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HAMILTON, Bermuda-It's getting to be like old times again in Bermuda.
Captive formations are at a 10-year high and, like some of their predecessors, some captives in the domicile today are broadening the spread of risks they cover to include third-party risks.
While a resurgence in the formation of captives is unequivocally welcomed by regulators and managers in Bermuda, they say a repeat performance of the debacle of losses that followed the previous surge of third-party risk diversification by captives in the late 1970s and early 1980s is being closely guarded against.
While many captives in Bermuda still write little or no third-party business, the pressure to write more unrelated risks will increase if the Clinton administration's tax proposals for captives become law, captive managers say.
The rise in captives writing third-party business is accompanied by increases in other lines of business not traditionally written in Bermuda.
In particular, due to a recent boom in health care captives, about 90 captives on the island now cover health care risks, one manager estimates.
And the geographic diversity of captive owners selecting Bermuda continues to expand, with inroads being made into the Southeast Asian markets last year, captive managers say. Anticipated growth from Mexican captives, though, was dealt a blow last year when increased taxation by the Mexican government made captives less attractive for companies seeking a tax break.
Although the number of captives is increasing, several managers are reporting a drop in premiums written due to the continued soft market.
The number of international insurance and reinsurance companies in Bermuda rose 4.9% to 1,470 in 1996 from the 1,401 in 1995.
Bermuda had 1,050 active captives in 1996, an increase of 6.5% over its 986 active captives in 1995.
Ninety-seven international insurers and reinsurers were formed in 1996 and 28 were wound up, compared with 90 formations and 46 closures in 1995.
The record number of new company formations was 158 in 1978.
Of the formations, 23 were single-parent captives, which carry Class 1 licenses under the Bermuda regulatory system; 28 were multi-owner captives which have Class 2 licenses; 30 were Class 3, which include non-catastrophe insurers and reinsurers, finite risk insurers and reinsurers, as well as captives writing more than 20% of their premiums for third parties; three were Class 4, which include property catastrophe insurers and excess liability insurers; and 13 were long-term or composite insurers.
Gross premiums written by Bermuda's international insurers increased 24.5% to $23.4 billion in 1995, the latest year for which figures are available, compared with $18.8 billion in 1994.
Net premiums rose 23.5% to $18.4 billion from $14.9 billion the year before.
The total capital and surplus of Bermuda's international insurers increased 23.8% to $36.9 billion in 1995 from $29.8 billion in 1994.
The most marked change among the formations in 1996 compared with the prior year was the increase in Class 3 formations and the decrease in Class 1 formations: there were eight more Class 3 formations last year, but 10 fewer Class 1's.
The growing popularity of Class 3 formations reflects the increasing number of captives writing third-party business, according to Kymn C. Astwood, Bermuda's registrar of companies.
Class 3 insurers can obtain more than 20% of their business from unrelated risks.
"What we've seen is that a number of Class 3 companies were formed, as opposed to Class 1, to write third-party business to achieve certain tax objectives," Mr. Astwood explained.
Currently, captives with parents in the United States generally have to derive more than 30% of their premium from unrelated business to tax deduct premiums paid to their captive. However, this has been established by tax case law, not legislation.
That could soon change, however. For the second time the Clinton administration is proposing to change tax law to require captives seeking that tax deduction to obtain at least 50% of their premium volume from unrelated business.
That threat of the increased threshold is likely a factor in the growth of captives seeking to write more unrelated business, Mr. Astwood said.
However, he stressed, any actions captives take to increase their unrelated business, for tax purposes or other reasons, will be closely watched by regulators.
"From a regulatory standpoint, I'll be monitoring the response of captive owners to this proposal, because the last thing we want is a repeat of what happened in the 1980s, when there was reckless writing of third-party business," Mr. Astwood said.
The new regulations are a check on this issue as single-parent captives will have to seek regulatory approval before they can write a significant amount of third-party business, he said.
Captive owners generally are interested in writing more third-party risks and, often, it is not to obtain a tax advantage, said Andrew Carr, president of Marsh & McLennan Management Services (Bermuda) Ltd.
