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Industry professionals reflect on this year’s trends and challenges as the continued hardening market and abiding impact of the COVID-19 pandemic drove captive formation and expansion

As a year measured in incremental phases by lockdown announcements, travel tier lists, vaccine rollouts and government roadmaps draws to a close, the captive industry continues to thrive amid difficulty and slowdown around the world. While posing immense challenges to governments, industries and people alike, the COVID-19 pandemic was instrumental in promoting alternative risk management and insurance as an attractive resolution to the problems present in the commercial market.

These issues are indicative of the conditions of a continued hardening insurance market, which consists of diminished capacity, high premiums, stricter underwriting standards and widespread volatility and uncertainty. This, alongside the lingering impact of the COVID-19 pandemic, generated a favourable environment for the captive industry as a provider of coverage that is too expensive or simply unavailable in the traditional insurance market.

The Marsh Global Market Index reveals that commercial prices increased by 15 per cent in Q3 2021. “While increases are moderating somewhat and new capacity is entering certain markets, such as directors and officers (D&O), this is the sixteenth consecutive quarter of global price increases,” explains Lorraine Stack, managing director of Marsh Captive Solutions.

This is affirmed by Peter Kranz, captive practice leader at Beecher Carlson. He says: “While there was some tempering of the traditional insurance market pricing, albeit from triple-digit increases to high double-digit increases, there were increases in exclusions and decreases in capacity, continuing to push more organisations into risk retention and captives.”

With many insureds experiencing a fourth year of tough renewals, Stack notes that the further increases in fronting and collateral costs has caused insurers to reconsider exposures and restrict terms for some large, complex risks, particularly those in the auto, chemical and waste industries.

She adds that these hard market conditions and subsequent volatility are “likely to remain in the near future” owing to uncertainties in the commercial market over the impact of natural catastrophe events, increasing climate-related losses and supply chain interruptions following extended periods of national lockdown.

Captive growth is traditionally driven by such challenging insurance conditions. As anticipated, this market activity, combined with greater focus on captives, has caused an increase in formation activity in 2021 compared with 2020, a trend which is affirmed across numerous domiciles, adds Kranz.

“The ongoing hard market conditions have provided a backdrop for captive development and expansion, both in terms of new formations as well as optimisation and greater utilisation of existing captives,” says Mark Elliott, CEO of Humboldt Re and chairman of the Guernsey International Insurance Association (GIIA).

“Rate increases by the global commercial marketplace carried over into 2021, both on the insurance and reinsurance side. These last two years of market challenges led to the explosion of new single-parent captives, group captives, risk retention groups, and especially protected cell companies (PCCs) and cell captives,” adds Michael Serricchio, managing director at Marsh Captive Solutions.

Stack notes that Marsh is set to implement around 100 new captive formations, on top of a similar number in 2020.

“We are seeing increases in the premium written by the existing captives we manage. Fifteen of our domiciles saw premium growth of more than 20 per cent in 2020, including some of the most mature domiciles such as Bermuda, Cayman, Singapore and Guernsey,” she adds.

“We are also seeing significant acceleration in the number of cell formations globally, suggesting that the challenging market conditions are impacting the types and sizes of companies that were not traditionally users of captives.”

Marsh’s annual benchmarking Captive Landscape Report indicates a 53 per cent increase in new cell formations, attributed to the simplicity, cost and ease of set-up. However, the report noted that cells still only make up less than 10 per cent of total captives managed by Marsh, with single-parent captives remaining the most popular structure despite a slower 6 per cent increase in new formations.

Where there’s a risk, there’s a way

In 2021, companies were encouraged to assume greater control of their risk financing structures to incorporate captives and even consider insurance-linked securities (ILS) markets to a greater degree.

“All of this is indicative of a fundamental change in the risk financing landscape which, absent an incredibly sudden soft market, may continue for several years,” Kranz comments.

As well as changes to the structural landscape of the captive industry, 2021 saw notable developments in the type of coverage offered by captives as a response to market conditions and new emerging risks.

Serricchio explains that as the commercial market changed, hardened and challenged, “the captive market responded to their owners’ needs by allowing them to take large global retentions or deductibles, and having the captive fill in on that layer, both directly written and reinsurance from fronting carriers where needed”.

Aon’s 2021 Global Risk Management Survey, published in October, noted that the pandemic highlighted the increasing importance of firms’ ability to manage long-tail risks, including cyber and business interruption, as they shift their focus from event-based to impact-based risk assessments. Elliott observes an overall restructuring of programmes, including a trend of increased retentions in traditional lines such as property and casualty, as well as captive involvement in structured reinsurance solutions. Notably, he points to a “significant uptick” in captives writing coverage for cyber and D&O liability, as these are lines where market capacity has declined and premiums have increased considerably.

