Captive Risk Explained

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• Introduction

Captives, as an attractive alternative to self-insurance, have long been used by many prominent companies to manage their insurance risks. While the captive concept has existed for centuries, it has gained widespread acceptance only in the past few decades. Today, the captive market is as active as it has ever been, with its benefits now attracting worldwide attention. Captives are widely used both domestically and abroad. A.M. Best estimates that there are more than 5,000 captives worldwide. While Bermuda, the Cayman Islands, Barbados and Guernsey have historically been the most popular domiciles for captive formations, many of the captives formed today are in the United States.  This article provides an overview of the captive market—including the types of captives, popular domiciles and typical risks underwritten—and discusses the recent emergence of captive reinsurers/special purpose vehicles to transfer third-party insurance risk.

• Captives Defined

In its simplest form, a captive is a wholly owned subsidiary created to provide insurance to its non-insurance parent company (or companies). Captives are established to meet the risk-management needs of the owners or members. They are essentially a form of self-insurance whereby the insurer is owned wholly by the insured. Once established, the captive operates like any commercial insurer—i.e., it issues policies, collects premiums and pays claims, but it does not offer insurance to the public—and it is regulated as a captive, rather than as a traditional insurer.

The International Association of Insurance Commissioners (IAIS) defines a  captive as “an insurance or reinsurance entity created and owned, directly or indirectly, by one or more industrial, commercial or financial entities, other than an insurance or reinsurance group entity, the purpose of which is to provide insurance or reinsurance cover for risks of the entity or entities to which it belongs, or for entities connected to those entities, and only a small part if any of its risk exposure is related to providing insurance or reinsurance to other parties.”

The type of entity forming a captive varies from a major multinational corporation to a nonprofit organization. Captives are held by the vast majority of Fortune 500 companies as an alternative method of risk financing (e.g., Gold Medal Insurance Co. was established by General Mills as a captive  and Allstate was originally set up as a captive by Sears & Roebuck Co.). The industries with the greatest number of captives are finance, real estate, construction and manufacturing. Over the past several years, there has been particular growth in areas such as health care, property development and securitization for life insurers. A corporation that forms a captive will normally organize the captive as a subsidiary. Because few companies are in the business of insurance themselves, most captive parents will hire an outside firm, often an insurance company or captive manager, to manage the captive for them.

• Origin of Captive

To give a bit of history, the captive concept has been around for a long time. In the early 1500s, ship owners met in the London coffeehouses where they retained, shared and transferred the cost of risk associated with their ships, akin to today’s captives. During the 1700s and 1800s, there were instances of mutual insurance companies being formed by members of a particular industry to provide insurance coverage.

The term “captive” was coined in the 1950s by Frederic M. Reiss, a property engineer turned insurance broker in Youngtown, Ohio. Reiss, known as the father of captive insurance, used the term “captive” to describe an insurance company he helped form to provide insurance coverage solely to the parent.  In 1958, Reiss incorporated American Risk Management and began to assist corporations in setting up captives.  During this time, U.S. regulations made it prohibitively expensive to form and operate captives in the United States, leading Reiss to seek out other jurisdictions to allow his captive idea to flourish.  In 1960, Bermuda became an offshore financial center and, in 1962, Reiss set up the first modern-day captive there called International Risk Management Ltd.

The captive concept took a while to catch on. It gained momentum in the mid-to-late 1980s during the hard commercial insurance market, when liability coverage was either unavailable or unaffordable for many buyers. Over the past three decades, there has been significant growth in the captive market. Today, there are more than 5,000 captives that do business around the world in a variety of industries, compared to roughly 1,000 in 1980. Almost 3,000 captives are domiciled in the Caribbean; 1,200 captives are domiciled in Europe and Asia; and more than 1,000 captives are domiciled in the United States.

• Type of Captives

There are various types of captives, depending on the needs of the parent company or owners. The vast majority of captives insure only the risks of its parent. Over the years, variations have flourished as companies come up with more sophisticated and innovative ways to use captives. The types of captives in use continue to evolve and proliferate to address the growing need for alternative risk transfer.

The most common types of captive structures are listed below:

  • Single-Parent Captive – A company writing only the risks of its parent and/or affiliates. Single-parent structures are often referred to as wholly owned or “pure” captives.
  • Group Captive –A captive established by a group of companies with similar businesses or exposures writing only the risks of its owners and/or affiliates.
  • Association Captive – A captive owned by a trade, industry or service group (e.g., doctors) writing only the risk of its owners and/or affiliates. An association captive is similar to a group captive except that it is sponsored or owned by a group of entities within a particular organization with common insurance needs and similar exposures.
  • Rent-a-Captive – A captive owned by an outside organization and open to participants for a fee. Members “rent” licenses and capital from the rent-a-captive owner. A rent-a-captive, or rental captive, is often used by entities that prefer not to form their own dedicated captive or for a program that is too small to justify incorporating its own captive.
  • Risk Retention Group (RRG) – Approximately 250 RRGs in the U.S. are organized as captives. An RRG is an association or group captive formed for the principal purpose of assuming and spreading risk for commercial liability exposure. It is important to note that not all RRGs are licensed as captives. The formation of RRGs is authorized by a federal law—the Liability Risk Retention Act of 1986—that limits many of the regulatory requirements that otherwise might be imposed on RRGs by non-domiciliary states.