The third-party risks usually have some connection to the captive owner, he said. For example, the captive owner may use the captive to offer coverage to subcontractors, agents or suppliers.
"They are trying to augment their business relationship," Mr. Carr said.
At the same time, the owners are benefiting from writing controlled business that is well known to them, added Rory Gorman, senior vp at M&M in Bermuda.
"People are looking to add an extra dollar onto their bottom line rather than just manage their insurance better," he said.
The captives write the business because it is profitable rather than simply to increase the unrelated business premiums for tax reasons, Mr. Gorman said.
"If the Clinton proposal goes through, it probably won't have a dramatic effect on the captives we manage," he said.
Many captives would be unaffected if the legislation goes through, agreed Nicholas S. Dove, president of Skandia International Risk Management Ltd.
"Very few of our clients are actually taking a tax deduction, so I don't see it having a big affect at the present time," he said.
If the Clinton proposal does go through, many captives would be hard pressed to find enough third-party business that is in some way connected to the parent to obtain a tax advantage, said Peter J.N. Strong, president and director of Independent Management Group Ltd.
"There is only so much warranty and other connected business out there, and I don't think that writing other third-party business just to reach a certain percentage is a very good idea," he explained.
Some captive owners welcome the Clinton proposal because it would firmly establish what level of unrelated business has to be met, said Denville C. Reed, president of Sedgwick Management Services (Bermuda) Ltd.
"If it goes through, we'll know what you have to do, whereas up to now it's largely been speculation," based on court rulings, he said.
The Clinton proposal emphasizes, though, that captives should not be established for tax reasons, said Nigel M. Godfrey, senior vp at Sedgwick.
"One always glibly says that you shouldn't form a captive solely for tax reasons, and this illustrates that point," he said.
Captive owners that want to obtain a tax advantage will likely look to pool more risks with other captives, said Roger C. Gillett, senior vp at Johnson & Higgins (Bermuda) Ltd.
Several J&H-managed captives already are pooling more of their risks through the newly formed Green Island Pool.
The pool, which was launched with $60 million in premium, will reinsure member captives' liability risks, Mr. Gillett said.
"The principal benefit will be the stabilizing of loss costs through a greater spread," he said.
The risks covered are at the primary level, so while the volume of claims may vary, there will be little variation in the size of claims, Mr. Gillett said.
Losses and dividends will be distributed in proportion to the amount of business participants put into the pool, he said.
Another trend that is emerging in Bermuda is the growth in the number of captives being formed by health care companies.
Traditionally, the Cayman Islands has been the preferred domicile for captives covering risks of health care providers, but now Bermuda is home to some 85 to 90 health care captives, estimated Alan C. Cossar, executive director at Alexander Insurance Managers Ltd. and also president of the Bermuda Insurance Management Assn.
One of the six new formations at A&A in 1996 was a health care captive, and A&A has formed several other health care captives in Bermuda in recent years, Mr. Cossar said.
Often the formation of health care captives reflects the changes in the health care industry in the United States, he said.
"A lot of it is to do with integrated health care delivery systems. You can tie the members of a network together with a captive," Mr. Cossar said.
And Bermuda is gradually managing to persuade health care organizations interested in setting up a captive that it is a good domicile for the risks, he said.
"There is nothing you can do in the Cayman Islands in terms of health care captive business that can't be done here-and to our mind done better-because of our synergy with the commercial market here," Mr. Cossar said.
Four of the five captive formations at Atlantic Security Ltd. were health care captives, said Colin C. James, president and CEO.
The opportunity to access the rest of the insurance market in Bermuda is an added attraction to captive owners who previously may have gone to the Cayman Islands, he agreed.
"There is no tax or other advantage to either domicile, so the decision often comes down to other issues, like how easy is it to get here and the fact that we do have an actual insurance market here," Mr. James said.
Independent Management Group is currently forming a captive to reinsure the underwriting risk of a workers compensation managed care program for small businesses in Tennessee, said Mr. Strong of IMG.
The workers comp program is administered by one of the investors in the captive, Provident Assurance Co., an insurer. The hospital providing health care is the other investor.
"The hospital and the managed care provider are putting their hands in their pockets to take the risk and the reinsurers have been lining up to reinsure it," Mr. Strong said.