D&O in particular has been identified as a significant emerging risk being written more into captives, which Serricchio highlights is another example of captives being effectively utilised to respond to the problems in the commercial market.

“Captives are fulfilling that need with all of those different types of deductibles, excess quota shares, and even these new emerging risks that are finding their way into the captives,” he says.

Stack adds: “Over the last 18 months we have seen increased use of cell captives, including PCCs and segregated account companies, to secure Side A D&O coverage. We have formed Side A D&O cells in Bermuda, Guernsey and Washington DC, with an application underway in Malta.”

Beecher Carlson’s Kranz indicates that, owing to recent claim activity, cyber risk has seen an increase in exclusions, most notably for ransomware. This, in combination with forced increased retentions and reduced excess capacity, has made captives a more viable solution for providing coverage for cyber risk, particularly during the pandemic where remote working models exposed the vulnerabilities in companies’ systems.

Cyber risk was particularly emphasised at this year’s Airmic conference — one of the first to return to an in-person event after the pandemic — and in the association’s annual survey reports, which identified that the commercial insurance market is vastly ill-equipped to meet the needs of organisations regarding scope of cover and capacity as premium rates rise to as high as 400 per cent.

The Airmic survey also noted that cyber risks are the most likely new risks to be financed by captives. This will target a range of common gaps in cyber coverage, including a lack of proper asset inventory, poor identity and access management, lack of segmentation, and an emphasis on security at the expense of resiliency.

“In 2021, cyber has become increasingly problematic for insurers and insureds alike, largely due to recent high-profile ransomware claims. Premiums are rising, and insurers are seeking to limit coverage, indicating a marked reduction in appetite for cyber risk in the commercial insurance market,” Stack affirms.

Serricchio notes that, although an emerging product rather than an emerging risk, the rising use of parametric insurance and alternative structured risk has seen captives participate in more creative and strategic methods of purchasing insurance, particularly to finance catastrophe risks such as earthquakes, wind and flood.

The pandemic encouraged the use of captives for business interruption by exposing coverage gaps and causing companies to reconsider their risk management programmes to ensure they adequately addressed business interruption issues.

GIIA’s Elliott affirms that the optimisation of business development opportunities to capitalise on the favourable market conditions was prominent in many firms’ development agenda in 2021.

Captive managers had to ensure they had the resources available to efficiently and effectively manage the heightened demand for captive consulting services, such as feasibility studies and strategic reviews. Stack highlights that this was a priority for Marsh, as well as consolidating local resources in domiciles to deal with the higher number of formations. Elliott also points to talent recruitment as a significant priority in 2021. In the context of the ongoing talent crisis in the captive industry, the lack of sufficient education and awareness surrounding captives as a niche sector of the already misinterpreted insurance industry has created challenges in talent acquisition and retention.

Serricchio adds that although it is inevitable that organisations have some natural attrition of staff, it is fundamental to find and retain talent that understands the industry and is able to process and handle new captive formations from a service provider, actuarial, audit, legal and regulatory perspective.

Through internships, mentor programmes, skills training and networking opportunities, the industry has made strides to address this dubbed ‘crisis’ in recent years, and 2021 was no exception. Although the pandemic exacerbated the practical issues associated with conducting training and networking online, the majority of in-person events looks set to resume in 2022, fuelling the skills, knowledge and networks of the next generation of captive professionals.

Regulatory developments

While the focus this year was predominantly on the alternative risk solutions being developed in the markets, there have also been some interesting updates in US states concerning the direct procurement tax.

Kranz highlights Washington as the key example, where a captive insurance law passed in May (similar to procurement tax changes passed in Minnesota in 2020) allowed for the creation of a framework to register eligible captive insurers in the state and imposed a 2 per cent tax on the insurance premiums provided to the captive’s parent company or affiliate in the state. Although the Washington electorate voted in a ballot measure to repeal the premium tax, this was a non-binding advisory vote and the Washington Office of the Insurance Commissioner formally adopted the captive regulations last month.

The bill attracted criticism from senior figures in the captive industry in its draft stages as a potentially detrimental precedent surrounding the regulatory oversight of state commissioners and the status of US states as captive domiciles.

“We have seen other states make clear they are not going to pursue such taxes, but it is an added complexity to the evaluation of domiciles based on where the captive parent and risk is located,” Kranz comments.

Across the pond, a slightly more optimistic view: the Guernsey Financial Services Commission’s pre-authorisation pilot scheme for cell captives was successfully implemented by Robus Group’s PCC for a client’s professional indemnity programme.

Elliott explains: “[This gives] insurance managers the ability to respond quickly to put in place captive insurance solutions towards the end of challenging insurance programme renewals.”

More broadly, EU-domiciled captives continue to await the final results of the European Commission’s ongoing review of Solvency II — in particular the proportionality principle, which is designed to ensure the requirements and powers of supervisory bodies are proportionate to the nature, scale and complexity of risk inherent in the business of the insurer or reinsurer.

