Regulations, domicile choice and the impact of enterprise risk management are hot topics for the captive insurance business.
- Best's Review Staff
- September 2018
Panelists at the A.M. Best webinar, State of the Captive Insurance Market discussed issues shaping the captive insurance market, including financial results and the business environment for captives, risk retention groups and related organizations.
Panelists included Michael O'Malley, managing director with Strategic Risk Solutions; Susan Molineux, associate director at A.M. Best; Ed Malaspina, president and CEO of HAI Group and Fred Eslami, an associate director at A.M. Best.
A.M. Best Group Vice President Lee McDonald served as moderator of the panel. Following is an edited excerpt of the webinar's transcript.
What types of captives does A.M. Best follow?
Fred Eslami, A.M. Best
"A.M. Best rates currently about 200 captives globally."
Eslami: A.M. Best rates currently about 200 captives globally. We have a number of offices that we dedicate to a specific domicile. From our U.S. office, we rate about 140 U.S. domiciled captive companies, and Bermuda, as well. Our Mexico, London, Hong Kong, and Singapore offices have captive teams that dedicate themselves to the captives which are domiciled there.
We have both single parent captives domestically and single parent captives internationally. Also, the rest fall into other types of captive, which include group captives, cell captives and other type of alternative risk transfer companies.
How does A.M. Best rate captives?
Molineux: A.M. Best has rated captives for decades. We apply our rating methodologies to companies globally. We do have separate methodology that considers the factors specific to captives. That's the alternative risk transfer criteria.
In October of last year, our credit rating methodology, or BCRM, was updated. The elements of our ratings did not change at all. However, we introduced the building block concept in order to provide more transparency to the rating process. (See graphic on page 43.)
The building blocks begin with balance sheet assessment, which is the foundation for financial security, as the starting point for the rating and the point from which all the building blocks are notched.
Risk adjusted capital, as measured by Best's Capital Adequacy Ratio, or BCAR, is one consideration of the balance sheet assessment. The other components of the balance sheet are also assessed on a quantitative and qualitative basis.
The captive sector as a whole has a balance sheet strength that is considered at least strong, with 60% considered strongest. This reflects the high risk adjusted capitalization, a pattern of stability, strong reserving practices, and high quality of capital. This is not surprising, considering that capital preservation is a key element of the captive business model.
A.M. Best also takes into account letter of credit and loan backs when assessing the strength of the captive's balance sheet. We then look to operating performance, the next building block. That considers profitability, stability, diversity, and sustainability of earnings, as well as the impact of prior year liabilities on earnings.
We take into account features specific to captives here, such as cost sharing, that helped keep expenses low and strong loss control since the captives are very close to the risks that they write.
Our assessment of operating performance for the captive sector overwhelmingly falls into either the adequate or strong assessment categories. The operating performance assessment is not simply a review of the numbers.
We're looking at results before and after dividends. We're also taking into account that some captives, particularly those with a narrow scope, may have bumpy results. We're looking to the parent's track record of support when making our assessment. We're next looking at business profile, the next building block. The captive sector here is predominately limited with nearly a third considered neutral. When assessing business profile, we're looking at geographic and product line diversification. We're looking at leadership position in the market, control of distribution, and other factors. The rated captives sector is diverse, but some have a narrow focus. Others are very diverse, writing in multiple territories and multiple lines.
That's reflected in our assessment where some are limited and some are broader, which results in a neutral assessment.
Our last building block is ERM, where we're assessing the captive based on its nature, scale, and complexity of operations. Nearly all the captives here are assessed as appropriate.
In the captive sector, we have companies that have their own ERM framework. We also have captives that are an extension of the parent's ERM framework. We spend a good deal of time here getting to understand the companies and the ERM environment in which they operate in light of their business profile.
The building blocks will result in an Issuer Credit Rating, an ICR. Largely, the captive sector is in the excellent rating category. They are largely stable. This year confirms the strength of the captive market and a reflection of the proximity to the risks written, the quality of data, and the involvement and support of the captive owners.
How widely is enterprise risk management being adopted?
O'Malley: I think it's being adopted across the board. We're seeing more and more, at least internally at SRS. We've gone to the SAS [Statement on Auditing Standards] 70 reviews and taken the extra step to have an external party come in and monitor how we do things, our internal controls.
We're seeing that on the same at the client level and the captive management level. Overall, significant increases, and compliance, and requirements related to ERM.
When we manage a captive, we also have imposed certain guidelines in terms of constant performance monitoring. We have a loss scorecard system and other systems that, on a monthly basis, assess performance. There's no lag time in claim activity, increases in claim activity, and the responsiveness to it.
Overall, I would say a broader expansion of ERM across the board is what we are seeing.
What have you seen in terms of captives' performances, especially around combined ratios?
Susan Molineux, A.M. Best
"From a rating perspective, tax reform hasn’t impacted any ratings of captives."
