The captive centerpiece
Insurance transactions marry risk with capital. That’s all. All other parts of the insurance transaction deal with credit risk. As many corporate-owned captives finance parental risk, this article will focus at a high level on capital.
Captives are not capital vehicles, they are financing vehicles. The captive parent injects capital and the captive consolidates this capital back under generally accepted accounting principles. One reason why captives have been successful to date is that this injected capital offers a return to the company that is greater than the return derived from the parent’s balance sheet. But capital, in today’s economy, moves quickly and is attracted by industries that provide improved rates of return. Some of that capital has been attracted by the insurance industry. The attraction is the ability to invest and manage premium income within an investment portfolio alongside the invested capital.
If the insurance industry has attracted so much capital, how do captives participate?
My response is based around captive resiliency and a view of the future of insurance based solely around corporate risk appetite. The captive industry has responded to many challenges—encounters with our friends at the Internal Revenue Service (IRS), interpretation of the Dodd-Frank Act, Solvency II, optical views of offshore versus onshore vehicles, the rise of micro captives, and so on—the next challenge is how to invigorate captive growth given the rise of the availability of risk capital.
Before we get to the above, a quick revisit to the ‘knitting’ of captive basics is in order. Here are two major reasons why captives have been important historically. It is for these reasons that investors will be attracted to captives, remembering that capital is fleeting:
• Captives reduce the cost of insurance (a corporate benefit but also a benefit to outside capital as it can cleanly underwrite corporate risk without taint of industry losses); and
• Captives provide access to reinsurance (a source of capital that is unencumbered by onerous regulation and may be cheaper than insurance).
The captive basics list hasn’t changed for a long time. What has changed is the opportunity for companies to access the capital market to finance their retained risk.
Capital flows to areas of greatest return. Risk will trend towards the cheapest and most efficient form of capital. I believe that it is at that intersection that the future of captives exists.
To date, most captives rely on parental/internal capital and reinsurance to finance risk. If a company’s internal capital is less expensive than external (insurance company) capital, the company will self-insure. As a self-insurance financing entity, a captive therefore becomes the repository of a company’s internal risk capital whose cost of risk capital is reassessed annually.
This reassessment, in my opinion, will lead to a review of new options for captives. The development of the Bermuda market and the growth in the reinsurance companies backed by pension funds, hedge funds and private equity has led to some softening in the reinsurance rates.
This softening of rate is evidence of lower cost of capital. Access to reinsurance, as outlined above, is a key use of captives. Some captives are using reinsurance markets to transfer legacy risks. Loss portfolio transfers are more popular than ever.
There are a number of reasons for this:
• Loss portfolio transfers may be able to clean up the corporate balance sheet;
• They may offer adverse development coverage, protecting the transferring company from downside risk;
• Loss portfolio transfers may reduce the administrative burden of claims management; and
• They may reduce the credit risk if the reinsurer is able to post collateral back to the corporate captive.
But loss portfolio transfers are backward looking. What is of interest is the forward-looking options for the use of captives using the capital markets.
Below are the options that are being considered for companies moving forward:
• Companies reinsure a block of business, likely long tail business (reinsurance companies want to manage the cash associated with the reserves within their investment pool) with a reinsurance company that offers collateral in return. Note that this collateral can be used to support collateral posted to the carrier. To treat the transaction as a reinsurance contract, there must be risk transfer in the policy. Captives, therefore, receive a 10 percent or more increase in limits, a potential reduction in collateral and favourable terms. This has become an attractive source of capital in the current market and is being considered by many companies.
• The next generation of the captive market may lead to some reinvention. Capital is key, as evidenced by the rise of the cat bond market. And the insurance-linked services market. And offshore hedge fund reinsurance companies. There is capital circling the insurance market. The reason is because the insurance market is uncorrelated with the equity markets and the uncorrelation leads to some attractiveness. To cleanly access the insurance market, however, why would capital look any further than captives?
So here’s where I see the market going, for large companies with significant portfolios:
• Companies set up cells within their captives. Cell 1 includes property risk. Cell 2 includes executive liability risk. Cell 3 includes all deductible buy-down risks (as statutory coverages require rated carriers).
• Companies access their capital markets division to attract investment in each cell. The issue with this approach is that the coverages with longer tails require exit options.
• The capital markets place either cash or collateral into the cell to accompany the risk. The investor manages the funds within the cell.
• Losses are paid from the cell until exhausted. After exhaustion, the risk falls back to the captive’s owner.
• At the end of the risk period, the funds left in the cell (premiums minus losses plus investment income) are distributed to the investors in the cell.
Because investment is made directly in the cell, the compliance costs of the transaction are different from a normal insurance transaction.
This transaction is a capital transaction and therefore would be governed by investment law. As a result, there may be complexities in the drafting of the offering memoranda. However, should the cost of the investment capital be lower than the cost of insurance capital, this structure may become more attractive. The advantage of this is that there is no reliance on traditional insurance markets. The reliance is on capital markets, and a corporate pension plan could potentially be the investor. Similarly, the captive owner, depending on the location of the captive, pays captive premium tax (often capped) rather than the admitted premium tax. The captive owner may also be able to lower premiums from commercial rates depending on the cost of commercial capital. From the investor’s perspective, cell funds remain under management but premiums can also be invested. This offers an augmented return to the investor. Given that the investment rules offshore are more expansive than those onshore, the above structure works best in Cayman or Bermuda, but those domiciles may offer more tax complexity.
This may be a few years away unless the delta between interest rates and insurance returns widens due to a catastrophic event. If that is the case, the interim step includes companies reviewing their cost of capital and reviewing reinsurance offerings behind captives to achieve almost the same fiscal results, although with greater frictional cost. But this could become commonplace over the next 10 years and captives will become the centerpiece of all insurance transactions for a company.