Today, it is estimated that almost 60% of the top 1000 US companies use captive insurance of some sort, underlining the significance of the sector, both for the insured companies as a means of transferring risk, and for the financial institutions and professional services firms that support the business.
Moreover, Roland ‘Andy’ Burrows, head of commercial banking at Bank of Bermuda, notes that the proportions are reversed when looking at the global picture: only just over 40% of the top 1500 companies worldwide cover their risks through captives, leaving significant scope for expansion. A new generation of major companies, sometimes based in countries with less developed insurance markets, is beginning to consider the option of setting up offshore captive insurance subsidiaries.
In this context, The Banker’s round table discussion on global captive insurance held in Bermuda on May 8 provided a timely opportunity for leading practitioners to set out the advantages of these vehicles, and the best practices for establishing and managing them. The discussion was sponsored by Bank of Bermuda, but this report is independently edited and written.
The panel also discussed how Bermuda can maintain its role as the dominant jurisdiction in the offshore captive insurance industry. There are an estimated 2700 captive insurance companies worldwide, and Shanna Lespere, director in the insurance department of the Bermuda Monetary Authority (BMA), reported that 840 active captives were registered in the domicile as of end-2006. These accounted for total assets of $72bn and gross premiums written of $22bn.
THE PARTICIPANTS
| The chair: Philip Alexander, finance editor, The Banker | |
| Roland Burrows, head of commercial banking, Bank of Bermuda | |
| Shanna Lespere, director, licensing & authorisation, insurance, BMA | |
| Oliver Heyliger, managing director, Willis | |
| Brad Adderley, insurance partner, Appleby | |
| Rick Irvine, tax services partner, PwC | |
| Jill Husbands, Bermuda head of office, Marsh | |
| Charles Collis, partner, Conyers Dill & Pearman | |
| Renée Lewis, head of captive insurance, Bank of Bermuda | |
| Tony Bibbings, senior vice-president, Beecher Carlson |
THE THEMES
- A flexible tool
- A long-term commitment
- Risks and regulation
- New opportunities
- Bermuda retains pole position
- A flexible tool
The universe of companies that can benefit from the use of captive insurance is a broad one: more or less any company that has to manage significant risks, according to Oliver Heyliger, a managing director at insurance broker and captive manager Willis. He listed manufacturers, service providers, banks and insurance companies as major captive owners. Brad Adderley, insurance partner at law and fiduciary services firm Appleby, said that companies in the automotive industry have also become leading clients. The irony of captive insurance is that the original stimulus for its growth came from the commercial insurance industry itself, “through their lack of coverage and inflexibility”, noted Rick Irvine, tax services partner at PwC. The creation of captive insurance companies helps the parent to develop coverage tailored to their specific risks, whereas there might be a gap or ambiguity in the commercial policies on offer. According to Jill Husbands, Bermuda head of office for insurance broker and risk adviser Marsh, an insurance industry that was initially resistant to the concept as a competitor has now recognised that these companies are potential partners and clients.
For the parent companies, there are also general financial advantages, said Mr Adderley. They will benefit from greater earnings retention because any profits on the investment of insurance premiums paid into the captive stay within the group as a whole. It is possible to identify more abstract rewards as well, which are still strategically important. Charles Collis, partner at law firm Conyers Dill & Pearman, argued that “purely having a captive forces the parent to focus on the risk of the organisation; to be tracking the risk; to look at more areas of safety within the organisation, and risk-management within those areas”.
The sector offers further flexibility through differing structures: directly-owned captives with a single parent or defined group of parents, or “rent-a-captive” and segregated cell companies, with a legally separate cell for each user or even each individual risk underwritten. The BMA recorded 317 single-parent and 115 group captives in 2006, compared with 62 rent-a-captives.
Ms Lespere said many companies choose to “cut their teeth” through the rent-a-captive structure before graduating to the more complex and demanding risk management processes of a directly-owned company. The shared infrastructure of a rent-a-captive minimises the running costs and management time required for insured parties – for instance the statutory auditor for the business.
“Timing can be an issue,” added Mr Collis. “It is often faster to use a cell” in a pre-existing captive than to set up an entirely new venture. However, Mr Irvine pointed out that the insured companies would not have overall control of the captive’s business strategy, “so you have to weigh that balance”. Moreover, said Mr Collis, individual cells must be fully funded through letter-of-credit or cash up front, reducing the parent company’s flexibility on making premium payments.
