Soft Market-Impact on Captives (Strategic Risk Solutions 180 Newsletter)
Premiums in the commercial insurance market have been declining since they peaked in late 2001 following the terrorist attacks of 9/11. The Counsel of Insurance Agents and Brokers market survey (2nd quarter, 2007) indicates that premiums are falling at a rate of 11% per annum and are at their lowest level since the survey was started at the end of 1999.
It is a commonly held belief that the rate of captive formations and their use declines in a soft market. So is the current soft market negatively impacting captives? The evidence shows that activity is still strong, although some areas such as group captive formations are down. This is less to do with anomalies with the current soft market than misperceptions about captives in a soft market.
Captives have been steadily increasing in numbers over the past twenty-five years. Since the late 1980s the number of captives worldwide has increased at a rate of approximately 4% per annum. The rate of increase has been consistent and unaffected by hard or soft markets. There are now roughly 5,000 captives worldwide and the moderate growth rate is more reflective of a mature captive market than the effects of commercial market cycles.
In addition to the long-term trend, the recent growth in formations remains strong. In the eight domiciles in which SRS operates, the number of captives has increased at a rate of 6% per annum over the past two years.
This is slightly down from the prior couple of years, but still strong. Growth has been strongest onshore where there has been considerable competition among the domiciles themselves to attract captives. Offshore domiciles have seen some slow down in captive growth. The shift between onshore and offshore is due to:
Increased competition from domestic domiciles.
Liquidations in mature domiciles.
Re-domestications.
Some unique advantages of domestic domiciles: ERISA benefits, RRGs, and access to TRIA.
Single Parent Captives
The soft market is exerting minimal pressure on single parent captives. These vehicles are typically formed as an alternative to self-insurance, either qualified self-insurance or self-insurance through large deductible programs. They are rarely formed as an alternative to conventional insurance. As a result, changes in the commercial insurance market have little impact on the decision to form or use a single parent captive.
As captives are still reliant on the commercial insurance and reinsurance markets to provide support to their programs, the softening of the commercial market is having a beneficial effect on single parent captives.
Fronting is becoming more available with some competition on price.
Collateral requirements are easing.
Attachment points are being lowered both on per loss and aggregate basis. Adjusting attachment points is the most significant area in which single parent captives are adjusting to the softening commercial insurance market.
Insurers are more willing to unbundle services supporting the captive program (fronting, reinsurance, claims handling, loss control).
Single parent captives continue to be formed as part of the risk financing strategy of their parents. The perceived benefits vary on a case by case basis but include:
The ability to achieve tax deducibility on funds accrued to pay for self-insured losses. The current tax situation is more favorable to captives and more clearly defined than in previous years.
The need for a more formalized funding mechanism than self insurance
For unique program structures such as ERISA benefits or TRIA.
We continue to see a strong rate of formation of single parent captives. There is interest in all industries and risk areas, although those which are still relatively distressed are seeing the highest rates of formation. These include construction defects, mold and fungi exposures, windstorm risks, real estate and healthcare.
Group Captives
Group captives face the greatest pressure from the commercial market. Their members are typically middle market accounts who lack the size to retain significant amounts of risk on their own. Group captives are one of the few options to commercial insurance.
Reductions in the cost of commercial insurance make group captives a less attractive option. As a result we are seeing a drop-off in the rate of new formations.Group captives are particularly difficult to put together requiring a group which is comfortable in sharing risk and cohesive enough to stay together for the long-haul. With commercial rates dropping, the challenges of putting the group together are exacerbated.
One area where formations are still strong is risk retention groups (RRGs). Numbers had been declining through the soft market of the 1990s, but there has been a significant increase in numbers post 9/11. The increase coincided with the hardening of the insurance market post 9/11 and RRGs proved to be an attractive option for liability risks in many industry sectors. The growth also coincided with an increase in the number of domestic domiciles. Many of the new RRG formations have been domiciled in less mature domestic domiciles.
In the last couple of years, the commercial market has softened and the regulation of RRGs has tightened, fuelled in part by a report by the Government Administration Office. Despite these changes, the growth rate for RRGs remains strong and in line with the growth post 9/11.
Group captives remain an attractive option in the right situations. These typically involve a cohesive group, which probably exists outside the captive, and an industry sector which is still fairly under-served by the commercial market
Conclusion
Captives are a long-term risk financing solution. They provide consistency in the availability and cost of insurance.
Short-term changes in premium rates in the commercial market have been shown to have a minimal and isolated impact on the captive industry. The signs are that the same is true of the current soft market. There may be some tactical changes in the use of captives such as the lowering of attachment points. There may also be some weeding out of marginal captives.
Those with solid reasons for forming and a long-term commitment will continue to be formed and will continue to deliver value to their owners.