The above list is not exhaustive. In addition to these types of captives, there are agency captives, branch captives, senior or diversified captives, protected cell captives and producer-owned reinsurance companies (PORCs).

• Risks Underwritten

Companies form captives to mitigate their exposure to a wide range of risks. Practically every risk underwritten by a commercial insurer can be provided by a captive. The majority of captives provide mainstream property/casualty insurance coverage such as general liability, product liability, workers’ compensation, director and officer (D&O) liability, auto liability and professional liability (e.g., medical malpractice).

Captives also provide specialized coverage for unusual or hard-to-insure risks (e.g., terrorism risk). Oil companies have used captives to gird against environmental claims related to infrequent but potentially high-cost events. Other types of nontraditional insurance coverage that a captive could underwrite includes credit risk, pollution liability, equipment maintenance warranty and employee benefit risks, including medical benefits, personal accident and, in some cases, whole life insurance.

• Why Companies Establish Captives

The captive concept was originally created to solve a problem: Historically, captive formation and utilization peaked during periods of rising commercial insurance costs and when there was difficulty in obtaining certain types of insurance coverage. This could happen after major events hit commercial insurers, such as the Sept. 11, 2001, terrorist attacks or Hurricane Katrina in 2005. Today, captive formation and growth continues to rise during both hard and soft markets. Most companies now establish captives for microeconomic reasons such as cost reduction, risk management or risk control.

Captives have become a popular risk-management tool for organizations seeking greater control over managing their insurance needs. Two main drivers for forming captives are risk management and risk financing.  A captive helps a parent company manage a block of business. It also allows the parent company to respond quickly to changes in the commercial insurance market and to identify the most efficient way to finance an identified risk. This could mean a lower cost of coverage than conventional insurance markets. The parent also could use a captive to obtain coverage for risks that would otherwise be quite costly, or unattainable, in the commercial insurance markets.  Companies also establish captives to gain direct access to the reinsurance market, which can reduce the cost of insurance protection to the parent company.

Moreover, while certain tax advantages exist with respect to a captive, this is not the primary reason why captives are established. All U.S. jurisdictions require a business plan for regulatory approval and the premise for a captive must be non-tax-related; in other words, the genesis of the captive arrangement must be a legitimate business need for a corporate parent or group. Nevertheless, there is important incidental tax benefits associated with forming captives. The principal benefit is the treatment afforded an insurer with regard to establishment of loss reserves under the U.S. Internal Revenue Code.

• Domicile of Captives

Captives can be formed in a wide number of domiciles, both onshore (located within the jurisdiction of the United States) and offshore (located outside the jurisdiction of the United States).  A domicile is the jurisdiction in which a captive insurer is incorporated and regulated. Captives were initially formed in offshore tax haven jurisdictions such as Bermuda or the Cayman Islands. Over the years, however, these long-standing offshore domiciles have been joined by Vermont and other U.S. states, as well as places as far apart as Malta, Panama, Singapore, Dubai and Bahrain.

The number of captive domiciles is growing and remains competitive. Many new domiciles are attempting to emulate the success of some of the major domiciles. In terms of number of licensed captive insurers, Bermuda remains the largest jurisdiction, followed by the Cayman Islands. Barbados, Guernsey, Luxembourg and Ireland are also market leaders. In the United States, Vermont has more captive insurers than any other jurisdiction and is considered a leader in captive legislation.

Over the past decade, there have been a growing number of U.S. jurisdictions allowing captive formations.  In the 1970s, the first U.S. special law to encourage captive formation was passed in Colorado, followed by Tennessee, then Vermont. In the past several years, the number of captives has nearly doubled as an increasing number of states have passed captive legislation and/or modified existing legislation to gain a foothold as a captive domicile. Today, more than half of U.S. jurisdictions have captive licensing laws. Tennessee and New Jersey are the most recent states to enter the market. Figure 1 shows the top U.S. captive domiciles. With close to 500 captives, Vermont, which began licensing captives in 1981, is the largest onshore captive, followed by Utah with roughly 189 captives, Hawaii (167), South Carolina (160), Kentucky (127), Nevada (117) and Delaware (86).

However, not all of the states with captive legislation have seen growth in their respective markets. While Colorado was the first state to form captive legislation, they have seen a decline in the number of captives licensed. It is also important to note that, while captive formations have grown substantially in many of the states, not all of the states are enacting “captive friendly legislation” to attract captive business. Many of the states continually modify their captive laws to balance their rulemaking between provisions designed to ensure solvency and to remain competitive.

