Captive insurance outlook: 2018 and 2019

For the captive insurance industry 2018 bears a strong resemblance to the end of 2017: a long-awaited tax court opinion dealing with small captives, the post-Brexit environment for European-domiciled captives, and continued strong growth and underwriting performance. New captives formations remained strong both internationally and domestically and appear set to remain that way for the foreseeable future.

The long-awaited Tax Court case opinion of 2018 was released for the Reserve Mechanical case (Reserve Mechanical v Commissioner, T.C. Memo 2018-86) and provided some additional clarity for the industry. Although the case did little to address the distinction between business risk vs insurance risk the opinion did provided guidance on acceptable methods of risk distribution for smaller captive insurance companies.

Captives and captive promoters that used pools in which risk was shared in varying layers (specifically where the premium for each associated layers was not actuarially determined) found themselves in the lurch as they were forced to make wholesale structural changes to adhere to the new guidance or, in some cases, exit the industry entirely.

In 2018 there was also an aggressive shift in the approach of domiciles to the collection of self-procurement and direct procurement tax, specifically in New Jersey and Washington. In New Jersey, the New Jersey Tax Court denied a ~$55 million refund for Johnson & Johnson (J&J), a New Jersey based corporation. J&J obtained various lines of insurance from its Vermont-domiciled captive, Middlesex Assurance Company. Starting in 2008 J&J proactively paid self-procurements taxes to New Jersey based on the premiums of all of its US-based risks. As a result of the passage of the New Jersey Nonadmitted and Reinsurance Reform Act of 2010 (NRRA) J&J took the position that the previously paid self-procurement taxes were not applicable to its transactions and requested the previously mentioned refund (Johnson & Johnson v Dir Div of Taxation & Comm’r, Docket No. 13502-2016).

As has been a common theme with statutes passed regarding captive insurance, the language of the NRRA was less than clear. Ultimately the court weighed what it referred to as “the precise language” of the statute “against its true legislative intent,” and the court found itself “convinced that the New Jersey legislature intended to include self-procured insurance in the adoption of the Home State Rule because it intended to include all non-admitted insurers, and not to limit it only to surplus lines”. As a result of this decision the court found that J&J must pay the tax on all premiums for risks located in the US.

Microsoft

A similarly disappointing result (for the taxpayer) occurred in August for Microsoft’s captive insurer, Cypress Insurance Company (Cypress) in the State of Washington. Similar to the J&J case, the statute in Washington is less than ideal—Washington Insurance Commissioner Mike Kreidler has been quoted as saying “Captives are a gray area in state law and this is the first case where we’ve tested them.”

The state of Washington was the aggressor in this case, issuing Cypress and Microsoft a cease and desist letter and demanding payment of 2 percent sales tax for the $91 million Microsoft had paid in premiums to Cypress since 2008.

Microsoft elected to settle the case and purchase new policies through a surplus lines broker in order to avoid the issue in the future. Although it made for a splashy headline this case will more than likely have little to no effect on the captives industry as Washington has never been deemed “welcoming” to the captive insurance industry, and statements post-Microsoft certainly haven’t done anything to change this perception.

Talent

The captives sector has also not been immune to the talent shortage currently facing the insurance industry as a whole. Impending retirement and a perceived lack of appeal from a younger workforce has not gone unnoticed. The Captive Insurance Companies Association (CICA) has taken specific actions to help introduce the concept and attract and retain new talent through the CICA Mentorship Programme that launched mid-2018.

Universities have also implemented captives-focused programmes and curriculum (following the lead and success experienced by the University of California system), helping to introduce future captive insurance professionals to as many aspects of the industry as possible. Although not directly related to the captives space the Self-Insurance Institute of America is also working to close the age and talent gap through its Future Leaders programme.

Commitments by these universities and their students to attend and participate in industry conferences have also helped to make the captives industry a viable and attractive option for young professionals. Industry efforts to help remedy this issue are expected to continue and increase in the coming years.

M&A

In 2018 there was an uptick in M&A activity in the industry. Shrinking/invalid risk pools, retirement and high insurance sector EBIDTA multipliers are all contributing factors. Big splashes of activity occurred throughout the year, with Randall & Quilter Investment Holdings selling its insurance services and captive managements operations to Davies Group; Risk Strategies’ acquisition of Oxford Risk Management Group; and the merger of JLT and Marsh.

Although these transactions garnered media attention perhaps the more significant activity happened (and continues to happen) behind the scenes. Longstanding members of the captives community migrated from recently merged entities to join competing firms and took their relationships with them. The guidance provided by recent Tax Court cases has also led to a number of “mega-brokers” quietly exiting the space as well. The age of industry principals and elevated sale multipliers would point to a 2019 with at least as much activity in the space as was seen in 2018.

There could be some significant changes in the industry in 2019. The strong desire of fronting and reinsurance carriers to have managing general agents (MGAs) take risk in their programmes could lead to new captive insurance formations. The use of captives for stop-loss coverage is expected to continue as well. The flexibility and adaptability of captives is expected to continue to drive innovation in the industry as a whole through adaptation of new cyber policies, blockchain integration and a renewed interest in parametric coverages—particularly for specialty and catastrophic risks.

Although now past the change mandated by Solvency II, the world post-Brexit continues to be hazy for international insurers, while presenting challenges and opportunities for regional domiciles (Malta, Gibraltar, Ireland, etc) as they compete to be the first to provide a solid solution to the industry. Industry growth should also be expected internationally as new domiciles emerge to take advantage of captive insurance momentum—particularly in the ASEAN region.

US-based regulatory change is shaping up to be as stable as the captives industry has been this past decade or so. Captive insurance statutes can be expected to be enacted and updated throughout the upcoming year (as Kansas did in mid-2018). Changes in efforts of domiciles to attract and retain captives business will likely be tied to how competing states view self-procurement tax as it pertains to captives and their insureds.

It would take something significant and unexpected to upset and reverse the trends of financial performance of the captive insurance industry. Even accounting for catastrophe losses, underwriting profit continues to be strong in the captives space. When measured against the unpredictability of the commercial insurance market the ability of captives to closely mirror the exposures of their insureds, advantageous reinsurance pricing, and insulation from adverse selection all point towards continued success for captives in the years ahead.

Nate Reznicek is director of operations at CIC Services. He can be contacted at:  nate@cicservicesllc.com