This diverse range of products also allows financial services providers to offer “more customised solutions for our clients”, said Renée Lewis, head of Bank of Bermuda’s captive insurance team. Companies can use variations of the segregated cell model in particular to tackle different kinds of risks. Mr Heyliger explained: “There are a number of segregated cell companies that are not in fact rent-a-captives: those cell companies are used to segregate different portions of the same parent company’s business, either by division or by product class.”
Life insurance companies increasingly use this model, said Mr Adderley, especially for their high-net-worth client segment, with each client’s account being allocated to a separate captive cell. This approach is particularly helpful for separating out and managing the more complex and non-standard risks of unique privately placed policies and variable annuity products, said Mr Collis. For variable annuities, “either the whole policy runs through the cell, or the investment portion only, and the mortality account goes out to a reinsurer”, he said.
- A long-term commitment
Given the administrative costs of running a captive, a premium volume of $1m is applied as a rough guide for the minimum threshold level, below which the insured party should consider using a cell or regular commercial insurance, said Mr Collis. Using a captive gives tax advantages to the group as a whole because the payment of insurance premiums is usually tax-deductible. But Mr Irvine emphasised: “We wouldn’t let the tax-tail wag the business-dog… There are certain tax advantages to having captives, but when you consider the whole business aspect, I think they’re relatively neutral.”
This feeds into a wider point of agreement among all participants: that the most important criteria is to make sure the would-be parent company is committed to its captive as a long-term strategy. “A captive isn’t something you set up, and then two years later you liquidate. You’re bound to lose money if that’s the sort of attitude that you have when you go into it,” said Ms Husbands. For each dollar switched into the captive insurance market, very few cents subsequently returned to commercial insurance, she said. Consequently, the decision needs to be based on more careful calculations than just a suspicion that commercial insurers are overcharging for a risk on which the company has had limited loss-experience.
“Parent companies probably need a real business reason for setting it up, rather than just thinking that their experience over the last couple of years has been better than industry, and they could have recouped a profit,” said Mr Collis.
In practice, steep price increases on commercial insurance were frequently the initial stimulus for a fresh round of captive creation, argued Mr Burrows. Moreover, a captive insurance subsidiary, especially one based in a leading offshore reinsurance jurisdiction such as Bermuda, could often access the reinsurance market more cheaply than if the parent had insured directly, he said. Still, he agreed that the pure cost-saving motivation needs to be replaced by a longer-term funding strategy once the captive is up and running.
When a captive is maintained in this dedicated way for at least five years, it becomes a more genuine tool of risk management rather than just a “risk buyer”, Mr Irvine pointed out. This is because the high level of funding offers the parent significant flexibility to transfer new risks to the captive if general commercial market conditions become tougher, for instance after major insurance events such as September 11 and Hurricane Katrina.
- Risks and regulation
A further question for any would-be captive owner is the type of risk that should be insured through this vehicle. Mr Heyliger emphasised that the layer of “low premium, high volume” risks was the best suited for the captive. By contrast, said Mr Irvine, larger long-tail risks were best transferred to the wider commercial market to protect the solvency of a single-parent captive. The selection of items underwritten by the captive will then dictate whether the manager chooses to reinsure. “You wouldn’t buy reinsurance for handset insurance on mobile phones, you would keep the risk, because you wouldn’t expect all several million customers to lose their handsets on the same day,” said Tony Bibbings, senior vice-president at insurance broker Beecher Carlson.
There also appear to be geographical divides, said Ms Husbands, with captives owned by European parents more likely to access reinsurance than their US counterparts, although about 60% of all captives use some form of reinsurance.
The whole risk-management process in captives is overseen by the BMA, and Ms Lespere emphasised that its regulatory approach has always recognised the difference in risk profiles between captive and commercial insurance companies. Most fundamentally, for a single-parent captive, the shareholder and the insured party are one and the same, with interests aligned. The BMA’s solvency and capital resources requirements are therefore founded on four insurance categories, with single-parent and group or association captives each placed in their own category (classes 1 and 2, respectively), quite separate from property and catastrophe insurers and reinsurers (class 4). “Class 3 was a catch-all – in that group there are smaller or newer captive companies as well as commercial companies, but we are now refocusing,” said Ms Lespere.
This unique risk-based model was widely hailed by other participants at the round table for providing would-be captive insurance clients with clarity on how their companies would be treated. However, Ms Lespere added that the BMA is also keen to engage with the highest standards of international regulation and compliance legislation, such as the EU’s Solvency II regime and the US National Association of Insurance Commissioners (NAIC) guidelines. “We are gearing ourselves up for cross-border supervision and mutual recognition, but a lot of what is developing on that front is more geared towards our commercial market as opposed to our captive market,” she said.
