How is the insurance market changing? Are captives struggling to adapt?
Captives, as they have always done, are adapting to a softening market. Soft market strategies include the review of old reserves held either on the parent or the captive’s balance sheet. With the growth of the investment-backed reinsurance vehicles in Bermuda, access to premium has become very important.
Companies may be able to reinsure or novate these reserves to a partner willing to offer favourable terms. Similarly, some captives are using the soft market to negotiate commutation terms with their fronting carriers.
The soft market offers other strategies too—there are risk managers who use these times, and the profit created in the captive, to invest in safety programmes and procedural improvements to risk management techniques, in order to prepare for a hard market, whenever that might be.
Also, although theory dictates that a captive should shrink in a soft market, its operational efficiencies remain valuable to companies. It can also offer companies the ability to assume risks from affiliated third parties, something that has become very important over the past five years.
What kind of challenges are captives facing, and how are they overcoming these?
Captives face many regulatory problems. Happily, all captives are different. What stands before each of them, however, is regulation. Base erosion and profit sharing (BEPS) regulation is becoming an issue, as is some of the US states’ approaches to self-procurement taxes.
There are still captives re-domesticating, creating home-state branches and setting up new vehicles in new states. That trend seems sure to continue as the number of states with captive laws who integrate their insurance and treasury functions continues to rise.
BEPS itself will require more disclosures from companies owning captives, and more oversight. Transfer pricing will be scrutinised further and individual transactions reviewed for efficiency and appropriate disclosure. There will be more regulatory burden on companies as a result.
How can domiciles combat the rise of the Non-admitted and Reinsurance Reform Act? What options are there?
There are a number of steps a captive can take, including actually paying the tax. That’s what many captives are doing while they lobby for an amendment that will exempt them from having to pay the self-procurement tax to their home state in the first place.
The next obvious step is to redomesticate back to the parent’s home state. This has happened in states such as Texas and Georgia recently, largely because it made sense to bring risk management into the same domicile, and because the home state offers a cheaper independently procured tax rate.
Other options exist, such as using a fronting carrier, but these can come with catches that might not always be fiscally attractive.
Is the soft market allowing companies to explore run off markets, and why?
Capital is king. Insurance is essentially access to someone else’s balance sheet. If an insurer’s balance sheet has access to cheaper capital than your own, buy insurance. If your cost of capital is less than an insurer’s, retain the risk.
Captives, as a financing tool, are seeing that capital at the parent level is becoming more available, but this is also true in the insurance and reinsurance markets, so much so that the cost of capital in reinsurance has provided companies with an opportunity to transfer risk at favourable rates.
The main options that companies are using include selling the captive to clean the corporate balance sheet and start again; novating the policy to a reinsurance market or commuting back to the front; or reinsuring the policy with a reinsurance carrier that offers surplus relief as well as some profit share on the portfolio (this may also be investment income).
Each one of these options, should capital be cheaper at the carrier level, will allow a company to transfer risk, clean the corporate balance sheet and free up collateralised funds that support the liabilities.
Are captives adapting to emerging risks? How are they doing this?
Yes they are. Cyber, for instance, is a coverage that has emerged as a risk, but a not entirely quantifiable one. Companies are insuring the portion of the risk that is quantifiable in the captive, notification and regulatory risk, and looking to transfer to the market the unknown, indemnity risk.