Expert Commentary

Captives in Review

As we launch a new year, it seems a good point from which to assess the past year and muse a bit about 2007. Some of the common themes will always be with us, some influences are unforeseen, but there are some new factors on the horizon.


Captives
February 2007

In 2006 we saw a concern for reinsurance which nicely disappeared with the non-appearance of major windstorms. Regulators continued to wrestle with issues of turf, i.e., federal versus state licensing standards, entrepreneurial risk retention groups versus pure risk retention groups, and staffing. More on that later.

Fronting/risk sharing was an issue, although not as urgent as in prior periods. Some of the lessening can be attributed to a declining use of fronts, but also to a quiet increase in the number of firms offering this very valuable service.

Looking ahead through the murky martini glass I can make out a few solid trends.

The Growth of Alternative Risk Finance

The field is well established and not likely to go away any time soon. It is true that the rate of new formations slowed a bit, but by no means was there a downturn of interest. I attribute some of the slowdown to the overall proliferation of new domiciles. The slowdown in the rate of formations was most noticeable in the mature domiciles, which is understandable. In fact, the overall number of new formations appears to have grown reasonably again in 2006.

It is amazing to me that, according to a recent survey, most Fortune 500 companies do not use captives. Often, it seems that everybody has one. So, the opportunities remain. The large companies are seeing the potential of captives to be utilized in a variety of ways.

While established companies are seeing value in the use of alternative risk finance, many investors view the value of alternative risk structures as a type of hedge funds. Just as excess catastrophic property insurers were formed in Bermuda after Hurricane Andrew, so Katrina has spurred new growth. Even though there were significant losses after Katrina, the past year of favorable claims history has brought new players into the business, and some old players have returned.

My prediction is that new formations will continue to increase, and new uses will be developed, which will spur even more growth.

Regulatory Challenge

My understanding of one of the chief purposes of insurance regulation is to ensure that consumers are treated fairly and properly by their insurers, and that claims to third parties are paid accurately and promptly.

This purpose, while still necessary and in the public’s interest, is increasingly difficult to align with the interests and operations of sophisticated financers of risk. If your wallet is larger than the insurer’s wallet, why do you need a regulator to protect you? If you know your risk better than anyone else, and manage it better than anyone else, why do you need to pay someone else to do little or nothing beyond regulatory filings?

Regulators and those who enable them feel that entrepreneurial captives or risk retention groups are "bad." Aren’t all commercial enterprises intended to be entrepreneurial, at least in the beginning? Is the expectation that a risk retention group will spring fully financed from the collective foreheads of a group of down trodden physicians, ready to finance the torts of wily personal injury attorneys?

In fairness, it is incumbent on regulators and everybody else to avoid operators who are setting up ventures with little understanding or regard for the rigors of underwriting, claims, and long-term viability. Of course, failures occur without the risk retention group structure or the label of "entrepreneurialism."

Domicile shopping, searching for a domicile which is more likely to grant a license to your hare-brained scheme than another domicile, will continue, driven by the triennial examinations of the National Association of Insurance Commissioners (NAIC). In other words, if the exam is 3 years away, and the state is looking for new revenues, your scheme begins to look sound and eminently deserving of a license. If the exam is this year or next year, be certain to check out other domiciles.

Regulatory concerns will remain near the top of lists, but since most elections are over for a few months, legislators will turn their attention elsewhere.

Opportunities

While alternative risk finance matures it also opens new doors. Many have spoken and written of the coming convergence of insurance and the capital markets. That began some time ago and is in full blossom. Hedge funds as reinsurers and collateralized debt obligations as insurers are now common. Debentures for catastrophic risk are issued and purchased by public entities. Risk today can be analyzed, measured, and managed in far more sophisticated ways than the traditional markets or personal lines oriented regulators can deal with.

This opportunity will spread rapidly as smaller firms, more nimble consultants, and more imaginative financiers see ways in which to use alternative risk financing as never before.

I expect to see really interesting new ways to finance capital for coverage that cannot be handled well by the traditional marketplace. The Terrorism Program is set to expire at the end of this year, and with no election in sight, may cause headaches for those firms that have a genuine need for this coverage.

Challenges

The converse of opportunity is challenge. One of the great challenges of the entire insurance industry, and captives in particular, is the dearth of qualified staff. Alternative risk finance is dominated by large firms who are able to hire and train smart, hard working young people. They are not always able to keep them however.

This industry need actually is shared on the regulatory front where, with the proliferation of domiciles allowing captive formations, there are few truly qualified regulators. Regulating increasingly sophisticated structures will become very difficult on public servant compensation packages that don’t attract new people. Staff experienced in captives will become very valuable.

It will be an exciting year.


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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