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Slow, steady, stable growth ahead

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Slow, steady, stable growth ahead

Despite a general softening of the insurance marketplace, captive service providers and regulators still expect 2007 to be a busy year.

Providers will be helping buyers find more affordable coverage for a few lines, including medical malpractice insurance. They also will be dealing with new demand for warranty and property coverages, several observers said.

"We've not seen a lot of exodus from the market, although the growth has slowed down," said Julie Boucher, managing director of Marsh Management Service Inc. in Burlington, Vt., which has more than 260 clients. Overall March Inc. manages more than 1,000 captives.

Formations include coverage-specific captives such as life reinsurance or warranty coverage, she said. In addition, owners are still interested in using captives to obtain terrorism coverage, Ms. Boucher said.

"There is a general softening, but it is sporadic, depending upon the risk," said Gary Osborne, the Montpelier, Vt.-based president of USA Risk Group. There is continuing demand for medical malpractice, commercial auto and workers compensation coverages, he said.

His company, which formed 24 captives last year, expects to form nearly as many this year, Mr. Osborne said.

"I expect there to be a (net) increase in the number of captives formed in 2007, but not as much of an increase as in the last few years in the hard market," said Jon Harkavy, executive vp of Risk Services L.L.C. in Arlington, Va., an organizer and manager of risk retention groups.

Demand for captive services also extends offshore, two Hamilton, Bermuda-based executives say.

"There have been a lot more inquiries and discussion about how to use a captive," said Philip Barnes, managing director of Aon Insurance Managers (Bermuda) Ltd. In addition, a number of newcomers continue to use rent-a-captives as a stepping stone to establishing a captive of their own, he said.

"The industry is mature enough for double-digit growth to have to slow down," said David Ezekiel, president and managing director of International Advisory Services Ltd., an independent Hamilton, Bermuda-based captive manager with 180 clients.

ORGANIC GROWTH AHEAD

Growth will be primarily "organic and internal" as captive owners add more lines of coverage, such as employee benefits, he said. In addition, more experienced captives typically have greater capital resources that allow them to take on more risk and reinsure less, Mr. Ezekiel said.

"What we see are captives being used a lot better, as a complement to the existing market," Mr. Ezekiel said. If the commercial market is prepared to sell coverage for very little, that's where captive owners should buy it, rather than paying more to obtain it through a captive, he said. During such soft markets, a captive may go dormant and run off claims.

While most lines of coverage are softening, there is still buyer demand for some specific lines, industry experts say.

Coverage premiums for medical malpractice and contractors liability are stabilizing, but not softening like many other lines, Mr. Harkavy said.

There is continuing interest among hospital professionals to use captives to obtain hospital professional liability and general liability coverage, Ms. Boucher said. In addition, increased partnerships between health care institutions and physicians have brought more capital to the market, she said.

"The price of medical malpractice insurance has declined from the highs of three or four years ago, but it's still sufficiently high that alternatives like risk retention groups and captives are still popular," Mr. Osborne said.

It's important, however, that RRGs have rules to protect themselves from losing price-sensitive members when traditional markets become competitive. For example, members are encouraged to continue participating in the RRG by rules that set a minimum number of years to participate before a doctor is eligible for a refund of his capital stock, Mr. Harkavy said.

Captives are designed to provide affordable coverage in addition to offering the benefits of tailoring policy forms, controlling losses, and earning income from investments and underwriting profits, he said.

A VIBRANT MARKET

During 2007, the captive market "will still be vibrant," said Thomas Hampton, commissioner for the District of Columbia's Department of Insurance, Securities and Banking.

While captive clients historically have returned to the traditional market to buy coverage and captives go dormant when prices in the commercial market fall, "I don't think that historical practice will occur," Mr. Hampton said. Companies, especially those that have completed reviews in compliance with Sarbanes-Oxley Act financial reporting requirements, often realize they need broader and more complex protection not readily available in the marketplace, he said.

The "jury is still out," though, about whether the demand for coverage

from small RRGs will continue, Mr. Hampton said.

"I think the formation of captives could continue," said Tim Wagner, director of the Nebraska Insurance Department. "It's definitely a good risk management device."

Captive service providers predict growth in agency captives as well as captives that provide warranty coverages, among others.

The prohibitions against contingent commissions have encouraged interest in agency captives, which agents typically establish with the help of a fronting carrier to help insure their most profitable clients, Mr. Osborne said. That allows agents to earn income by bearing some of the risk, Mr. Osborne said.

Agency captives are generally established in Bermuda, the Cayman Islands or the British Virgin Islands, he said. Some established U.S. domiciles won't accept them, although newer domiciles such as Arizona and South Carolina will, he said.

Interest in warranty captives continues to build, primarily from product manufacturers of cars, cell phones, computers and golf clubs, Mr. Osborne said. Such captive business requires frequent actuarial reports as well as trust agreements to avoid the service warranty problems that caused the 2003 collapse of the National Warranty Insurance Risk Retention Group, he said.

In addition, Mr. Ezekiel expects there will be continued growth among companies that are new to captive insurance and who often chose rent-a-captives for the first year or two.

PROBLEM LOOMS

A problem is looming, however, because of the current mismatch between the small size of companies interested in establishing captives and insurers' desire to deal with larger clients.

Specifically, buyer demand is increasing, although the minimum premium level for those interested in establishing captives has dropped to $2 million annually for the four key lines--general liability, workers comp, commercial auto and property. At that premium level, "it will be hard to find a carrier to make it work," Mr. Osborne said. Sellers of reinsurance services want captive clients to have a minimum annual premium of $5 million to $10 million, he said.

Catastrophe-prone property coverage is one line that is challenging for captives, several service providers said.

"Captives operate best with high-frequency, low-severity lines," which lend themselves to actuarial analysis and the potential for investment income, Mr. Ezekiel said. "It is very much a liability-based business" that has dealt historically with lines such as medical malpractice, auto liability and workers comp.

"The problem with property is that it is prone to very, very severe losses," Mr. Harkavy said. The issue is whether the captive has the capital or reinsurance coverage necessary to responsibly address such risks, he said.

A privately owned captive, however, can help a large company make traditional coverage more affordable by allowing the company to take a large deductible on windstorm coverage and fund that through the captive. In addition, a company can build catastrophe reserves over the years to take an ever larger deductible in the future, Mr. Harkavy said.

Despite higher rates for catastrophic property coverage, there has not been a wholesale change in the dollar amount of risk that companies are retaining, Mr. Barnes said. Among Aon's 270 clients in Bermuda, most still retain about $500,000 to $1 million, he said.

A small number of property owners are participating in an unusual captive program, however.

Some restaurant and nursing home chains with multiple locations in catastrophe-prone areas are placing their property risks in captives under a tax-favored program that may allow them to build up multiyear reserves in catastrophe-free years, Mr. Osborne said.

The program is limited to companies that can qualify as insurers and elect to be covered under section 831(b) of the U.S. Tax Code. In addition, only companies that pay $1.2 million or less in annual property premiums can participate, he said.

Under the program, the captive owner is taxed on its investment income but not its underwriting profit, so funds can accrue during catastrophe-free years. The negative aspect of the arrangement is that when there is an underwriting loss, the owner cannot carry it forward, Mr. Osborne said.