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Captives’ Q&A with A.M. Best
US Captive interviews Henry Witmer
of A.M Best about the captive scene.
April 2006
With rates softening in the casualty lines of business and in many property lines as well, do you see this as a poor time for companies to use their captives or form one?
Witmer: A captive insurance company requires senior management commitment for the long resources are required to start up, fund, and operate a captive properly. If there is not a perceived long-term benefit from investing in a captive, then one probably should not be formed.
In addition to long-term savings on insurance premiums, investing resources to establish a well-run captive will provide a focal point for effective risk management and control of loss costs. And this is the key point: regardless of hard or soft market conditions. Captive owners must balance intermittent low cost insurance, which will lead to volatility, with the stability of a captive programme. Besides premium cost considerations, with commercial insurance an insured faces potentially inadequate policy services or ones that do not address its unique circumstances.
Regardless of when a captive is established, a sophisticated approach to enterprise risk management and economical use of corporate resources will generate long-term financial benefits to the owners. The captive will offer opportunities to respond to new exposures or gaps in coverage, particularly as its experience and capital base expands. What are some of the critical issues facing captives today?
Witmer: Fronting availability is one issue. There is growing concern that with fewer insurers offering these services, prices will be prohibitive and too much control of the captive insurance product will reside with the fronting company. A related issue is the amount of collateral that fronting carriers require either in the form of premiums held, investment accounts under the control of the front, or letters of credit to protect the front’s exposure for statutory relief purposes. Another issue is the increasing pressure on captives to retain higher limits on risks. Excess carriers and reinsurers are demanding even greater distance from the exposures to loss. To have the capacity to absorb these potential losses poses tremendous strain on available capital. Although a cost/benefit analysis may prove it is more economical to retain these limits, it could require the owners to infuse capital.
In order to ensure relevance and that value is added, a captive must maintain long-term capital strength appropriate to the levels of risks assumed and avoid following market rates down to uneconomical levels. With fewer insurance companies offering fronting services, how are captive insurers responding?
Witmer: Some captive companies have been seeking licences as an admitted carrier or excess/surplus lines carrier status in those jurisdictions in which most of their business takes place. Although this will yield long-term benefits, it is a time-consuming process and requires diligence in monitoring all the submissions and responding to requests for supplemental information and documentation.
Another avenue of approach taken by group captives domiciled offshore, but with their risks sourced in the United States, is to establish their own fronting risk retention group in a US domicile and cede most of the risks to the offshore captive. The advantage with this arrangement is the ability of the new risk retention group to offer coverage to members in all the States with minimal licensing activity. The downside is that a second insurance entity is created, which needs to maintain its own capital strength to front the business, to retain a certain percentage of the business to satisfy its domicile requirements, and to cover the credit exposures on ceded premiums and reserves. In addition, risk retention groups are able to provide liability coverages only.
On good accounts, some fronting carriers have offered more favourable programmes if they are able to participate either on excess portions of the risk or as a quota share participant on the working layers. The key is to enhance one’s negotiating position through knowledge of all viable options, maintaining a strong captive operation based on capital strength and sound risk management programmes, and a willingness to make adjustments as circumstances dictate.
It seems each week another State or offshore domicile is proposing or enacting legislation to permit the formation of captive insurers within that jurisdiction. Is this encouraging or do you see problems ahead?
Witmer: It is encouraging that there is an increased interest on the part of legislators and regulators in the alternative risk transfer market. Even more so, it is a tacit recognition that the ART market has become a sizeable component of the insurance industry and that it can have a favourable impact on local economies. Currently, there are more than 25 captive domiciles in the United States alone, and a few more are considering laws to promote captive formation in
their States. Obviously, there will be some competition to draw captives into these domiciles and that may lead to some abuses or unscrupulous operators taking advantage of the unwary. Nonetheless, on the whole, there is no need to disparage any domicile, either within the US or offshore, so long as the authorities perform their due diligence in reviewing captive submissions and monitoring captives residing within their jurisdictions.
More of an issue is how strong is the captive management infrastructure for establishing and operating a captive, particularly a large, multi-faceted one, which requires actuarial, legal, and accounting services. Captive owners need to assess whether most of the work in operating a captive efficiently will be performed in-house or outsourced. The latter will require a domicile with a broad infrastructure.
Another consideration is access to markets, whether it be the United States, Canada, the European Union, or Asia. Does the location make sense in relation to where the risks are located; where corporate management is situated; and, where reinsurance capacity is available? Is this a zero sum game with captives moving from one domicile to another, but the total count of captives remaining
the same?
Witmer: There will continue to be some limited redomiciling, as in the past. However, most growth will occur from new captive formation and from parent companies forming additional captives to address a need in a certain area. An example of the latter is the number of US parents forming a second or third captive in Dublin for direct insurance of risks in the European Union. One also can point to the interest in segregated cell captives in which small companies without the resources to establish their own captive can take advantage of the alternative risk transfer market.
One also needs to consider the natural life cycle of a captive insurance company, as in anything else. A captive is set up for one reason but needs to adapt and adjust to new needs and circumstances.
Parent company business profiles change, the factors that made sense for a captive a number of years ago evolve over time and a fresh look at the economics of the captive, how it operates, and where it is located is beneficial. This can be propelled by merger and acquisition activity—or changes in laws and regulations. Opportunities in a new domicile will generate a business decision to redomicile. What are the driving factors for a captive insurer in selecting one domicile over another?
Witmer: These will differ from one captive to another and will fall into one of two categories: operational factors and financial factors. The quality and availability of captive management services, proximity to the insured exposures and corporate risk management departments, regulations regarding licensing to write direct insurance, and access to reinsurance underwriters and brokers are important operational considerations. A number of financial and economic issues come into play including set-up fees, taxes on income generated within the captive, and the costs of services provided and of holding the annual meeting within the domicile.
A further consideration is whether the results of the captive will be consolidated with those of the parent for financial reporting purposes and tax filings or whether the captive will be treated as an investment. Finally, if the parent is considering including third-party business in the captive to enhance tax deductibility of premiums, a domicile selection may be important to exemplify an arms-length treatment of the captive.
Despite all the rhetoric about risk management and control of programme, do most captives still represent a cheap way to get an insurance policy and tax deductibility of premium costs?
Witmer: Yes and no. There are many captives and many captive owners, so there surely are some captives that are insurance in name only, providing protection that can be described as “shaky” at best.
On the other hand, it is clear that a majority of captive owners, these days, are well aware of the long-term benefits of a financially secure, well-run captive insurance programme. Captives have become an effective tool in a broader corporate-wide enterprise risk management philosophy. This now is a big part of the picture in determining what should go into the captive and how financial and business exposures will be secured so that the overall cost of risk to the parent organisation or group is minimised. When loss cost awareness is driven down to the divisional level and assigned line management accountability, significant further reductions in losses and expenses have been garnered. Here the captive programme will act more in an excess role, reducing higher layer insurance costs and the trading of dollars with commercial carriers.
Furthermore, captives are taking a much more conservative approach to writing third-party business. Although the aim is accelerated tax deductibility in most cases, the focus is on developing a profitable book of business to supplement the related party account.
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