The reinsurers believe that the combination of the managed care company and a hospital will produce better controlled and more profitable risks, he said.
The health care captives forming in Bermuda are often covering risks not traditionally associated with captives, said Tracy E. Keill, senior vp at Aon Risk Services (Bermuda) Ltd.
Two of the seven new captives formed by Aon last year for clients were health care captives. Including captives that were transferred from other managers, Aon added 14 new captives in 1996, she said.
The health care captives are covering capitation risks and long-term care programs, as well as the medical malpractice risks that are traditionally covered by such captives, Ms. Keill said.
Three of the other new formations at Aon were agency captives, she said.
Bermuda generally is seeing more interest from insurance agencies seeking to establish captives, noted regulator Mr. Astwood.
"A typical example is where a U.S. fronting company would like to reward its best agents by allowing them to obtain an ownership stake in an agency captive so they can receive a small quota share of the business they produce," he said.
Mr. James of Atlantic Security agreed that more insurance agencies in the United States are interested in setting up captives.
The agency captives allow insurers to cement a stronger relationship with their best agents or brokers and they allow the agents or brokers the opportunity to profit from their good business, he said.
Many agency groups are too small to form a captive so they join a rent-a-captive instead, said Mr. Dove of Skandia (see story, page 26).
Three of the eight captives taken on by International Advisory Services Ltd. last year were insurance agency captives, said David Ezekiel, president and managing director of IAS.
One of the agency captives covers special sports events. The coverage ranges from hole-in-one coverage for golf events to prize free throw competitions at National Basketball Assn. games, he said.
"The loss ratio is excellent," Mr. Ezekiel said.
In addition to writing new risks, captives setting up in Bermuda are coming from a more diverse range of countries, managers report.
For example, Yukong Ltd., a South Korean manufacturing group, set up a property insurance captive in Bermuda last year. The captive is one of 12 new ones set up by J&H last year.
The formation of the Yukong captive comes after several years of marketing the captive concept in South Korea, said Mr. Gillett of J&H.
"Once you get one company in a particular country to set up a captive, usually it is followed fairly quickly by others," he said.
Another large Southeast Asian company, Petron Corp., an oil company in the Philippines, formed a captive in Bermuda last year. The captive, which will cover property risks, is managed by International Risk Management (Bermuda) Ltd.
In general, Southeast Asian companies are becoming a lot more interested in captives, said John R. English, president of IRM in Bermuda.
"We get so many questions from Japan and South Korea. They tend to look at things that companies from other countries take for granted about Bermuda like infrastructure and regulatory issues," he said.
In the future, IRM expects to see more Bermuda captive formations from European companies, said Gareth Bradburn, president and chief executive officer of International Risk Management Group Ltd.
Earlier this year, IRMG signed a co-operation agreement with GECALUX, a captive manager in Luxembourg (BI, Feb. 3, 1997). The agreement will give IRMG greater access to central European countries, Mr. Bradburn said.
"We have done very little marketing in that area because of the language barrier," he said.
Eastern Europe could also begin to generate more captives, but it is likely to be a slow process, said Mr. Reed of Sedgwick.
"There are a lot of obstacles to overcome, which is often due to the regulatory environment, but there are some opportunities there," he said.
A more promising area for Bermuda captive managers is Latin America, Mr. Reed said.
IRM set up captives for Colombian and Venezuelan companies last year, Mr. English said.
However, he added, some captive owners in Latin America may opt to set up captives in Panama, which last year set itself up as a domicile targeting Latin American companies (see story, page 76).
"We have a consultant in Panama, and we are seeing interest in Panama from some clients," Mr. English said.
J&H continues to see interest in Bermuda from Latin American companies, said Shaun A. Reape, senior vp at the captive manager. J&H now manages 12 captives from Latin America in Bermuda, he said.
Six of the Latin American captives are from Mexico. And while J&H formed one of the Mexican captives only last year, there may be a hiatus in new Mexican captive formations due to recent tax changes, said Mr. Gillett of J&H.
Late last year, the Mexican government introduced controlled foreign corporation legislation that took away many tax advantages of captives, he said.
