidal rates. Just how long could the concept of smoothing be sold when outside markets were willing to buy in the cash flow for less than expected claims? Not very long. Captives were earning the label of "non-viable".

The long soft market was made possible by the extended bull market for equities, the realignment of reinsurers and insurers, low claims activity and stable and increasingly productive economies in the USA and Europe. The downturn in Asian and South American economies has proved to be a somewhat uncomfortable hiccup.

The financial case for a captive is much easier to make when premium rates are high - and that is where they are going today. Property rates have doubled in some cases and motor rates are slated to increase another 25% next year. Some insurers have left the non-life market altogether. But life is never simple, and the scenario is not quite as before. The imposition of insurance premium tax in the UK has put a drag on paying premiums to captives. There is a move towards self-insurance funds and virtual captives instead.

Tax attack
Alongside the soft market, captives have been beset by attacks from the tax authorities in a broader environment of changing accounting standards. Captives have always sought tax efficiencies which are, after all, part and parcel of risk financing. These have been eroded over time, to the point where, for the UK at least, most captives dividend 90% of their profits back to the parent. This strategy leads inexorably to the stagnation of the captive, since it is then unable to use profits to grow the business. Controlled foreign company (CFC) legislation is pending in a growing number of countries, while accounting changes are disallowing "big bath" reserves. Both of these will impact on captive formation. Already we are seeing Dutch companies, hitherto happy to stay at home, looking elsewhere to domicile their captives.

Another drag on the establishment of new captives in the past five years has been the saturation of some sponsor markets. In the UK and Sweden, the top companies all had captives. Other countries were slower than expected in filling the gap, due partly to governmental disapproval and partly to longstanding relationships with insurers. While there is plenty of interest in the captive idea from middle market companies, the low interest rates of recent years have made it difficult to make the financial case for simple vanilla captives. The insurer account and cell participation appear to have been more attractive options.

Today, the top 100 companies in the UK are different animals. The e-commerce members do not have the same level of assets to protect and their insurance spend is quite thin. The listing also has an alarming tendency to change its composition rather frequently.

M&A activity
Mergers, acquisitions and de-mergers also have an effect on the number of live captives. Where one company with a captive buys another - also with a captive - it is difficult to see the rationale of keeping both. In special circumstances, this may be warranted. In general, it's a good chance to repatriate capital to the parent, at a time when cash funds are important. This is not to say that only one captive per parent is desirable in every case. Indeed, the larger the company or group, the higher the proclivity to have multiple captive holdings. Best has analysed the Fortune 500, where results show that 10% of the top 100 companies have more than four captives. For the top 50, that rises to 14%.

UNCTAD's recently published World Investment Report expects global flows of direct foreign investment to exceed $1,000 billion this year - the highest ever. Mergers and acquisitions activity has reached unprecedented levels, with 24,000 cross-border deals. These companies will become global groups and their appetite for captives will be larger than as single entities.

The other side of mergers is de-mergers. If a company has a captive before a demerger, it generally elects for the remaining part to continue to own the captive. This gives the captive two options. It can continue to write all the existing business - thus giving itself and its owner the chance to enhance tax efficiencies through the acquisition of third party risks. Alternatively, it can confine activities to first party risks only, in which case the de-merged entity may have to set up its own captive, thus increasing the numbers, if not the business written.

The continuing steady growth in the USA and Europe should encourage risk retention as companies see risk in other parts of their activities diminish.

Special situations
Some of the most valuable contributions made by captives have been in special situations created by lack of market support, lack of capacity or an inability of insurers to underwrite "new" areas of risk. Mortgage indemnity captives were born in such conditions, as were many customer insurance programmes.

The globalisation of employee benefit programmes has been on the agenda for a very long time, but adequate administration and servicing were not really available until now. Insurers and insureds are both showing interest, and programmes are being placed. The obvious focus for the company is a captive, which can capture the premium flows and the management information so necessary and so absent in current programmes.

It is not unusual for globally represented companies to have multiple policies, placed locally and representing conditions available in the local market. This may not satisfy conditions necessary to retain staff in an increasingly sophisticated and mobile global marketplace.The total amount spent on benefits is also difficult to pin down when the programme is fragmented.

The move is mirrored in the USA, where the regulation of ERISA benefits is also changing to allow greater use of a captive. In eastern European states, there appears to be an appetite for putting employee life, personal accident and pension plans into captives.