Molineux: We do find that, time after time, the combined ratio beats the commercial casualty composite. I think, touching back on ERM, it is usually, in many cases, a reflection of the effectiveness of the ERM framework. It translates into the combined ratio.
Although we have these building blocks, they do very often feed off of each other. The benefits of the good ERM framework will translate, in many cases, into an improved combined ratio because the results are within the appetite and tolerances.
Have there been any changes in terms of numbers or types of captives being formed that you're observing?
Eslami: The new formations both in terms of domestic and international is 441. At the same time, there were closures but the closures doesn't mean that the captives went out of business or they were impaired for any reason, although there may have been some.
It's mostly a function of mergers and acquisitions, especially with the big companies.
Is this a typical year? Anything driving the numbers either way?
O'Malley: In general, for smaller captives there's been increased scrutiny on the tax profile of smaller captives. It's slowed the growth of those entities.
For larger captives, I think it's a fairly mature market. Large corporates when there's acquisitions oftentimes there may be two captives involved so they merge into one. You can see a natural attrition rate.
What we're seeing in terms of growth is a lot of for-profit structures coming into play, entrepreneurial-type captives where there's an opportunity to market insurance to an affiliated part of the business.
For example, a cell phone carrier may sell cell phone insurance, partner with the commercial market, and then place that risk into a captive. Insurance is tied to the core business in some form. The client is getting comfortable with risk and deciding to retain it and finance it in a captive.
A lot of our activity recently has been those opportunities we're seeing. We're also seeing significant growth in medical stop loss programs where the client takes a certain retention. They'll finance a layer above that within their captive. Then, they'll buy catastrophic protection from the reinsurance market.
Any trends in terms of domicile selection?
O'Malley: For SRS internally, there's more growth domestically than there is offshore. There's continued growth offshore but I would say 80% of our new captives are being formed onshore. Part of that is additional tax compliance from going offshore and a growing, robust market onshore.
There's so many captive domiciles now so oftentimes things like self-procurement tax come into play where you want to go to a home state for your captive. In general, we're seeing most of our captives, I would say the majority of our captives, are being formed onshore but we're still seeing growth offshore, as well.
Why do clients choose captives, RRGs, whatever they happen to be into?
O'Malley: When you become a member of a group captive you're purchasing a customized product. For example, we have a restaurant program. It's a homogeneous group. All of the loss control is focused on the restaurant exposure.
Oftentimes, competing with the traditional market, you're getting a generic product versus a customized product that's specific to you. The coverage areas are specific to the restaurant owner. I think, in general, it's more information, transparency, and long-term stability. Keeping captives active and keeping them growing.
If you get comfortable with your risk and focus on proactive loss control, then the embedded profits in the program would ultimately go back to the insureds over time. They're a little bit less sensitive in terms of price sensitivity initially.
That's what we're seeing. That belief in, over the long term, if you're focused on your proactive loss control and you're a cohesive unit then it's going to be a good decision over the long term.
Malaspina: Loss control is the cornerstone to all of our programs since the very beginning. Even the extensions and enhancements we have to providing them insurance is we have an online learning network that's available to our members any time of the day or night. It's an extension of our risk management and loss control programs.
To get back to one of the other advantages and things to remember with captives, we're generally mission-based. The traditional market is more of an opportunistic market. They can come and go more frequently than we do. We're in it for long-term value.
O'Malley: One other piece, just a tangible example, is we have a trucking firm that has a captive. They've studied their exposures over time. Technology has come into play. Within their trucks they've heavily invested in loss control. When there's a certain acceleration in the truck an alarm goes off. If there's an accident, there's cameras involved.
They've spent significant resources on building the loss control. Their view is, “Naturally, we think our risk profile is going to improve. Why don't we retain additional risk?”
It's that thought process of studying your exposures, proactive loss control, using technology where needed, increasing your attention, and then financing into the captive. The process that we see a lot of times with entities considering captives.
What role is taxation playing these days?
Molineux: From a rating perspective, tax reform hasn't impacted any ratings of captives. However, when you look at captives and what they're navigating through on tax reform, we're looking at it in terms of their business decision—that goes into ERM—and their handling of regulatory risk.
It is, in many ways, the cost of doing business. It may impact choice of domicile. I think we have seen cases where there are new captives being set up onshore where they might have had one that was offshore. By the same token, you'll also see in places like Bermuda, companies have made the 953(d) election where they're already being taxed as U.S. taxpayers. Tax reform doesn't really affect them.
In terms of the BEAT [base erosion and anti-abuse tax], I think that's part of a wider issue because that's looking at payments, tax receipts globally. It may not be specific to a captive particularly but if it is a captive of a multinational company that has a number of entities operating globally they may be caught up in that unintentionally, so to speak.
The Best's Market Segment Report, For All the Rated Captives, It's Déjà Vu, All Over Again is available at ambest.com.