An important factor in establishing a captive is determining where it will be domiciled. U.S. companies have the option of domiciling onshore or offshore. The decision largely depends upon an organization’s analysis of a given domicile’s benefits and drawbacks. Key considerations for choice of domicile include: applicable taxes, operation costs and fee levels, permitted lines of business, experience, approval process and regulatory restrictions. In addition, restrictions on permissible investments and capital requirements are key considerations, as well.

The parent company’s industry also impacts the choice of domicile. Many captives are domiciled in jurisdictions that specialize in specific types of risk. Conversely, some jurisdictions have sought to tailor their captive legislation around certain types of coverage.  For example, the Cayman Islands are the leading domicile for health care captives and Vermont is a leader in captives for medical malpractice coverage and risk retention groups.

• Regulation of Captives

The key purpose of insurance regulation is to protect policyholders first and foremost, as well as investors and other stakeholders. A captive is different from a commercial insurance company, because it just serves its parent company. Therefore, captives are regulated differently than traditional insurance companies that serve the public. Like traditional insurance companies, captives are regulated by the state in which its headquarters are located.

Each domiciliary regulator requires an annual audit by an independent CPA firm (or its equivalent) with industry-specific experience in the insurance industry. In addition, many domiciliary regulators require a formal actuarial review of the captive’s policy on pricing and loss reserve methodology.

• Captive (Re)insurers/Special Purpose Vehicles

The majority of captives are owned and used by non-insurance companies. The term “captive” originally referred to subsidiaries set up by non-insurance companies to insure the company’s own risk. However, the use and definition of “captive” has broadened over time, as insurance companies are now creating captives. Notably, some life insurers have entered the market, utilizing captives to form captive reinsurance subsidiaries and insurance securitizations. This development has led to questions regarding whether third-party insurance risk should be a risk undertaken by a captive insurer.

The introduction by the NAIC of the so-called “Regulation XXX” in February 2001 sparked the creation of various XXX reserve funding securitization structures to help ease conservative reserving standards.  “Triple X” reserves, required by the NAIC Valuation of Life Insurance Policies Model Regulation (Model #830), require conservative assumptions and valuation methodologies for determining the level of statutory reserves. For term life products, the acronym XXX is used to denote these reserves, and for universal life products, the acronym AXXX is used. These conservative assumptions can result in higher reserve levels than were previously maintained.

Over the past several years, insurance securitization has been used by insurers and with greater frequency. Most of the securitization structures center on the concept of starting a captive insurance company to be used as a repository for the funds that were available from the securitization. In a simplified structure, an insurer or reinsurer (“ceding insurer”) transfers the risk associated with policy liabilities, subject to the guidelines outlined in Model #830, to a captive reinsurer.  As compensation for the assumed risk, the ceding insurer pays the capital, plus an initial economic reserve, into an SPV (the captive reinsurer).  In return, the SPV will issue debt securities in the capital market to finance the statutory reserve requirement exceeding the economic reserves.

In May 2011, a New York Times article compared captives to the “shadow banking system that contributed to the financial crisis.” The article did not cite examples of problems occurring in the industry as a result of the use of captives. In addition, the article did not distinguish between captives owned by non-insurance companies (to self-insure a portion of their risks) and captive reinsurance subsidiaries and insurance securitizations. In response to the article, captive experts noted that the article did not present a fair representation of the captive industry,because it focused on a small fraction (1%) of captives and that the vast majority of captives do not bear risk and have designed rules to ensure solvency.

Some regulators question whether the regulatory framework established to oversee captive insurers is appropriate for regulating a captive that has assumed third-party insurance risk. In response, the NAIC will examine how insurers are using captives and determine whether there are regulatory changes that need to be made.  In October 2011, the NAIC Executive (EX) Committee charged the Financial Condition (E) Committee to: “Study insurers’ use of captives and special purpose vehicles to transfer third-party insurance risk in relation to existing state laws and regulations and establish appropriate regulatory requirements to address concerns identified in this study. The appropriate regulatory requirements may involve modifications to existing NAIC model laws and/or generation of a new NAIC model law.”

The Financial Condition (E) Committee has appointed a subgroup of state insurance regulators to fulfill the charge. The subgroup, called the Captives and SPV Use (E) Subgroup, will consist of two members from each of the following three NAIC groups: Financial Analysis (E) Working Group, Life Actuarial (A) Task Force and Reinsurance (E) Task Force.  If the study turns up any concerns, the Executive (EX) Committee will recommend possible modifications to existing NAIC model laws or the creation of a new model law.

• Conclusion

Traditional insurers do not meet every risk-management need for every business. The captive insurance industry initially developed to formalize a large business enterprise’s self-insurance program. However, the captive insurance marketplace today is much more diverse than when it began. As risks evolve, responses to managing them change. It is incumbent upon insurance regulators to keep pace with this ever-changing, dynamic marketplace. The most recent test is the evolving nature of the risks transferred to captive insurers in the form of third-party insurance risk. We plan to report on the activities of the Captives and SPV Use (E) Subgroup as it considers the merits and issues associated with the use of captives to cover third-party insurance risk. – CIPR Newsletter

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