2 December 2020ArticleAnalysis

Cayman can ride the wave of new captive formations

“It’s important to look closely at the economics of the structure to understand how much risk you are truly on the hook for.” Pete Kranz, Beecher Carlson

There’s no doubt that COVID-19, combined with the related insurance price hikes and market exclusions, is driving increased interest in self-insurance, and that captive formation is on the rise. While captives have historically been more popular in certain sectors, Pete Kranz, executive managing director and captive practice leader at Beecher Carlson, is seeing interest from “pretty much any industry and right now almost any line of business”—because the hardening market has hit everyone.“We’ve established captives for healthcare, manufacturing, family office, retail, real estate, traditional insurance, service clients, just to name a few,” he says. “The lines of business have crossed all traditional property and casualty lines and moved into lines which have long been discussed but not often financed in captives, such as cyber and directors and officers liability (D&O).“Cyber specifically has led to forced increased retentions as well as reducing capacity in the excess layers. With D&O, while side A isn’t really a captive play, sides B and C have seen premium increases which have made them more feasible. Further, the market has created more opportunities for small and middle-market companies as there has been increased utilisation of cells and group structures.”Making it work
Beecher Carlson has long led the way in finding opportunities for companies to use their captives to deliver lower cost solutions to customers and controlled, unaffiliated risks which are also profitable for the captive—a “win-win situation” as Kranz puts it.“That then helps build surplus in the captive which an organisation can use over time to take greater control of its risk financing and continuing to become less dependent on the traditional insurance markets,” he says.“All of that said, a captive isn’t always the right solution or in some cases at least not right away. Take for example an insured with $1 million of guaranteed cost premiums for traditional property and casualty lines of business with $200,000 of annual expected losses. That’s a lot of profit to give to a carrier, but frankly the economics of a captive don’t work.“The captive adds about $125,000 (or more) of operating costs and the expected loss pick, should the transaction qualify as insurance for tax purposes, is simply too small to generate enough time value of money benefit to exceed those costs,” he explains.In this situation, Kranz says, the better play would be to look at taking, or increasing, retentions, ideally with an aggregate on the retained layer, and banking the excess premium credit (the decrease in premiums in excess of the expected losses) on the corporate balance sheet as opposed to a captive.“Some might look to a group captive, and there are some good group structures in the marketplace, but it’s important to look closely at the economics of the structure to understand how much risk you are truly on the hook for, and how much the expense load of the structure is,” he adds.Focusing on Cayman
Over the past 24 months Beecher Carlson has made a concerted effort to invest in its Cayman operations. As a full-service firm in all North American and major Caribbean domiciles, it views Cayman as very much part of its growth plans into the future.“We are selective in who we invite to join our team and have been very fortunate to snag two very well-qualified folks over the past few years to strengthen the base upon which we will continue to build in Cayman,” says Kranz.“Among our differentiators is the fact our strategy and consulting services are fully integrated into our management operations, not bifurcated like those of our contemporaries. Further, we are the only manager which has established consistent policies and procedures across all our captive management operations and has annually subjected our key controls to independent audit by KPMG—out of Cayman, by the way.“Again, we take a very different approach from other managers in that all of our captive operations, from Hawaii to Bermuda and Cayman, work in concert—we don’t treat any of our team as though they are on an island.”As one of the largest domiciles in the world, Cayman has a long, strong track record, is rich in expertise and well placed to broaden its offering beyond the healthcare foundation on which it was initially built.“It’s certainly not limited to that industry,” says Kranz, who has worked with Cayman captives for at least the last 14 years. “We have captives from a variety of industries domiciled in Cayman, including healthcare, finance, energy, and others.“What makes Cayman very appealing is the quality of regulatory regime. While they’ve faced their challenges—and I want to be very clear, those challenges are global regulations which Cayman has been forced to respond to—the team at the Cayman Islands Monetary Authority (CIMA), led by Ruwan Jayasekera, head of the Insurance Division, has done an excellent job implementing those forced measures while still being a receptive partner to the insurance industry.“As an industry, we understand the regulators have the significant responsibility of oversight and ensuring not just solvency and compliance but that business, generally, is being done right. The challenge in some jurisdictions can be how that then gets implemented—put into practice—and Cayman has done it very well.”Potential challenges
Kranz notes that Cayman does face potential headwinds, as does every domicile. With most business in offshore domiciles such as Bermuda and Cayman coming from the US, the fact that some states (whether within their legal authority or not) are pursuing direct procurement taxes, means that for any company or entity within a group whose “home state” under the Nonadmitted and Reinsurance Reform Act 2010 would be in the US, any transactions with Cayman would likely be subject to direct procurement tax.“Additionally, depending on how the captive in Cayman would be treated, there ends up being potential exposure to federal excise tax, as well as base erosion and anti-abuse tax (BEAT) provisions, etc,” he says. “Cayman, in particular, is also still fighting perception issues as an offshore tax haven or a ‘junket’ for board meetings. These perceptions are undeserved as Cayman stands tall from a regulatory and infrastructure standpoint, but we’d be kidding ourselves if we pretended they didn’t exist.”Looking to the future
“I do believe the future is bright for Cayman as a leading domicile,” says Kranz. “The infrastructure and regulatory regime are very strong and responsive to the industry. In addition, the structure of licensing and proportionality applied to regulatory compliance, which is the cornerstone to any effective regulation, is foundational in everything CIMA does.”He sees Cayman’s strong experience in the healthcare industry as providing a significant advantage when potential captives are considering a domicile—and one of the greatest bright spots for Cayman is the potential business coming from the EU.“The approach to risk financing, as the hardening market has spread around the world, has forced all organisations to consider how they approach financing their risk,” he says. “Where organisations in the EU, and in many countries around the world, previously shied away from taking much risk at all, they are now being forced to take risk by the markets through increased retentions, unsustainably large premium increases, coverage exclusions, and/or reductions in capacity.“Utilisation of a captive should continue to see increased interest from the EU, which should benefit all domiciles, including Cayman.” Amid the current landscape of hardening re/insurance rates, Kranz notes that “it seems as if everyone wants a captive whether it makes sense or not.” Beecher Carlson’s approach is to always be honest with clients when discussing whether a captive makes sense and, if it does, what domicile might make the most sense.“I believe very strongly that organisations should take greater control of their risk financing, for two primary reasons: strategically retaining risk compels an organisation to focus more on driving claims costs down and it allows an organisation to retain more of the upside potential, taking profit out of the hands of the traditional insurance markets.”As the captive insurance market has continued to expand over the years, structures and risk financing mechanisms have become more accessible to the middle and small market through cell and group captives. According to the National Association of Insurance Commissioners, there are 35,000 companies with over $100 million in annual revenue in the US.“If those companies spend 2 percent of their revenue on property, casualty and employee medical insurance, one could argue the captive market has barely even been tapped,” says Kranz. “Follow that with there being over 181,000 companies in the US with revenue between $10 million and $100 million and it starts to boggle the mind. I do need to caution here, again, that a captive is not for everyone and not every group structure is right.“Still, when you think about the possible population of companies, there are significant opportunities remaining for companies to consider how they finance their risk.”