Global captive formations slipped in 2017 amid the continued soft commercial insurance market, but captive managers anticipate growing interest in alternative risk transfer vehicles as some lines of coverage see rates edge up.

In addition, while traditional captive risks — general liability, auto liability, workers compensation and some property coverages — continue to dominate, other lines, such as medical stop loss coverage, are increasingly being covered via captives, and owners are showing interest in covering cyber liability, operational risks and some parametric coverages through captives, captive managers say.

And recent tax rulings and changes in tax law don’t appear to have yet dented the appeal of captives as risk management tools, they say.

The total number of captives worldwide slipped less than 1% to 6,647 in 2017, according to a Business Insurance survey of captive domiciles. Domiciles submitted more robust data for the past two years as the most recent survey requested more detail.

Several of the larger, well-established domiciles, including Bermuda, Cayman Islands and Vermont, saw net reductions in the numbers of licensed captives, but smaller, more recently established domiciles, especially in the United States, continued to see growth in captive numbers. Tax changes arising from the 2010 Nonadmitted Reinsurance Reform Act, which can make it advantageous for captives to be domiciled in the same state as their parent company, in part continue to drive domestic domicile growth, captive managers say.

Captive opportunities

Looking forward, captive managers expect to see captive owners making more use of existing captives and other companies forming captives if commercial insurance rates rise in 2018.

Following the chain of catastrophe losses in 2017, various market surveys show rate increases of 5% to 10% for property coverages and more modest increases in some other lines of coverage.

“There’s finally a sense that rates are about to rise, and we are seeing captives look at deductibles and exclusions in their existing commercial policies,” said Karl Huish, Phoenix-based executive vice president-North America, at Artex Risk Solutions Inc., the captive management unit of Arthur J. Gallagher & Co.

And economic growth, especially the booming construction sector, is driving captive growth, he said.

“We have construction companies that have very strong cash flow, and they are looking to do medical stop loss, workers compensation deductibles and subcontractor risk in captives. I think construction is an area where we will see growth with captives this year,” Mr. Huish said.

The hardening in the property insurance market is prompting more interest in insuring a portion of named storms coverage or wind or earthquake deductibles, which are increasing, in captives, said Indianapolis-based Anne Marie Towle, executive vice president, captive consulting practice leader, at JLT Insurance Management, a unit of Jardine Lloyd Thompson Group P.L.C.

Aon P.L.C.’s captive management business saw a 22% increase in premiums last year through a combination of new formations and existing captive owners utilizing their captives more, said Burlington, Vermont-based Nancy L. Gray, regional managing director, Americas, at Aon Risk Solutions.

“We are seeing increases in the property area and a reflection that captives are being utilized a bit more than they have in the past,” she said.

Captive owners are in some cases increasing retentions from a risk-reward perspective and utilizing their captives to access the reinsurance market, Ms. Gray said.

New areas

Aside from lines of coverage that have traditionally been placed in captives, captive owners are placing — or at least considering placing — a more diverse range of coverages in captives.

In recent years, for example, more captives are being used to cover medical stop loss exposures, which cap exposures on self-insured health plans, said Ms. Towle.

“A lot of it is driven by the sheer numbers. If you are a smaller organization, we see some of those employers joining group captives for medical stop loss. If you are a larger employer and you have the numbers, there could be some savings in insuring a layer of the medical in your existing property/casualty captive,” she said.

Captive owners can achieve savings by covering medical stop loss exposures, said Ms. Gray.

“It’s an expensive coverage for companies to purchase and there’s a cost-benefit associated with it if they are able to retain that and write it through the captive,” she said.

However, growth in the coverage of ERISA-type benefits — group term life and long-term disability — is sluggish in part because the cost of the coverage in the commercial market remains competitive, Ms. Gray said.

Owners are also considering, and in some cases including, coverage for cyber risks in their captives, managers say. The interest is in part driven by the lack of comprehensive cyber insurance coverage available in the commercial market, they say.

“There’s cyber coverage out there, but it’s more limited in terms of some of the policy coverages being provided so you can utilize a captive to issue a stand-alone policy. There is some takeup in terms of looking at this, but this is an area that’s still developing,” Ms. Gray said.

More captive owners are considering cyber risk, said Mr. Huish of Artex.

“The cost for commercial cyber is going up, and there’s a realization in the market that the cyber policies that are provided in many cases have a lot of exclusions, so covering some of those risks, or a layer of the risks or the exclusions in your captive, seems to be a topic that people are considering,” he said.

While most captive owners would not want to cover potentially catastrophic cyber exposures in their captives, they might consider carving out some elements of the risk, such as business interruption or the cost of hiring outside advisers in the event of a breach, and providing coverage for those risks through a captive, Mr. Huish said.

But captive owners have concerns about how to price cyber risks, said Ms. Towle of JLT.

“When you hear about these large limits, people are trying to understand and determine what layers make sense to insure in a captive and access reinsurance,” she said.

Some captive owners are looking to use captives for more sophisticated risk management strategies, said Sean Rider, executive vice president and managing director, consulting and development, in Willis Towers Watson P.L.C.’s global captive practice in New York.

“It’s about using the captive as an aggregator or hub for correlated and noncorrelated risks to create a diversified approach to how you manage the financing of your organizational risk,” he said.

“When you take that and buy reinsurance for it on an integrated basis, the reinsurer also has the benefit of the noncorrelation that provides the natural insulation to adverse unexpected outcomes

that comes by virtue of noncorrelation, and as a result you end up with a much more efficient risk transfer program at meaningfully lower cost,” he said.

In addition, captives can be used to structure protection for operational risks via parametric coverage, where coverage is triggered by various indices, such as wind speed for storm coverage.

“The growth of the parametric risk transfer market has triggered ideas around how you can use parametric structures to fund risk retention in a captive,” he said.

Industry developments

In addition to insurance-related changes, last year saw regulatory and legal developments that affected captives.

For example, the Organization for Economic Cooperation and Development’s Base Erosion and Profit Shifting initiative, or BEPS, is likely to affect captives globally, Mr. Rider said.

The initiative, which began in 2012, targets multinational companies that use tax planning strategies that exploit gaps and mismatches in tax rules to shift profits to low or no-tax locations where they have little economic activity, such as through a small subsidiary. About 100 countries and jurisdictions have signed up to the project, according to the OECD.

Different tax authorities are applying the initiative in different ways, and in the United States, the initiative has been addressed by the base erosion and anti-abuse tax provision included in the recent tax reform law, which targets financial payments between U.S. companies and foreign affiliates, he said (see related story).

Captives and captive managers in the United States are also facing changes in light of last August’s Benyamin Avrahami and Orna Avrahami v. Commissioner of Internal Revenue tax court decision against the owner of an 831(b) captive.

In the case, the IRS alleged that the microcaptive for a jewelry business in Phoenix that ostensibly covered insurance risks charged unrealistic premiums and did not meet risk distribution requirements for captives.

Captives that are established for risk management purposes and include true risk transfer should not be affected by the Avrahami ruling, said Ms. Gray of Aon.

“If an 831(b) captive is structured correctly, there’s no problem with tax election,” she said.

Even though the Avrahami ruling went against the captive owners and their advisers, the case could be beneficial to other captive owners, said Mr. Huish of Artex.

“Avrahami has be a learning experience for the industry — a positive learning experience where people have a chance to evaluate their captive,” he said.