Risk, regs and the IRS


If asked at the end of 2015 what to expect in 2016, I would likely not have taken the long odds offered on Brexit, a Donald Trump presidency and the Dow Jones approaching 20,000. But that’s the point. Things change so quickly in this digital age that a reactionary vehicle such as a captive may struggle to keep up. So what do each of the items above mean for captives? Ask me again in 2018. The standard deviation is too great for predictive purposes.

That said, with a slant to my own brand of myopic foresight and understanding that none of what follows should sway any betting decision, here’s what my visible horizon looks like in 2017.

Captives will continue to explore cyber risk

This exploration will yield little by way of a resolution around the risk itself, but will provide companies with the security of a financing option that offers some modicum of sleep insurance. But it will be a restless sleep.

What I see some companies looking into, in a cyber market that evolves quicker than most, is the development of prescriptive wording for coverage in a captive, written as a best-in-class policy to cover as many aspects of the risk as possible.

Companies can take this policy to the market and look for reinsurance behind the captive. Terms and conditions are very important in a changing market, and owning the primary risk taker —the captive—may allow some flexibility in following the daily/weekly/monthly trends within the online world. One item that no doubt will be addressed in 2017, and captives may have an angle here, is the assessment of the controllable nature of cyber risk. What I mean by this is that cyber risk has many facets and one aspect often neglected is the human element.

Behavioural reviews of human interaction with the internet can be financed through captives and may yield positive results. As always, humans can be a morally weak link in the cyber chain and will remain so until something is done so that all employees understand that not every winking cat video viewed on a company device is as benign as its visible content.

Captives will delve deeper into the alternative market

Capital is king and return is its queen. Always was and always will be. Although captive income statements will be bolstered by rising interest rates, captives can still look to insert themselves into the capital food chain in a very real way. Assuming all risk into the captive and purchasing reinsurance behind the captive potentially reduces frictional costs (captive premium tax can be lower than admitted insurance costs, for instance). Captives offer wording benefits as alluded to in the cyber paragraph above, and they open up an access point to capital markets.

Currently, the capital markets operate within offshore reinsurance vehicles, but we’ve seen that they have started to play a greater role in the insurance industry as a whole in 2016, and 2017 shows no signs of this back-end capital letting up. Good risk will always find capital, and companies with good risk profiles and healthy retentions can find support from reinsurers on a multi-line, multi-year basis.

This structure allows budget certainty for companies in a financially uncertain world; an efficient tracking and reporting mechanism through the captive’s financials; and the ability to assume more risk in the retained layers. Companies will look to their captives, or will form captives, to position themselves for capital market access and a potential hardening market over the coming years.

The IRS’s review of captives will continue

The Internal Revenue Service’s (IRS) review of captives will continue apace in 2017, but that’s best dealt with in other articles. That said, risk management-focused captives with the appropriate structure will reap the benefits of the elevation in qualifying premium from $1.2 million to $2.2 million.

From a regulatory perspective, I expect Bermuda to pass incorporated cell legislation. Although this may have been under consideration for some time and might stray into 2018, I expect Bermuda to develop a law that competes with the Cayman Islands and the onshore domiciles. Solvency II will continue to drive European regulation and companies, but hopefully regulators will place captives into the correct regulatory bucket, allowing for their continued usage and floridity within their owners’ risk financing plan.

Along those lines, companies will look for regulatory stability. Migration back to home state domiciles, although slow at present, will continue as home state regulators have another year of experience under their belts.

With the market relatively soft, I see companies looking to lay off legacy liabilities. Some Solvency II regulatory pressure on capital could also encourage captive owners to explore loss portfolio transfers, commutations, novation or captive sale. The aged liabilities may be in the form of an specific book of business, a dormant captive in run-off, or merely individual claims that can be extracted from the book for sale to a third party. The reason that this is attractive currently is the focus of the reinsurers on premium volume in order to utilise their capital in an efficient manner.

The thing companies ‘cleaning’ their balance sheets receive from the transaction is certainty. They release reserves and cash and, in return, no longer need to manage claims. They also insulate themselves from any adverse claim development and free up risk managers’ time to manage risk prevention rather than risk development.

As companies focus on budget control, more entities will look to medical stop-loss within their captive, taking a corridor of risk and ceding the excess (up to the statutory level) to a reinsurance partner.

From an industry perspective

I am confident that the board of Captive Insurance Companies Association (CICA) will appoint a new president who can be a uniting force within the industry. CICA exists among many other captive associations but retains an independent, domicile-neutral voice. That voice often offers reactionary support to issues and other associations. I believe the new president will take on the challenges of a changing captive environment, provide a conference with educational material that supports the industry as a whole as well as the next generation of captive professionals, for whom the industry will appear markedly different.

In short, much of the industry will stay the course in 2017. There are nascent opportunities available to those whose approach to risk management allows for a long-term view and an extensive use of their captives.

The insurance markets seem to be running close to a 100 percent combined ratio and, with investment income only now starting to return, the market may well start placing some rate pressure on renewals.

Should this occur, many captive owners will look to their captives for larger retentions and to other sources of capital in the reinsurance market. Hard market or soft market, there are opportunities for captives.

I hope that you’ve read this article quickly, as the speed at which captives innovate may well mean that it is out of date come the CICA International Conference in March.
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