Steady As She Goes: 2014 Captive Domicile Review

Caroline McDonald


August 1, 2014

RM07.8.14_captive_mapIn recent years, some captive domiciles in the United States have seen big growth in formations because of the rising popularity of small captives. Others, however, have opted for a steady course, favoring larger, single-parent captives, which remain the majority of those formed.

In its 2014 study "The Evolution of Captives: 50 Years Later," Marsh reported that 66% of captives formed are single-parent structures. Use of special purpose vehicles was second at 9% of captives formed in 2013, and group captives and cell captives were tied at third place with 4%.

Captives are most frequently used for liability coverage. In fact, according to Marsh's study, 30.8% write general liability risks, making it the most popular risk category for captives. A close second is property risk, included in 29.4% of captives.

Marsh reported that captives are increasingly being used for non-traditional coverage, such as crime insurance/crime deductibles and cyber liability. Third party risks, including employee benefits, customer risks and pooling arrangements, account for 18% of the coverage in captives. Voluntary employee benefits such as identity theft, critical illness, pet insurance, group home, group auto and group umbrella are also becoming more common.

While most domiciles are seeing more interest in formations of small captives-such as the popular 831(b) captives, which can offer tax benefits-some domiciles' growth has skyrocketed because of them. Most captive regulators are selective with 831(b) captives, however, choosing to only allow those used to cover risks, rather than those formed as investment vehicles for individuals.

"We're seeing typical things continuing-growth in [single-parent] captives is still very good," said captive manager Jeffrey S. Kenneson, senior vice president of client development with Strategic Risk Solutions, Inc. "The real growth is in the 831(b) captives. To us, they are small insurance companies, so we're seeing a lot more formations in the middle market and we're seeing a lot more activity in cell captives."

Those companies forming small captives are typically not large enough to have a dedicated risk manager, Kenneson said. While there are exceptions, these duties are usually handled by someone with another job function, such as the CFO or safety manager. Small and mid-size companies also hire insurance consulting firms or brokers to help with their captives.

Domestic Growth
In 2013, domiciles that saw the most growth in the United States were Delaware, Utah, Nevada and Tennessee, but mostly as a result of relatively new or recently changed cell captive legislation, Kenneson said. Utah, which already had a number of small captives, updated its legislation, while Montana recently passed sponsored captive legislation and Hawaii has experienced "slow and steady" growth by attracting the Pacific Rim market.

The District of Columbia also experienced steady growth. "They want to regulate properly and they don't want to do a lot of 831(b) captives or health care stop-loss captives," he said. While D.C. passed early legislation to allow association captives because of the large number of such organizations located there, not many are being formed because of startup costs and requirements that all members be eligible to participate, regardless of their risk profile.

Vermont, the largest U.S. domicile and third largest globally, licensed 29 captives in 2013, "just a few less than 2012," said David Provost, deputy commissioner of the state's captive division. "Nothing drastic is happening; it's nice to have a little calm. We don't have huge numbers, but we've got several licenses already and a number of applications on hand."

Captive formations dipped in the wake of the financial crisis, but the impact did not last, he said. "When the financial crisis hit during the second half of 2008, things shut down. In 2009, it went right back to normal once people felt they could make decisions with a reasonable expectation of what the market would look like."

Part of the reason for the resurgence of formations since 2008 is that companies realize their captives are money-saving tools. "They were just as valuable, if not more so, in hard times as in good times," Provost said.

Although it would appear that most large companies already have captives, there remains room for growth. "There are still a fair number of Fortune 1,000 companies-several hundred-that don't have a captive," he said.

With the wide variety of recent formations, it is difficult to identify specific trends. "We have some small companies, some groups, some large companies-a little bit of everything," Provost said. Industries, too, are varied. Three large companies that formed single parent captives in Vermont this year are insurer Stewart Title Co., mining company Active Minerals and private equity firm American Industrial Acquisition Co.

In the queue are hospital groups, physician groups and a few manufacturers-some publicly traded and some private. "It makes it interesting and keeps me from worrying about getting too many captives in one bucket, in case there are changes in their industry and they want to close up," he said. Indeed, this was the case just a few years ago, when new building all but stopped and construction companies were forced to close their doors-and their captives.

Delaware has greatly benefited from formation of small 831(b) captives. The state has had captive statutes since the mid-1980s, but few captives were formed until 2009, when Karen Weldin Stewart became insurance commissioner and formed a state captive bureau. Steve Kinion, director of the Bureau of Captive and Financial Insurance Products for the Delaware Insurance Department, said that captive laws have since been updated and the state has seen exponential growth. Delaware had 38 captives at that time and, by the end of 2013, reported 266 active captives.

While 831(b) captives have added greatly to the numbers in the state, they are regulated with care because of controversy surrounding them. Some financial planners and a few captive managers have pushed their use in estate planning, because, among other benefits, captive ownership can be shared with heirs as premiums can be accumulated tax-free up to a specified amount. A business owner can transfer this accumulation to heirs without tax implications. This arrangement may not stand up to regulatory scrutiny, some contend.

As a result, Kinion sees that 831(b) captives are set up to operate as small insurance companies. These captives have been a boon for small- and medium-size businesses, which use them for a variety of coverages, "from cyber to difference-in-conditions, or for filling the gaps in their standard commercial policy by insuring exemptions," Kinion said.
Regulatory Concerns
U.S. regulators have concerns about large life insurance companies forming captives as they are traditionally formed by businesses and organizations, not insurers. Insurers are using them to finance reserve redundancies associated with regulatory requirements. In response, the National Association of Insurance Commissioners (NAIC) has written a proposal to help regulate these captives.

