Captive challenge

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The financial crisis, changing regulations and the emergence of new jurisdictions are creating challenges and opportunities for the captive insurance industry, writes Stephen May.

Previous hard markets have shown that risk retention becomes a more attractive proposition when commercial insurance prices rise. When premiums go up and terms and conditions become more restrictive, buyers are more inclined to consider the benefits of captive insurance. Parent companies with existing captives are likely to write more exposures through their self-insurance vehicles, while others may consider captives and protected cell companies for the first time.

The financial crisis, which escalated in September 2008, has had a profound impact on the global economy; primarily a banking crisis, the insurance industry has emerged relatively unscathed. Nevertheless, the credit crunch has meant that fresh capital has been difficult to find and expensive to acquire where it is available. Without adequate supply, reinsurance has found it difficult to recapitalise following last year's investment and catastrophe losses.

Reinsurance prices have risen as a result, particularly for capital-intensive lines in which increases of up to 15% were witnessed at the mid-year renewals. With reinsurance becoming more expensive for primary insurers, these companies in turn are likely to increase their rates as renewals approach, if they have not already. The downturn also means that many insurers are unable to boost poor underwriting performance with investment returns, one significant result of which is that the days of aggressive price competition are over for now.

All this makes captives more attractive: they are less exposed to the general insurance cycle's peaks and troughs; they offer greater budgetary control and the ability to limit insurance spend; and their prices are based on the parent company's risk profile rather than an industry-wide loss experience. As a result, captive owners are not subsidising other companies with less advanced risk management techniques in the traditional market.

Because captives are designed to meet parent companies' unique risk management needs, they are able to offer depth and breadth of coverage generally not available in the commercial insurance sector, particularly during a hard market. Market conditions could even see captives taking on new forms of risk such as credit insurance. While reinsurance prices have risen, captive buyers benefit from their access to wholesale prices and can adopt flexible strategies to compensate for a reduction in capacity.

The failure of a number of financial institutions and the very public bailouts of others has created an environment of uncertainty. At the height of the downturn, companies that seemed outwardly robust and had solid 'A' ratings were suddenly announcing bankruptcy with little warning to investors and shareholders. Unsurprisingly, many buyers are now more wary of relying too heavily on (re)insurer balance sheets.

By contrast, companies employing captives have full grasp of their risk appetites and can ensure that all their exposures are securely funded. Profitable organisations with strong balance sheets and above-average risk profiles are therefore in a good position to reduce this counterparty risk through captive insurance. Most captives are extremely conservative investors and, while it was inevitable that some would lose capital in 2008, most are better capitalised than required by their current levels of risk assumption: this puts them in a good position to assume more risk.

Solvency II

Recession is not the only dynamic affecting the captive insurance sector. The introduction of new regulation - most notably Solvency II in Europe - poses some interesting questions for European Union-based captives. According to a report by AM Best, the financial and administration burdens associated with Solvency II could lead some captives to relocate outside the EU.

Even for non-EU jurisdictions, Solvency II is likely to inspire tougher standards and oversight as regulators elsewhere seek to raise the bar, particularly in light of the global recession. While most captive domiciles have robust regulatory frameworks, this new European regulation could instigate additional reporting burdens elsewhere. At the same time, tightening tax controls following the release of the Organisation for Economic Co-operation and Development's 'grey list' has put some captive domiciles under pressure to improve their position on the progress report. While such challenges are unlikely to directly impact captive owners, developments are being followed with keen interest.

For existing captives seeking to relocate (whether this is driven by Solvency II or some other impetus) and companies looking to set up captives, the choice of domicile is increasing. The sector has witnessed a surge of new entrants in recent years, with European countries such as Gibraltar and Malta and Middle Eastern centres opening their doors to captive insurers.

This is a positive development for the industry because it brings increased choice and allows new jurisdictions to benefit from the experience of mature domiciles in adopting tried-and-tested captive legislation; parent organisations are also seeing the benefits of closer proximity to captive structures. In the Middle East, where insurance - self-insurance in particular - is attracting growing interest, the option to locate a captive in Bahrain, Dubai or Qatar allows a level of control and convenience that would not be available in Europe or further afield.

The AM Best report concludes that the captive market will continue to develop and that it is far from saturation; it suggests that much of the future growth will be fuelled by cell formation, such as protected cell companies (PCCs) and incorporated cell companies (ICCs), which have lower capital requirements than wholly-owned captives. Seeming to support the ratings agency's conclusions, mature captive jurisdictions are showing continued growth in cell structures; there has also been a rise in the number of jurisdictions offering cell legislation.

The captive insurance sector is well placed to meet the challenges of both the credit crisis and Solvency II and it should benefit from growing volatility in the commercial insurance market. Existing owners are likely to utilise their captives further while many organisations will be considering captive structures for the first time. At Kane, we expect to see continued growth of PCCs and ICCs, although traditional structures are not going away. With an estimated 5,000 captives established worldwide, their appeal continues to spread - particularly in markets considering the benefits of captive insurance for the first time.

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