14 August 2013Analysis

Proof of their worth

AM Best rates more than 200 captives internationally. The rating agency therefore has an intimate knowledge of the health and heading of the sector. US Captive spoke to John Andre, group vice president, and Steve Chirico, CPA and assistant vice president at AM Best, about developments in the US captive sector and the continued and deepening appeal of captive entities.

What are the broad trends AM Best analysts are seeing in the market?

John Andre: When we first got involved with captives years ago, they weren’t as sticky as they are now. When markets turned, captives would be folded or put on the back burner; now captives are a much more permanent risk solution for corporations and groups globally. We’re seeing that in spite of what the market might or might not offer, captives represent a significant tool for individual risk managers.

Steve Chirico: Among single parent captives we are also seeing a lot of rating activity. The reason for this is that while companies might have established a captive some years ago, they have been using them in a demure way as a risk financing tool.

Parents have also realised it’s nice to have both an onshore and an offshore solution, so we find a number of Bermuda-Vermont or Cayman-South Carolina solutions in the market.

Since the crisis, but particularly in the last two years, corporate risk managers, CFOs and treasurers have sought to maximise the value the captive brings to the parent company. We see new lines of business and new ways of structuring programmes, and companies using their captives to do so. Some of those entities need ratings; others need certain types of licensure. So we see companies exploring their options and having that curiosity about how to maximise the employment of their captive.

And it isn’t just captives—I think businesses in general are trying to take efficiency to the highest level possible. Certainly the optimisation of a captive unlocks value and benefit in an already established entity.So we’re seeing a lot of new single parent captive ratings as parent companies seek to utilise their captives more actively.

Andre: The economy in the US and elsewhere is forcing people to be more creative with what they have and see what kind of cost savings they can institute without losing capabilities. Companies are super-bottom-line-focused these days, and certainly, if you can keep business within a captive as opposed to going to the commercial market, it fits with such a philosophy.

Chirico: I started in the captive space 10 years ago, and was told, “When it’s a hard market you’ll see captives form and be capitalised and start writing business they hadn’t before, and when the market softens they’ll shrink and become dormant.” We don’t notice that any more. What we notice is that captives are forming and continuing to be utilised in both hard and soft cycles. The reason for that is since the crisis of 2008 companies realise that control is important, with captives enabling them to control their risk management.

If there is a lack of coverage, they have their captive. If reinsurance becomes expensive they can take a bigger bite with their captive. If there is fluctuating pricing and they don’t know what the future holds, the parent has its captive to step in for price stability. We have noticed some parents for example increasing the capitalisation of their captives in order to act as a safety buffer, so they’re taking bigger lines from reinsurers and decreasing the level of activity that fronts are performing, with even single parent captives building their own claims departments. It’s an effort to retain greater control.

I guess they learned in 2008 that so much is out of their control, and the more you can control the better off you’re going to be.

Do you see the market hardening now or in the near future?

Andre: I think portions of the market are hardening; certainly risk-impacted areas. If you wrote business in a region affected by Superstorm Sandy, prices in the commercial market certainly went up this year at renewal. Workers’ comp is also coming around a bit, although it’s variable by state.

Chirico: What we have seen in places such as Florida is pricing dropping through the floor because there hasn’t been an event in Florida for the last few years. To John’s point, pricing has become more regional as opposed to a general hardening or softening, as the market has become more sophisticated.

What effect is the low interest rate environment having on captives?

Andre: It has probably had more impact on the commercial market than the captive sector, because the commercial market is generally not as good an underwriter as the captive market.

Chirico: The mission of captives has never been cash flow underwriting. The mission is more towards capital preservation. A typical captive has an investment portfolio that is generally composed of 80 percent sovereign and very highly rated corporate debt and maybe a smattering of equities just to act as a loss cost inflation hedge.

"A lot of the management is pretty consistent, and managers will often get involved with getting legislation approved or organised."

With very few exceptions, the 250 captives we intimately follow have very conservative investment portfolios with their focus being on preservation of capital. The investment income is a sweetener, so when they make 1.5 percent that’s all good, because they’re making substantial money on the underwriting side. But captives would much rather plough their resources into loss control and engineering to prevent losses. It’s a whole different perspective when talking about captive investment income. When you have to answer to a corporate CFO about what you’re doing with your investments, there tends to be a level of conservatism that really isn’t present in the commercial market.

Andre: Our research has shown that the underwriting performance of our rated captives is eight to 10 points better than the commercial markets, sometimes even higher.

Even though captives don’t invest in speculative investments, there really is no need because the underwriting generally performs far better. The commercial market doesn’t nearly have the cushion in terms of underwriting performance.

How are regulatory and tax uncertainty in the US affecting the captive market?

Andre: It has been a challenge and it’s gone on for some years. It spikes every time the US is looking for resources. A number of captives came onshore or are onshore anyway as a result of political pressures. While some parents might have one onshore and one offshore captive, and work it that way, it hasn’t slowed the captive market as a whole.

