Kerr Russell
Over the past five to seven years, captives have increasingly made the news, mostly for the wrong reasons.
Internal Revenue Code (IRC) Section 831(b) micro captives have been the subject of intense Internal Revenue Service (IRS) scrutiny and the captive industry has watched the IRS stridently pursue the lowest hanging fruit—831(b) captives aggressively promoted mainly for tax avoidance and for questionable insurance purposes.
Not surprisingly, the IRS has been on a bit of a roll, prevailing in several recent tax court decisions. Misinformed taxpayers, getting penalised by the IRS, are looking to the promoters for recompense. It all makes for interesting headlines, grabs the attention of the captive industry, and feeds the public’s cynicism.
Meanwhile, pure/single-parent captives organised for proper insurance and business purposes remain steady, with far less fanfare and drama. Group captives, beyond remaining steady, are flourishing as a result of a confluence of many factors, described below. Indeed, it truly is the “golden age” of group captives.
What is a group captive and what are some of its benefits?
Group captives come in many shapes, structures and sizes. They essentially allow companies that may not be large enough (from an insurance dollar standpoint) to form their own single-parent captive, to come together and participate in a captive programme enjoying its benefits.
If these companies have a positive loss profile, they should be able to lower and stabilise their overall insurance costs as opposed to being priced with their industry in a volatile market.
Another, perhaps less obvious benefit for companies participating in group captives, is that such companies typically become much better from a safety, risk control, and claims handling standpoint. Group captives engender a heightened focus on safety, risk management, and claims. There are a few reasons for this. First, the group captive members are working with their own dollars rather than insurance company dollars.
Second, they are accountable to the other group captive members, with whom they are sharing risk.
Companies also see the direct impact of their risk and claims management efforts on their bottom line and benefit from an increased awareness of risk management and loss control best practices. Participants can learn what other best-in-class companies are doing.
There is an exchange of risk mitigation ideas, especially in the homogenous group captive setting, which benefits the collective membership. Group captive participants are also able to share operational best practices.
Finally, by sharing their legitimate insurance risks, in whole or in part, with other like-minded companies, group captive members achieve the risk distribution necessary to constitute “insurance” which in turn allows for premium deductibility.
Who are group captives best suited for?
Group captives are ideally suited for companies that operate in industries with inherently difficult risk profiles, leading to volatile, high pricing in the traditional insurance market.
The best candidates are the companies in those industries that are best-in-class from a safety standpoint but are nevertheless still priced with the industry.
Some industry examples include trucking, construction and manufacturing. Homogenous group captives have responded to the need for these types of companies to look at alternative insurance structures.
Additionally, any company that spends significant insurance dollars and that has made risk reduction, safety, and aggressive claims handling a priority will benefit from the group captive model.
Likewise, companies that have not acted yet but have a desire to take control of their risk management costs and make themselves safer will always be good candidates.
Indeed, companies looking to leverage safety as a market differentiator will always benefit from the group captive structure.
Why is this the golden age of group captives?
Group captives achieved modest popularity in the 1980s and 1990s as companies, both large and middle-market, attempted to gain control of their insurance costs. In the late 1990s/early 2000s, as a result of a hardening insurance market and volatile pricing, insurance brokers looking to find solutions for their “best in class” clients, increasingly sponsored or financed group captives, many of which domiciled in the Cayman Islands.
Many of the group captives established in the 25-year period leading up to the Great Recession in 2008 were predictably impacted by the economic downturn, with member attrition causing some groups to liquidate and others to downsize. Even the strongest groups struggled to maintain member numbers and overall premium levels. Importantly, however, the well-managed, stable group captives survived and became better companies in the end.
The Great Recession, in a few important ways, helped fuel the golden age of group captives. Indeed, as surviving businesses started coming up for air in 2011 and 2012, they vowed not to repeat the mistakes of the past and scrutinised their expenses, including insurance expenses. In turn, corporate purchasers of insurance have become much more sophisticated. In this environment, a vehicle to lower and stabilise insurances costs makes a lot of sense. The Great Recession similarly caused group captives to become smarter, more efficient, and increasingly competitive. The Great Recession also led to increased regulation, some of which has impacted group captives positively, leading to better-run captives.
The strengthening economy—especially in the US—over the past five to seven years has also contributed greatly to the golden age of group captives. With increased economic activity, low unemployment, a rising stock market, low-interest rates, and increased consumer confidence and demand, large-cap and middle-market companies are thriving. Also, the demand for traditional business lines of insurance—workers compensation, general liability, auto liability, property—is up, as is the demand for newer insurance lines such as cyber liability.
Medical expenses and health care costs remain high, and the reinsurance markets have been impacted by natural disasters and other global events. Auto liability—especially for transportation/logistics companies—in the US has increased dramatically as jury awards have skyrocketed. Over-regulation in jurisdictions such as New York, California and Illinois, and in certain industries, has caused rates to increase or insurers to exit the market altogether. All of these factors—and more—have caused rates to increase or dramatically increase and remain generally volatile. General liability rates, even for “best in class” companies, are increasing in the traditional marketplace, while auto liability rates are substantially increasing. All of this inures to the great benefit of group captives as companies seek shelter from the expense and volatility of the traditional marketplace.
Other factors contributing to the group captive golden age include the overall increased awareness of captives as a result of the internet, word of mouth, insightful and aggressive marketing, and the realisation by brokers that a captive solution needs to be a part of their repertoire; the growth in the number of legitimate domiciles–especially in the US; the advent of innovative coverages in an increasingly complicated world; the continued availability of traditional reinsurance which allows fronted programmes to remain competitive; and a new generation of professionals entering the industry, energised and bringing new ideas.
Finally spurred-on in part by regulation and increased competition, group captives are better operated and more efficient than ever before. Successful group captives are completely transparent and able to withstand the most intense scrutiny. Best practices are routinely employed so that the members fully understand the captive structure, its risks, the money flow, the costs and coverages, the service provider roles and compensation dynamics, and exit strategy. All of this and more must be fully transparent and explained to the members upfront and in writing. Group captives must be run properly, with regular meetings, appropriate checks and balances, proper corporate governance and internal controls. They also need a detailed risk management framework, vigorous committees, written protocols and procedures and significant member involvement, all to avoid problems and surprises from a financial or risk management perspective. Members need to educate themselves concerning all aspects of the captive.
Not surprisingly, given the mix of conditions mentioned above, group captives are thriving. The long-established groups are growing, with the largest problem often being how to weed out the best in class companies from those with few, if any, other good options. New groups are being established by well-known onshore captive administrators and commercial insurance brokers. New brokers are sponsoring groups, as are some traditional insurers.
What does the future hold for group captives?
So, when will the golden age of group captives end? It’s hard to predict—just as a complex confluence of factors led to the golden age, any realignment of those factors could cause it to end. Some of the larger, and most volatile, of the factors, could strike a decisive blow to the golden age. These include the global—especially the US—economy, the overall softening of the commercial insurance market, over-regulation, and regulatory/taxation reform.
The good news, however, is that even if we see an end to the golden age of group captives, in the absence of a catastrophic change to the captive industry as a whole it is unlikely that in the near-term the realignment of factors impacting the group captive industry will be its death-knell. After all, the industry has already survived an energy crisis, exorbitantly high and negative interest rates, the cold war, the dot-com bubble, Y2K, 9/11 and the rise of global terrorism, the collapse of the financial markets, the great recession, increased regulation, and climate change.