While the NAIC has carefully worded the proposal to clarify that property/casualty captives are not included, many in the captive industry worry that the language is too broad, which could have an unintentional impact, explained Matt Walker, financial services ratings associate with Standard & Poor's.

"What's being talked about regards life insurance captives, but a lot of the developments could end up impacting the property/casualty market," Walker said. "One of the proposals out there is for captives to be defined as multi-state insurers, which would subject them to NAIC accreditation standards."

A number of captives and captive organizations have submitted comments to the NAIC. In a letter to John M. Huff, chair of the Financial Regulation Standards and Accreditation Committee for the NAIC, Paul P. Johnson, Verizon's director of captive operations, risk management and insurance, wrote, "The draft language seems to be overly broad, thereby unnecessarily imposing onerous new requirements on almost all captive reinsurance transactions even though no significant issues have been identified with the current regulation of captive insurers in accredited states (other than the issues raised related to life insurer-owned captives)."

The Captive Insurance Companies Association (CICA) said in a letter to Huff, "CICA recognizes that life and annuity reinsurance provided by the captive subsidiaries of some of the largest commercial insurers in the world may need special attention because some of these entities are, in fact, large enough to present 'systemic risk' to the global financial system. However, this does not warrant the application of the same rules or scrutiny to the thousands of captives that are not in this category."

Because the inclusion of property/casualty captives is not the intent, "and no one wants that to happen, I have every confidence the NAIC will draft it so it's absolutely clear that property/casualty is outside of what they are doing," Walker concluded.

Like Vermont, Delaware is seeing interest in real estate investment trusts (REITs). "Part of the rationale is that REITs have long sought membership in the Federal Home Loan Bank system, which was formed in 1932 to provide liquidity for the housing market," Kinion explained. Current law states that only certain types of institutions may become Home Loan Bank members. "These include credit unions, savings and loan and insurance companies-which includes captives. So the captives can be a portal for membership," he said.

One reason Delaware likes REITs is the revenue they bring to the state. "Our regional Home Loan Bank is in Pittsburgh, and 10% of the profits generated have to be designated for affordable housing programs," Kinion said. "In Delaware, there are a number of organizations that receive grants from the bank to promote affordable housing, and that benefits the state."

Delaware's growth to the nation's third largest captive domicile has created jobs for service providers and other professionals, including attorneys and accountants. The state's captive staff has also expanded, with the addition of three new analysts this year and plans to add another. But the growth has presented challenges. "We need more staff and more space, so we will be relocating," Kinion said, "but it's a good problem to have."

View from the Top
Bermuda, the world's largest captive domicile, saw its share of troubles after the 2008 financial crisis. With tourism heavily impacted, the insurance industry became even more vital to the local economy. The industry quickly rebounded and is now seeing continual growth. The Bermuda Monetary Authority (BMA) reported a 12% increase in Bermuda's international insurance sector's 2013 gross written premium. The local captive sector wrote $46.1 billion in gross written premiums and reported total assets of $145.6 billion.

"Last year was excellent from a new company formation standpoint, with 91 new companies," said Shelby Weldon, director of licensing and authorizations for the BMA. "Of those, 24 were captives, which is a good new-formation rate." Most were single-parent with some association captives and rent-a-captive structures. The majority of captives still emanate from the United States-about 45% of new captives formed, Weldon said.

"What has driven the new formations is a new product we launched in 2009-our special purpose insurers, which is piggybacking on the insurance-linked securities (ILS) market, and the explosion of entities looking to seek reinsurance through these alternative risk transfer vehicles," Weldon said.

In addition, Latin America is expanding its presence in Bermuda.  Organizations from the region formed one-third of Bermuda's new captives last year. "There has been a significant push by the Bermuda market to educate Latin America about the captive solution," he said. "For the most part, they are using them for property-catastrophe. Most of it has been large corporate manufacturing and industrial corporations in Colombia, Chile and Peru."

A company may be based in Colombia, but have operations throughout Latin America. "They will have a traditional structure, come to Bermuda and access the reinsurance market," Weldon said. "A drilling company, for example, will be able to have insurance or reinsurance in place in case of a hurricane or other disaster."

Up and Coming
One captive domicile to watch is the U.S. Virgin Islands (USVI), which established a captive law in 1984 but updated the statutes in February 2014.

Percival E. Clouden, chief executive officer of the USVI Economic Development Authority, said that, as a captive domicile, "The USVI is in a unique position. The product is unique and the captive domicile has the full backing and blessings of Gov. John P. deJongh Jr."

The USVI currently has five captives. As a result of its new legislation and the interest he is seeing, attorney David Bornn anticipates 25 new captives within a year.

While the USVI is a U.S. territory, it is outside of the U.S. customs zone. Thus, it is "offshore," but has "a unique tax characteristic in that all individuals and companies domiciled in the territory only pay taxes to the USVI government," Bornn explained. "We unfortunately cannot exempt the premium revenue, which is considered U.S.-sourced and taxable to the U.S. government. But all of the investment income derived from captives headquartered in the USVI domicile is treated as USVI-sourced and 100% exempt from all USVI taxes. This is very unique among U.S. jurisdictions."

Two areas generating a lot of interest for captives are Employee Retirement Income Security Act (ERISA) and terrorism insurance. The USVI is considered a state and "onshore" for purposes of these coverages, explained John McDonald, superintendent of alternative markets for the USVI Division of Banking and Insurance.

The Department of Labor approved the USVI as a jurisdiction for ERISA benefits and has approved three companies so far to do their ERISA benefits captives from USVI. "Our law is written such that a company with a captive domiciled in another jurisdiction can establish a branch captive here in the territory," McDonald explained. "That branch can be operated to do the ERISA benefits, or any other type of insurance they would like to do, while receiving the territory's tax benefits."