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Best’s Overview
An electronic conversation
about the US captive market
with Henry K. Witmer of
A.M. Best Company.
April 2007
Markets are flat. How does that affect the rate of captive
formation?
A.M. Best: From trends seen by A.M. Best Company, the rate of
captive formation is affected by the competitive level within the
markets captive insurers operate. Over the long haul, many captives
are formed during periods of hard market conditions. Even if the
overall market is relatively calm, certain lines of business may be in
distress or ones from which commercial carriers pull out. In these
instances, numerous captives are formed to address coverage and/or
the rate needs of insureds. During the liability crises, which seem to
recur each decade, many captives are formed and existing captives
are given greater roles to play in the risk management programme of
parent corporations or owner groups.
On the other hand, as markets soften, captive formation declines,
though not entirely. Not only will the number of new captives be far
fewer, but existing captives find themselves in a balancing act whereby
they need to respond to rate pressures yet maintain sufficient income
to support capital requirements as a viable insurance entity. Group
captives in particular often find themselves in the position of deciding
where to draw the line between the desire to retain a valued member
and the need to avoid diving into the realm of inadequate rates.
One of the major themes, though certainly not the only one, in forming
a captive in the first place, is price stability in the cost of risk to the
owner or group members. This works well during hard markets when
the insuring captive can charge adequate rates to support underwriting
and loss costs, yet be below market conditions. When the market
turns, it takes a stalwart management team, effective communications
with member insureds, and substantial value-added programmes to
counteract the inevitable financial pressures member owners exert
when rates do not decline in lock step with the soft market.
What are some of the critical issues facing captives
today?
A.M. Best: There is not currently one overriding issue that is critical
over all others. Instead, there is a multitude of important issues that
is keeping captive management teams busy. These include line of
business-specific concerns such as the need for greater awareness
of true catastrophe exposures faced by captives offering property
insurance, monitoring trends in litigation types and court verdicts for
various types of liability insurance, and the potential for terrorism,
expropriation, and political risk losses.
On the broader front, all captives are undergoing greater scrutiny by
owners, regulators, and rating agencies to ensure financial viability
and transparency of operations. In addition, as captives perform
a necessary function for corporate owners, senior management
of those corporations is requiring proof that investments in the
captive programme are cost-effective allocations of financial and
human resources, and that the insurance structure and loss control
programmes are in line with their overall enterprise risk management
programmes.
Has the availability of fronting eased in the past year?
How are captive insurers responding?
A.M. Best: Although A.M. Best does not monitor directly the
availability of fronting services, based on information provided by rated
captive insurers, fronting remains a concern for those that need this
service. The number of large carriers that in the past offered fronting has declined, and those that remain charge higher fees and have
more restrictive policy provisions. In addition, collateral requirements
remain onerous, especially for those captives that have a tendency to
change fronts relatively frequently. Nonetheless, it appears that the
situation has stabilised, possibly in response to the general easing of
rates in the commercial markets and the slowing of the number of new
captives formed that may have needed fronting.
Captive insurers have used a variety of responses to the fronting
problem. These have included establishing a risk retention group to
take the place of a fronting carrier for liability lines of business and
ceding most or all of the risk to the more established captive carrier.
Another solution is for the captive to go through the application
process of licensing in its primary States of operation and using a front
for the less critical States, where securing a licence does not make
sense. Finally, some captives have been able to work with smaller,
regional commercial insurers as fronts if the risks insured are localised
in common geographic areas.
Do the forthcoming Alabama captive and developments
in South Carolina represent a new paradigm, or are they merely
localised responses?
A.M. Best: Currently, more than 25 States in the United States have
implemented captive-friendly legislation and regulations, with the
intent to foster an industry catering to the captive market. Many of the
laws are similar in scope and breadth to the laws existing in some of
the older, more established captive domiciles, with each having some
variation in an attempt to differentiate it from other States. Alabama
is a recent addition, as are several other States. In examining the
distribution of existing captives throughout the country, it is clear that
existing and newly formed captives still gravitate to the domiciles with
more favourable rules and proven regulatory capabilities and industry
infrastructure. Nonetheless, there will be some captives, especially
those focused on risks residing in the new State of domicile, which will
find it beneficial to obtain residency in that State.
Among the more established domiciles, competition is fairly heated,
with each of these States spending considerable time and resources to
educate the captive community about the relative values of their State
and how a captive’s programme will be enhanced by being located
there. It is significant to note that this competition is not a race to
the bottom, as might be expected on first guess, but in many ways,
a force driving regulators to strengthen their oversight capabilities
and supporting industry infrastructure to serve the captives better.
This clearly is in response to the need of captive management to
demonstrate to corporate owner senior executives that the programme
is financially sound and operating in a strong corporate governance
environment.
Have the driving forces for a captive insurer selecting
one domicile over another changed in the past year?
A.M. Best: The driving forces for the selection of a domicile change
gradually over time. The needs of captive insurers change in response
to market conditions and risk management priorities. As a result,
new programmes are initiated by captive owners, such as protected
cell captive options, life and employee benefit coverages, subsidiary
captives of parent captives, and captive reinsurance programmes.
Some of these push the envelope of existing legislation in various
domiciles, but with one-on-one consultations with regulators, an
effective solution can be worked out. This also often leads the more sophisticated domiciles to conduct a legal review of their current laws
and to implement changes in order to be responsive to the evolving
needs of the captive community.
Despite 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?
A.M. Best: Referring predominantly to those captive insurers monitored
and rated by A.M. Best Company, the vast majority are indeed about
value-added risk management and the control of programme, to be
able to address the specific needs of the insured parent or members.
In many cases, coverage costs would be prohibitive or simply not
available in the commercial insurance market. Furthermore, loss
control programmes are geared to the unique circumstances of
the insureds and enhance the enterprise-wide risk management
programmes being employed by them.
Is this a cheap way to get an insurance policy? In some cases, it is;
but again, as the goal of a captive insurer is in part to reduce the cost
of risk for the insured and make it more predictable, the cost is in part
applying reasonable rates relative to the market. This is combined with
loss control programmes to induce greater awareness corporate-wide
about the cost of risk and to foster better loss mitigation techniques.
In times of soft commercial market conditions, the captive’s insurance
policy may, in fact, be more expensive than that of another carrier.
In order to achieve the ability to tax-deduct premium costs, a captive
needs to make a serious commitment to write a substantial amount of
third-party business. As this presents additional operating costs and
risks of adverse outcomes, most captives avoid this move. Unlike two decades or more ago, captives today rarely, if ever, cite tax deductibility
as the driving force in forming a captive.
The number of RRGs reached an all-time high in March
2007. Is this growth likely to continue?
A.M. Best: There continues to be interest in forming risk retention
groups, especially as they address the insurance needs of certain
classes of insureds. Today, this may primarily be medical physicians;
tomorrow, it may be contractors or some other group. Offsetting this
growth, in part, are occasional dissolutions of RRGs as the members
lose interest in the programme, due to new options in the commercial
market or the financial results of the RRG being inadequate to ensure
long-term viability.
Also being monitored is the potential for national legislative change
based on the recent Government Accountability Office (GAO) study
of this industry, and the anticipated response to it by the National
Association of Insurance Commissioners (NAIC) and the US Congress.
There have been discussions over the years that RRGs may be
permitted to add property coverage and/or workers’ compensation
insurance. At the present time, neither of these potential additions is
receiving substantial attention.
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