"It will probably cause a pause in the formations because if you were about to form a captive and the tax advantages are taken away, you have to go back and look at the other benefits," Mr. Gillett said.
But the formations should return as the sound risk management reasons for forming a captive remain unchanged, he added. "In every other country where we've seen this type of legislation introduced, we've seen a pause in formations and then they pick up again."
J&H, like several other managers in Bermuda, saw a fall in the gross premiums written despite an increase in the number of captives it manages.
At J&H the reason for the 5.5% fall to $1.6 billion in 1996 from $1.7 billion in 1995, is that several large one-time premium payments were made to some reinsurance captives in 1995, Mr. Reape said.
Other captive managers cite the general soft insurance rates in the market as the reason for downturns in premium volume.
At M&M, gross premiums fell 10.2% to $500 million from $557 million in 1995.
"Rates are soft so captives are paying less premium for risks assumed," said Mr. Carr of M&M.
Net premiums for some captives are also down as captives take advantage of soft reinsurance rates to cede more of their risks, he said.
Soft rates also contributed to the fall off in premium at IRM, said Mr. English. Gross premiums fell 33.9% to $240 million from $363 million.
The reduction is also attributable to the winding up of the Hopewell captive reinsurance facility formerly managed by IRM, said Mr. Bradburn of IRM.
The successor facility, Harrington International Insurance Co. Ltd., is being independently managed by its investors, Swiss Reinsurance Co. and Winterthur Swiss Insurance Co.
In addition, Mr. Bradburn cited a growing trend of U.S. companies setting up a second captive in Vermont to manage high-volume business such as workers comp.
Captive owners say it is easier to manage the investments of the captive when they are closer to home, he said.
International Advisory Services saw a 12.4% increase in premium volume to $925 million from $810 million in 1995, but that was largely due to new business, said Mr. Ezekiel of IAS.
"Most of the premium volume for existing captives is pretty flat, if not reducing," he said.
The Mead Corp. in Dayton, Ohio, still receives benefits from its captive despite the soft market, said Terry A. Reiff, director of risk management.
"We continue to use the captive because of the ceding commission that we get back from the reinsurers. If we didn't have the captive, that would just be gone, so the captive serves as a cost reduction center," he said.
Mead originally set up a captive in Bermuda in 1971, when the island was one of the few captive domiciles available, Mr. Reiff said. When Mead closed the original captive and started a new one in 1987, there was no obvious reason to look for another domicile, he said.
"There was no tax advantage in going elsewhere, so we decided to stay in Bermuda," Mr. Reiff said.
Meanwhile, the Bermuda market continues to reverberate with rumblings surrounding the controversial redomestication of Electric Mutual Liability Insurance Co., the General Electric Co. liability insurance subsidiary that moved to Bermuda from Massachusetts shortly before it went in to liquidation in 1995 (BI, Dec. 11, 1995).
While no business has been lost as a result of the episode, Bermuda continues to suffer bad publicity from the incident, captive managers say.
Prior to its relocation, EMLICO had reorganized as part of a plan to separate loss-plagued old liability policies from more profitable, unrelated ongoing business. The poor business was included in the company that relocated to Bermuda.
The relocation resulted in a contentious dispute between EMLICO and its reinsurers, which argued that the liquidation should take place in Massachusetts.
While most managers in Bermuda argue that the relocation was justifiable on business grounds, they acknowledge that the controversy surrounding the relocation may have harmed Bermuda's image.
"The discussions going on cast aspersions on Bermuda's liquidation process, which is totally unfair," said Mr. Cossar of A&A. Bermuda's liquidation process is largely based on English law, and the liquidators are independent, he noted.
Among other things, the reinsurers were critical that GE picked the liquidators for its own failed insurer, which is permitted under Ber-muda law.
In spite of the controversy, risk managers are not discouraged from using Bermuda as a captive domicile, Mr. Cossar said.
"It comes up in discussions, but I don't think people are shying away," he said.
The EMLICO episode does not reflect badly on Bermuda regulators, said Mr. Reiff of Mead.
"It is an issue for GE and the way it chose to manage things. It is not a domicile issue," he said.