This is particularly important for captives as it will ensure that regulatory requirements do not become too onerous. In the review’s next steps, the European Parliament and member states of the European Council will negotiate final legislative language based on the commission’s proposals.

In terms of international regulations, while not taking effect until 1 January 2023, captives are recommended by Marsh to begin preparing for the implementation of International Financial Reporting Standard (IFRS) 17.

Comparative reporting under IFRS 17 will enforce material changes to the way in which captives value and report on insurance contracts, with Marsh recommending captive managers to be mindful of contract boundaries, underlying clauses, probability-weighted future cash flows, risk appetite and contractual service margins.

In addition, 2021 saw the Organisation for Economic Cooperation and Development (OECD) finalise its anti-base erosion and profit-shifting framework, which determined that multinational enterprises will be subjected to a minimum global tax rate of 15 per cent from 2023.

The two-pillar plan to ensure a fairer distribution of profits and control competition over corporate income tax was endorsed by leading captive domiciles, including but not limited to Bermuda, Cayman Islands, Guernsey, Hong Kong and Luxembourg.

Marsh’s Stack comments: “The potential impact of the minimum tax rate on major captive domiciles remains to be seen as the proposed programme to reform international taxation has not yet been finalised. The proposed legislation has the support of more than 130 countries, including the G20 and much of the OECD, and most of the world is monitoring how it will proceed.”

She adds that 2021 has seen an emerging trend of regulators requesting certain ESG disclosure as the wider insurance industry adopts and integrates ESG principles into its agenda and strategy.

Airmic’s annual survey named regulatory compliance in the context of ESG as the number one ‘hot topic’ of insurers, with climate change specifically being a fundamental area where insurance buyers and insurers must work more collaboratively in the future.

“Indeed, Guernsey launched an ESG framework in 2021 setting out requirements for the insurance industry there in terms of governance and disclosures,” Stack notes.

Other disclosures include the Task Force on Climate-related Financial Disclosures (TFCD). Almost 40 per cent of risk professionals in Airmic’s annual survey stated that their organisations are ready for TFCD reporting, with a significant number of respondents viewing regulations and reporting requirements as an opportunity to hone their focus on ESG issues and improve their organisation’s resilience and profit margins.

“While we expect much in the ESG space will be influenced by the captive parents’ approach, there will still certainly need to be due consideration at captive board level. We fully expect to see more activity in this area in 2022.”

Challenges

Although the captive industry has undoubtedly reaped the associated benefits of the hardening market and pandemic, this does not mean the year was without its challenges.

Kranz explains that over the past several years, the reaction of the traditional insurance market “has been an impetus to more creative solutions being developed, partly out of necessity and partly out of opportunity”.

He observes a slight shift in reinsurance markets offering large limits on integrated aggregate programmes, explaining: “On other such programmes, it means we might need two to four markets to fill out a US$50 million to $75 million panel. The markets are looking to diversify where their capacity is deployed, which makes such structures more feasible for more companies that are not of this scale.”

Litigation between captives and the Internal Revenue Service (IRS) continued throughout 2021. In May, the ongoing case between CIC Services and the IRS saw a landmark unanimous ruling by the Supreme Court in favour of the captive manager, which determined that the Anti-Injunction Act does not prevent federal courts from enjoining the IRS’ enforcement of regulations that establish affirmative reporting requirements.

More recently in the case, a federal judge issued a ruling temporarily forbidding the IRS from enforcing Notice 2016-66 against CIC Services, pending final resolution of the case.

Elsewhere, in November, the concessions of the IRS were accepted in a US Tax Court in a legal challenge against a captive owner. Following issuances of statutory notices of deficiency for three tax years of more than US$27 million, the IRS conceded the amounts of tax and penalties at issue. Whether this marks the beginning of a precedent remains to be seen in 2022.

Elliott adds that, from an association perspective, the most significant challenge in 2021 was resourcing to handle the increased demand for captives and alternative risk financing, as well as ensuring business continuity in a remote working and restricted travel environment.

Ensuring the mental and physical wellbeing of employees to keep staff engaged, happy and healthy was one of the biggest challenges of 2021, Serricchio adds. He notes that organisations strove to use their technology to their best advantage to maintain smart, simple and efficient processes in the remote working model.

As the world cautiously but optimistically returns to normal — or at least a state of ‘new normal’ — the captive industry remains confident in sustained future growth, with Stack affirming that “the captive industry is in a great space in 2021, with demand at a high”.

“The key challenges right now for us all are to manage growth, and to drive innovation in creating new products to enhance the role of the captive in the risk financing ecosystem. For the longer-term, attracting new and diverse talent and succession planning will be key to the continued health and success of the industry,” she concludes.