Elsewhere the Protected Cell Company (PCC) structure is being used for a range of new and exciting programmes, from credit enhancement to a platform for a range of structured financial solutions. Companies wishing to divest themselves of liability programmes, whether through de-merger or simple clean-up, can use a cell in a PCC to achieve an off balance sheet solution. Single company PCCs can also segregate business unit programmes within the group, while continuing to leverage the buying power of the company as a whole.

PCCs have proved very popular and many of the domiciles have followed Guernsey's lead in introducing the necessary legislation.

Which captive are vulnerable?
There are many factors that mitigate against captive formation. It can also be argued that some existing captives are non-viable because they do not take true risk, they overcharge on premiums and they simply move wooden dollars around the company. Maybe so, but they are still there, and presumably fulfilling their part in a coherent risk strategy. Sometimes that is questionable.

The companies most likely to disappear under current conditions are those that:

  • write low retentions in traditional insurance classes where profitability is marginal
  • have parents that are not committed to formalised risk financing
  • exist to provide tax savings for their parent
  • were set up because it was the "done thing" and not due to any business commitment to risk financing goals.

    Captives will flourish in an environment that provides new opportunities to add value. Despite more stringent tax requirements, this may come through the traditional avenues of smoothing and reducing the cost of risk in a volatile market and through special situations. The latter could arise through merger, acquisition and de-merger activity, through employee benefits, through PCCs or through the changing structure of companies and what they do. How we will be doing business in two or three years' time will be quite different from now, but someone will find a way to make a captive the solution to a problem. If a captive continues to add value to its parent, whatever the circumstances, it is still viable.
    Jenny Hill is an associate, Willis, Tel: 020 7975 2096, e-mail:

    AIRMIC comments
    Nick Chown, chairman of AIRMIC's captives and risk financing special interest group, sees the main benefits that a captive can bring as:

  • a key driver for good risk management through the medium of professional underwriting of risks in the captive and through the added focus that insuring a risk - rather than just paying losses out of revenue - gives to the risk in the eyes of line management
  • participation in profits earned by insurers where a company has better than average risk management and external insurance premiums don't necessarily fully reflect the high standard of risk management, ie keeping profits in house
  • direct access to the reinsurance market (although this is reducing as a benefit since reinsurers are increasingly prepared to deal direct)
  • a means of providing insurance for risks which the external market is not prepared to cover. An important sub-set of this is building up of a insurance track record which will facilitate the provision of excess coverage at a later date by the market. Such cover may not have been available had the captive policy not been effected
    * providing tailored coverage for subsidiaries (such as deductible buy-downs appropriate for each subsidiary's financial/risk profile) beneath group-wide coverage.

    "Tax is for all intents and purposes not a reason for setting up a captive nowadays. There are plenty of good reasons to do this regardless of the erosion of the tax benefits over the last few years. And captives are still being set up so clearly others agree with me. Of course, one company's situation will be different from another's so it is difficult to generalise. Each company has to consider the benefits on their own merits.

    "If a captive is set up, it is important to choose the captive manager carefully and to ensure that the manager's performance is monitored. All managers should be adding value in terms of assisting the parent to develop its captive strategy. They should not just be administrators. "I would advocate that a captive has a proper underwriting committee. There should be a forum for debating proposals for insurance in the captive attended by a professional underwriter and the parent's insurance consultant. This approach can add real value."

    Best's captive directory
    The former Captive Insurance Company Directory, published by Tillinghast Towers-Perrin, is now published by A M Best, in association with Tillinghast Towers-Perrin, as Best's Captive Directory, price $285. It includes:

  • approximately 4,000 single-parent and group or association captives, with risk retention groups listed separately
  • alphabetical worldwide index of captives, cross-referenced by owner/sponsor
  • list of management companies and investment advisors in all domiciles
  • analysis of parent country treatment of captive insurers.

    Is your captive viable?
    A quick health check on your own captive could indicate areas for further consideration. Answering the questions below will help you identify whether your captive is on track to create value for your company in the future. Does your captive:

  • have a mission statement that is known throughout the organisation? know its rate of return on capital for the last five years and its target for the next five years?
  • still offer a cost-effective financing solution?
  • comply with any new CFC legislation, transfer pricing rules and any self assessment tax requirements?
  • review its domicile and structure choices every five years?

  • know how it will respond to changing financial market opportunities?