Chirico: The Internal Revenue Service (IRS) constantly and continually challenges the deductability of premiums paid to captives, and also weighing in is the commercial insurance lobby. The facts are that captives onshore pay US taxes like everybody else and a lot of offshore captives take the 953d tax election to be treated as a US taxpayer. If you don’t pay that, you pay the excise taxes, so it’s six of one and half a dozen of the other. This whole idea that captives are beneficial from a tax perspective is not as significant as people think. There is a tax benefit, but it’s not that you pay no taxes.

The IRS has not been successful in challenging captives onshore and offshore from a tax deductibility perspective. The last serious salvo, which happened in 2007, involved the IRS pursuing single parentcaptives, challenging the deductability of loss reserves. The Vermont Captive Insurance Association and others mounted a successful defence arguing that a change would increase the cost of doing business and place captives in an adversarial tax position. They argued that if the premium had been paid to a commercial insurer company, they would get to deduct the entire amount—including the portion of the loss reserve—but in doing so they would have to cede control of their insurance coverage, leading to higher costs. The issue was effectively thrown back at the IRS and there hasn’t been a significant challenge since, but I am certain there will be another challenge in the future.

A lot of companies have, meanwhile, looked for an onshore-offshore solution. Certain types of risks make sense on and offshore. Risks such as global property risk could be best placed in Bermudian and Cayman captives. Other risks, such as excess workers’ compensation and terrorism make a lot more sense to write onshore. So a lot of companies have developed a bifurcated solution that allows them to maximise the captive’s benefits to the parent company.

What are some of the innovations you are seeing in the captive market?

Andre: Cell captives are leading the charge. There are various forms, depending on domicile, and different flavours of the cell captive concept. A lot of states are promoting specific state-related cell captive legislation.

Chirico: Last year, for instance, Vermont passed cell captive legislation. There’s a recognition that having your own captive and absorbing all of the frictional costs associated with running it doesn’t always make sense. Sometimes having a cell and being a part of a big organisation that can share costs and negotiate on your behalf is a more efficient way to go.

Andre: It’s a concept for the next-sized company, because the Fortune 500 types all have their single parent captives in place.

Chirico: The other development is Delaware’s inclusion of series captive legislation. We’ve been approached by several series captives for ratings and that will be a very interesting project. So not only do you see cell captives, you see the next permutation, which are series captives.

The captive market itself is an innovation. It’s an innovation of the traditional commercial market, where interests can often be misaligned. You pay a fixed premium and whatever your losses are they are absorbed by the insurance company. But as a parent the only impetus you have to spend money to control your losses is that your losses will stay low and you’ll be able to negotiate a lower premium. That takes time and it’s hard to show the cost benefit of securing a million dollars to put a loss control programme into place.

You contrast that with what happens in the captive space, where the company is paying its premium to its own company, which then provides loss control and claims mitigation services to its own company. Everybody’s interests are aligned to reduce losses—to prevent them in the first place and to mitigate them when they first happen. That alignment of interests is a large part of the financial success of captives.

How does the US measure up to other captive markets in terms of sophistication and innovation?

Andre: Captive mangers are proactive in every market. So a lot of the management is pretty consistent, and managers will often get involved with getting legislation approved or organised. Because ofthat, there are going to be nuances in every domicile, but there’s a lot of homogeneity between domiciles.

Chirico: There are good and mediocre domiciles onshore and there are good and mediocre domiciles offshore. If you are in a good domicile in the US, there are a lot of domestic resources to help you maximise the use of your captive and—from a sophistication perspective—add new lines of business.

That level of sophistication comes from the captive manager’s advice and counsel. In Vermont for example, there are a host of accounting and law firms there to help guide you through the maximisation of your use of your captive. If you are in a domicile that’s relatively new however, that will come in time, but in the immediate term the resources really aren’t available to guide you through your initial work.

What are some of the major developments you see on the horizon?

Chirico: The big thing that’s going on now is new products. Lines such as employee benefits have been talked about for a few years and we are now beginning to see some traction. This is where captives haven’t played before, but it makes a lot of sense. We are also seeing captives get involved in micro-insurance in Latin America and lines such as transactional coverage and surety bonds where captives can be used as the vehicle for such transactions.

Andre: Existing captive owners are looking to make maximum use out of their captives and new captives may be formed to follow more classes of business. It’s innovating and moving captives forward through product diversification. Chirico: It is essentially about increasing the use and efficiency of captives, something that parents are doing across the board, not simply in risk management and financing.

JA: Challenge what you’re doing, challenge your systems. It’s all part of cost control, and at the end of the day that’s what you’re looking for.

John Andre is group vice president at AM Best. He can be contacted at:

Steve Chirico is CPA and assistant vice president at AM Best. He can be contacted at: