April 2020 Issue
FW discusses captive insurance challenges with Jenny Coletta at EY.
FW: How would you describe the appetite for captive insurance in key regions around the world? To what extent has it grown in recent years?
Coletta: Captive premium volumes have grown between 5 and 10 percent year-on-year for the last 10 years and in general the size of captives by volume has grown. Interestingly, the total number of captives has slightly reduced – now slightly below 6500 globally – but this is not shocking as a feature of market consolidation is that many groups have looked to sustain fewer but larger captives, as well as a diminishing number of US micro-captives as a result of recent actions by the Internal Revenue Service (IRS). While the highest numbers of captives are still found in Bermuda, Cayman and Vermont – the three jurisdictions have about one-third of the world’s captives domiciled there – there is a notable trend in the growth of captives in the emerging markets, particularly Singapore and Latin America (LATAM). Additionally, as a result of tax changes and case law in the US, there has been a significant growth in captives across the US, outside of Vermont. While overall there are now over 42 states that have some form of captive legislation on the books, the US has a few clear frontrunners. Aside from that, certain jurisdictions in the US developed into preferred domiciles for certain types of captives and programmes, such as warranty, life and employee benefits. It is worth noting that in line with the rest of the world, US domiciled captives – or those domiciled in Bermuda or Cayman with US owners – also grew, some very significantly, in premium volume and insured programme diversity. Across Europe, Guernsey remains the largest captive domicile by number, but many other jurisdictions continue to look to compete for the captive market. Most notably, the UK has recently been suggested as a new captive domicile through the new Lloyd’s of London ‘Syndicate In A Box’ initiative. Switzerland is a frequent location for reinsurance captives. Across Asia, Singapore has diversified from a predominantly Australian owner domicile, with new entrants from the US, Europe and, increasingly, Asia. Continuing investment into Asia, as well as the Belt and Road Initiative, is expected to continue driving demand. Labuan has established itself as an innovative niche market, offering affordable protected cell structures. Hong Kong has had a later start but now offers very attractive tax rates. The appetite for captives continues to grow, as the hardening third-party market has led to capacity or volume issues for a number of classes. High rate fluctuations upon renewals seem to be pushing companies and their risk managers, especially those that were previously somewhat captive-averse, to revisit opportunities for planning in this space. At the same time, the risks that captive owners are looking to insure are becoming more bespoke as digitalisation means multinationals typically hold significantly more intangible assets than tangible.
FW: As a form of alternative insurance, what key benefits does captive insurance offer companies, or groups of companies? How is it typically used?
Coletta: The main benefit of a captive as compared to a multinational, either procuring third-party insurance at the local operating company level or retaining risk on local operating company balance sheets, is that risk and capital can be pooled in a captive to create capital and cost-reduction benefits. This is achieved through pooling global risk, bringing diversification benefits and therefore a lower cost of capital than if risks were retained on local balance sheets. Furthermore, the capital is ringfenced to cover insured liabilities, as compared to being subject to other calls if just retained on a local operating company balance sheet. Access to the third-party insurance market is also far more efficient and cost effective if accessed through a capitalised insurance vehicle, rather than through geographically dispersed single local operating companies. Increasingly, captive owners are using captives to generate value from risks and risk pooling, therefore bringing value to the multinational group as a whole. This is leading to increased retentions and more bespoke access to third-party reinsurance solutions. Finally, a captive structure allows an entity to consolidate, in most cases, its diverse and dispersed risk function, providing better insight and oversight across some or all jurisdictions where operations take place. This approach, in and of itself, allows for additional cost reduction, redundancy and inefficiency elimination and provides a more intuitive risk management approach.
“Increasingly, captive owners are using captives to generate value from risks and risk pooling, therefore bringing value to the multinational group as a whole.”
FW: With captive owners continuing to expand coverage beyond traditional property and casualty risks, what specialist and emerging risks are being addressed?
Coletta: The types of risks multinationals are now exposed to has dramatically shifted in the last 10 years toward coverage for intangible assets. This leads to risk exposures around proprietary data or intellectual property (IP) which multinationals may not want to place into the commercial market. Cyber, business interruption, supply chain and intangible property such as brand, patents and digital assets, are all examples of the types of risks that multinationals need to insure. Often a captive is the only viable solution. In special markets or industries, a need for ‘facts and circumstances’ based policies that are designed to address unique risks have also been on the rise.
FW: In what ways does an uptick in captive insurance licensing activity reflect a changing insurance environment? For example, how extensive is the interest in captive programmes from small and mid-sized companies in different regions?
Coletta: Increasingly, small and medium-sized companies are looking to captive solutions or looking to optimise existing captive structures. This is experiencing a visible uptick due to a hardening market on the commercial side. At the same time, regulatory and tax pressures that require an increase in substance suggests that smaller captives could struggle to be commercially viable given the operational costs associated with running captives in the new world. Protected cell companies and similar structures are often an attractive solution, providing a more cost-efficient model for captive owners and flexibility of entrance and exit when it comes to the captive market. Looking to the future and the trend around emerging risks and greater retentions, it is feasible that collaboration within industry sectors, particularly among smaller businesses, may result in mutual solutions. It also seems likely that these mutual solutions would be facilitated through digital exchanges and technology solutions, such as blockchain, as the use of data becomes critical.
FW: How would you characterise the robustness of the regulatory standards pertaining to the captive insurance industry in various regions around the world? To what extent is there a need for new legislation to modernise and strengthen regulations?
Coletta: While, in general, domiciles across the world and within countries, such as the US, are all working towards sufficient supervision of the market, each does it in its own way. Some jurisdictions regulate captives virtually identical to open market insurance companies, while others offer a slightly simplified supervision regime, such as not requiring an appointed actuary, recognising that the captive’s policyholders are corporations belonging to the same corporate group, rather than individuals or third-party customers requiring more protection and assurance. Regulations and any associated modernisation will be a function of the market movement. As new programmes develop and new risks emerge, it is feasible that regulators will start to address changes and augment their policies as needed.
FW: How have recent OECD and national moves to capture potential diverted profits within tax regimes impacted the captive industry? What do you see as the likely results of such increased legislation?
Coletta: The Organisation for Economic Co-operation and Development (OECD) has been focused on the captive insurance industry for many years, with many publications reflecting a negative perception of the industry. Most recently, the OECD produced a new chapter to the transfer pricing guidelines which includes a section on captive insurance. This reiterates other aspects of the OECD’s work in tackling base erosion and reinforces that the key components of a captive are that it must be commercially rational and must have sufficient economic substance. Broadly, this means that the captive must operate in the same or similar way as a third-party insurer, from the risks it underwrites and the commercial terms of the insurance coverage, the capital benefit it brings to the multinational group, to the operating model and interaction with group affiliates. While the OECD recognises that captives are often run on outsourced models, it heavily emphasises that there must be sufficient personnel, or ‘substance’, within a captive to make judgements and decisions on the outsourced functions, particularly pertaining to underwriting and risk management functions. Economic substance includes the capital base of the captive and ensuring that it is not overly capitalised or does not achieve excessive returns as compared to a peer group of similar insurers. This has led many groups to reassess the value proposition of their captive and whether it is sustainable, particularly from a cost perspective, in view of the need to increase substance. Similarly, if substance is to be increased, groups are looking at what else the captive can be used for to support the additional cost. Increasingly, we are also seeing operating models evolve to operationally segregate the captive from the rest of the multinational group in terms of teams and the way the captive operates to provide insurance to the group.
FW: Could you provide an insight into some of the current trends around claims analysis, marketplace pricing and capacity volatility issues?
Coletta: As multinationals increase the use of data and technology in their businesses, captives and their service providers can access claims and other trend data to better inform underwriting, pricing and programme structure. Ultimately, this will lead to programmes being a better fit for the multinational group, with more tailored access to the third-party market. It is likely that over time this will result in convergence between the market price and technical price as insurers respond to the need for bespoke solutions. This then provides a significant opportunity for captives to drive better deals with third-party insurers on fronting programmes and reinsurance. It also addresses market capacity issues as insurers and multinationals structure programmes in partnership.
FW: What advice would you offer to companies in terms of managing and maximising a captive insurance programme?
Coletta: Companies need to develop and stay true to a value proposition. Establishing a value proposition and appropriate substance is key. In some cases, this will require a change in group mindset to view the captive as an independent business, a value driver rather than cost centre. Regularly reviewing the group risk register and working in partnership with the insurance market in order to develop a bespoke programme to manage risks within the risk appetite of the group is critical. This also aligns well with a notion of not chasing quick results. A captive programme that drives true, holistic value for an organisation, especially on a global basis, is a marathon, not a sprint – so it needs to be well crafted, well executed, minded and, most importantly, aligned with the organisation’s long-term needs and values. A periodic review and alignment to updated group strategy and requirements are key as well.
FW: What are your predictions for the captive insurance industry around the world, in 2020 and beyond? How active is the pipeline of prospective new captive insurance companies?
Coletta: In the immediate term, the captive pipeline is very active, with an increasing number of multinationals interested in establishing or restructuring captive programmes. Given the current environment of looming pandemics, trade barriers and cyber crime all threatening supply chains, it seems the demand for captive solutions will be greater than ever. With the increase in US captives, emerging market captives and predictions of a new UK captive domicile at Lloyd’s, 2020 is likely to be a year of increased captive entrants, especially as parametric coverage starts to play a larger role in the captive market. Looking beyond 2020, as the risk landscape for multinationals continues to evolve, captives will be a critical part of the risk management value chain. As captive owners demand value from their captives and retentions increase, captives will become larger and more sophisticated in programme requirements, so will be able to demand more from the commercial market that will need to realign in response. This may not be limited to the largest multinationals as industries collaborate to establish industry-wide mutual captives. The rise of the ‘super captive’ seems inevitable.
Jenny Coletta is an insurance international tax partner based in London, with 20 years’ experience of providing international tax advice to insurance and captive insurance companies. She leads EY’s global insurance transfer pricing team and is Europe, the Middle East, India and Africa (EMEIA) lead. She is also engaged with the Organisation for Economic Co-operation and Development (OECD) and governments on the OECD base erosion and profit shifting (BEPS) project. She can be contacted on +44 (0)20 7951 5993 or by email: jcoletta@uk.ey.com.
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