After a January of firmer rates and tougher underwriting, corporate risk and insurance executives are viewing the captive option with more interest and urgency, as domiciles from Bermuda to Cayman to Vermont continue to see growth in captive formations--while newer domiciles struggle for market

Whoosh!

That's the sound of risk managers and corporate financial executives blowing the dust off old proposals for captive insurance companies--proposals that have been on the shelf for more than 10 years.

After the first January commercial insurance renewals in years that didn't feature across-the-board rate cuts and underwriting giveaways, corporate insurance buyers are revisiting the risk management strategies of earlier days, including domestic and offshore captives for workers' compensation, general liability and commercial automobile insurance.

"We've had more interest in captives in the last 60 days than we have had in the past two years, says Paul Obolensky, president of AIG Captive Services in New York. "A lot of companies and their brokers are revisiting captives from a conceptual standpoint--just in case there is a radical change in the commercial insurance markets."

In the 1970s, corporations were driven to create captive insurance companies by skyrocketing workers' compensation and liability insurance rates and extremely restrictive underwriting in some specialty coverages such as products liability and medical malpractice. For many companies, captives as a formal structure for funding these difficult risks were the only alternative to "going bare" or abandoning the risky business entirely.

In the late 1980s, when insurers began to aggressively cut rates and pursue larger market share, corporate buyers returned to more traditional markets and guaranteed cost insurance policies, gratefully accepting regular rate cuts and generous underwriting terms.

However, plenty of risk managers still remember the stranglehold of the tight markets, says Judith MacDonald, president of the Captive Insurance Companies Association (CICA) in Minneapolis, Minn., and vice president for risk management at Comerica Inc. in Detroit, Mich.

"Everyone's a little jumpy about the prospects of a change in the markets. No one wants to be stuck in the position of watching their rates increase out of their control. Companies that have a captive in place, whether or not it has been active in the past few years, are in a much better position to weather a market shift," she affirms.

Risk management control and access to the global reinsurance markets have always been key reasons for forming a captive, MacDonald explains. Companies that have maintained their captives may not have been in the thick of the rate cuts of the past few years, but they have kept a firm hand on the terms of their coverage and stabilized their costs through direct negotiations with reinsurers.

"As rates increase, corporations with captives will have maintained their ties to the reinsurance markets and will be better positioned to keep their rates under control," she says.

"Stabilization of costs, coverage enhancements, and risk control--those are the three traditional reasons for forming a captive," agrees Kevin J. Doyle, president of Gallagher Captive Services, a division of Arthur J. Gallagher Inc. in Itasca, Ill. "But these are components of a long-term risk management strategy. Some companies have been committed to a long-term strategy, but many have just been riding the markets. Now that is definitely starting to change and some companies are reevaluating their short-term strategy."

A long-term risk management strategy is what attracted TM Cobb Co., a building supply manufacturing company in Riverside, Calif., to participate in the formation of Milestone Insurance Co. Ltd., a Bermuda-based group captive which is managed by Gallagher Captive Services.

TM Cobb and a group of other California companies formed the captive in 1995 at the height of commercial insurance market competition, seeding the company with commercial automobile and general liability risks. Participants were required to provide a minimum of $500,000 in premium volume.

At the time, the project wasn't an easy sell to management, explains Jeff Cobb, operations manager at TM Cobb and a captive director. Pricing wasn't the motivation, since commercial insurance rates were low.

"We had to make sure the rates and coverage were at least competitive with what was being offered by the traditional markets. Otherwise, the captive would not be very attractive to participants.

"But what we were really looking for was a way to lower operations costs. We wanted a direct influence on risks, and by working with our administrator, we had more control and access to risk information than ever before," he says.

In 1998, the captive began to also pay off financially. Workers' compensation insurance rates began to tighten in California after several competitive years and the members switched comp coverage to the captive to stabilize their growing costs and maintain control over claims.

"The captive has met all of our expectations," Cobb says. "We're in this for the long haul and the right reasons."

The captive insurance company concept is also catching the attention of a new breed of corporate financial and legal executives. As risk managers focus on negotiating lower rates from traditional insurance companies, chief financial officers and corporate general counsels have been exploring captives to meet special financial needs, says Guy M. Ragosta, managing director of captive management services at Willis Inc. in Burlington, Vt.

"CFOs and corporate controllers have been turning to captives for balance sheet control. They have been using the captive structure to provide credit security, manage tax liabilities, and finance a wide range of business and enterprise risks," Ragosta explains.

Michael Moody, president of Strategic Risk Financing, a risk management consuiting company in St. Thomas, U.S. Virgin Islands, agrees: "Much of the latest interest in captives isn't coming from risk managers or their brokers at all. A lawyer in Detroit calls a lawyer in Bermuda and they discuss liability structures and taxes. Then the insurance experts get involved to settle the details."

In 1999, before the first signs of rate changes, new captives continued to be formed at a slow, but steady rate. According to preliminary information gathered for the 2000 edition of the Best's Captive Directory, formerly published by Tillinghast Towers Perrin, 171 new captive insurers were formed last year and 50 existing captives were liquidated or became inactive to run off existing liabilities.