Rather, the prime motivation for the BMA to remain at the forefront of the international standards debate in the captive insurance sector is to maintain Bermuda’s status as the leading high-quality captive domicile, instead of simply attracting large volumes of business. In keeping with this attitude, the BMA counts a segregated-cell company as just one captive in its survey process, rather than counting each cell separately to pad the statistics. The list is also cleansed of “dormant” captives, and the companies are monitored closely at the preliminary stages of creation.
“We take a very detailed and thorough review to see if we’re comfortable with the pedigree of those companies, the line of business, the level of risk... If you stop the bad companies from coming in, that mitigates risk,” said Ms Lespere.
The BMA also monitors each captive manager’s financial stability and controls, IT infrastructure and client servicing capabilities, and its most recent initiative, a Captive Manager Assessment programme, recently received a seal of approval from an IMF mission to the country.
For Mr Collis, this approach is vital for retaining the confidence of high-quality corporate clients, who are themselves subject to intense regulatory and reporting scrutiny in their own domiciles, such as know-your-client (KYC) legislation and Sarbanes-Oxley. Ms Husbands said that on the portfolio management side, the conservatism of most captive managers has ensured very limited exposure to the fall-out from the US subprime crisis, with a high proportion of investments kept in cash or money-market funds. But she acknowledged that the higher cost of capital and general lower investment returns have sometimes raised the threshold for a captive to be a feasible proposition.
- New opportunities
The lower penetration of captive insurance outside the more mature markets of North America and western Europe clearly presents one of the most significant opportunities for the industry. According to Mr Collis, although there are some new clients from south and eastern Europe, European companies tend to gravitate towards European insurance jurisdictions. Mr Bibbings said that, by contrast, “South America does not have any captive domiciles of its own, so it definitely has an interest in Bermuda.” Ms Husbands said the more developed Asia-Pacific markets such as Australia, South Korea and Taiwan were also generating new clients. In terms of the sectors offering most potential, Mr Irvine said: “Just watch for the next crisis is in the US”, because major events that have affected a given sector of commercial insurance have routinely generated new captive activity in that sector. This trend is becoming more marked because of the increased frequency of high-severity events. “Hurricane Andrew [in 1992] was billed as a one-in-100-year event,” said Mr Irvine. “Since then, we’ve had four risk events that were larger than Andrew”, including Hurricane Katrina and September 11. Mr Bibbings mentioned the professional indemnity cases against US nursing homes in the 1990s as another crisis that triggered new captive creation.
However, a more predictable source of growth in suitable low-premium, high-volume business has been the private health care insurance sector, as demographic change and higher medical costs squeeze the commercial providers. There are 58 health care captives in Bermuda, according to the BMA. Mr Bibbings said he also believed the longer-established captives would begin to use their capital more actively to underwrite third-party risks. “Instead of being a cost-centre, the captive turns into a profit-centre,” he said.
THE KEY THEME: Bermuda retains pole position
The success of Bermuda’s captive insurance industry has inevitably generated its imitators, but there was widespread confidence in structural factors that should help the jurisdiction to retain its lead. Mr Adderley explained the importance of symbiotic relationships: commercial insurance companies had originally gone to Bermuda in the 1960s onwards to seek new business from the captive insurance market. Now the roles are reversed: “The captives are coming because of access to a real commercial marketplace in Bermuda, which other offshore jurisdictions do not have,” he said.
The combination of a large commercial insurance sector and a longstanding captive sector has created a concentrated pool of expertise – a “one-stop-shop”, in Mr Irvine’s words.
The Bank of Bermuda hopes to strengthen that pooling of resources, following its purchase by HSBC in 2004. “We are now saying we can give you a global banking platform, our strategic partners can operate from here but see their worldwide operations, if they want to,” said Mr Burrows. “We are looking at meeting some of the captive parents, providing investment opportunities and custody opportunities for their core cash or core strategies.”
However, while the BMA’s clarity and accessibility for consultation remains a further important attraction compared with US or UK insurance jurisdictions, Mr Collis noted that factors beyond Bermuda’s control could always influence its appeal. Many US states are now passing legislation to enable captives, although these onshore jurisdictions are more likely to compete with each other than with Bermuda. And these changes can work both ways: a special treaty that gave Barbados favoured status for Canadian captives has recently been repealed.