The net gain of 121 captives was about the same as 1998, says editor Carol M. Pierce. New single parent captives outpaced group captives by about five to one as corporations sought to create insurance profit centers, Pierce adds.

Third party business dominates the underwriting strategies of many of the new captives as parent corporations seek to create a diversified book of insurance business to balance their own risks. In accordance with insurance case law, corporations that sponsor captives with large books of non-corporate business can take a deduction for premiums paid to their captives. Parents of captives that only underwrite parental risks cannot take a deduction.

Many corporate sponsors also seek to generate income by offering insurance coverage to customers through their captives, Pierce says. Term life insurance, product warranties, and mortgage insurance products were among the most popular products offered by captive companies, she notes.

Domestic domiciles

Vermont led domestic domiciles with 35 new captives, and placed second only to Bermuda for the most new captives of domestic or offshore domiciles, according to the directory's preliminary survey. About 10 captives were shut down during the year.

Many of the new captives continue to be untraditional, underwriting third party business rather than parent corporation risks. About 15 of the new captives were created especially to market mortgage insurance, a product trend that has been driving several new formations a year for the past few years, according to Lisa Ventriss, president of the Vermont Captive Insurance Association in Burlington, Vt.

"Captives have a definite life cycle," Ventriss says. "We are in a mature industry and we can only expect that captives will go through their own evolutionary cycle as corporate needs change. Mortgage insurance has created a lot of growth for Vermont, but that era may be coming to an end as the market becomes saturated."

Commercial market changes may spur some growth in more traditional captives, but Vermont is looking more toward the growth of "sponsored" captives, funded by insurers and other insurance industry financial companies for special purposes, and "branch" captives funded by offshore captives to underwrite domestic employee benefits.

Though the U.S. Department of Labor (DOL) has generally forbidden the use of captives for domestic employee benefits, corporations continue to seek new rulings.

Ventriss says recent negotiations between the DOL and Columbia Energy Co. may lead to a more flexible approach by the government agency.

"From what we have heard, DOL is more interested in hearing proposals, if the corporation seeking a ruling can prove that the captive use will lead to a benefits enhancement for employees," she says. "But in the meantime, we're just waiting for more news."

If benefits captives become a reality, the change could mean a flood of new business for Vermont and other domestic captives. Hawaii, which placed second among domestic captive domiciles with 10 new formations, could also benefit from a new attitude by the DOL. However, the state may have its own sources of growth from Pacific Rim companies.

"Japan is just beginning a process of deregulation," notes AIG's Obolensky. "The Japanese government has never been very supportive of the captive insurance company concept, but that could be changing and Hawaii has always had close ties with Japanese business and tourism."

The U.S. Virgin Islands has also had captive legislation for several years and local regulators continue to talk about the use of captives for employee benefits, says Moody from Strategic Risk Financing, "but so far it's all just talk until someone makes a breakthrough."

Other state domiciles continued to be stalled. Maine, New York and Tennessee reported no growth and Rhode Island, one of the newest domiciles, reports only one captive formation in 1999.

Nevada, the latest state to jump on the captive insurance company bandwagon, announced its own captive formation legislation in October. Modeled somewhat after the Vermont captive legislation, the law seems flexible and attractive, says Michael Mead, president of M.R. Mead & Co. Ltd., a Chicago-based risk management consulting company. Mead is also chair of the CICA legislative committee.

"Nevada has well-written legislation, low capitalization requirements and captive tax rates and no personal income tax. There are a lot of good reasons to consider Nevada as a potential serious player," he says.

What Nevada lacks is an experienced infrastructure, say captive management experts. Though the state insurance department is committed to a captive industry, few local lawyers, accountants, and insurance brokerages have experience with captive formation and management.

Offshore Domiciles

Bermuda continues to lead the world in captive formations with 39 new captives, according to the preliminary directory survey. However, the rapid growth of Bermuda as a global insurance and financial services center seems to be overshadowing its success as a captive domicile, say insurance industry experts.

Bermuda reported more than 80 new insurance company formations as international insurers and capital investment groups continued to create new insurance and reinsurance underwriting facilities. Access to these sources makes Bermuda the single most attractive domicile for large U.S. corporations seeking a home for global insurance and risk management operations.

Grand Cayman Island, still the second largest captive domicile, slipped for the first time to third place in new captive foremations with 34 new formations, one less than Vermont. Long a stronghold of captives for the medical industries, Cayman has also developed a reputation for creativity in specialty markets. However, the domicile has not found a way to match Bermuda's success in overall financial services growth.

Channel Island and European domiciles also reported some slow but steady growth in new formations. The island of Guernsey reported 11 new captives and the Isle of Man reported six new captives.

Among the European domidiles, only Dublin, Ireland seems to have strong business support for new captives. The domicile reported 14 new captives, including several from U.S. multinational companies.

"About 25 percent of captives in Dublin are formed by U.S. multinationals," explains Arthur Koritzinsky, senior vice president of Marsh Inc. in New York. "Dublin captives can issue policies on an admitted basis in European Union countries, eliminating the need for fronting carriers. This policy makes Dublin very attractive for U.S. companies with overseas operations in European Union countries."