Industry professionals discuss current trends among captive owners in Latin America, as well as the profound impact of the pandemic on the region as well as predictions for the future
An expansive term for the Central and South components of the continent as well as the country of Mexico, Latin America is known for the hybrid nature of its cultures, dancing, football and rich coffee production — and now, an insurance and reinsurance industry that is looking to recover from the COVID-19 pandemic and explore alternative capital and risk financing.
In its Latin American reinsurance market update report, Fitch Ratings identifies that the region experienced catastrophic losses of approximately US$18.6 billion in 2020, with the three largest catastrophe events — Hurricanes Eta and Iota in Central America, drought and wildfires in South America, and an earthquake in Puerto Rico — accounting for insured losses of more than $2 billion, which Fitch argues demonstrates the importance of continuing to narrow the protection gap in the region.
The small size of the Latin American reinsurance sector in global terms means that it is highly influenced by international pricing conditions, while competition from global reinsurers — particularly those in Europe with larger reinsurance capital — allows Latin American reinsurers to concentrate their efforts on regional insurance sectors.
Fitch expects demand for reinsurance in Latin America to increase during the second half of 2021 following COVID-related uncertainties, numerous high-impact weather events, and the improved ability of primary insurers to purchase reinsurance. However, the rating agency also notes that the expected increase in demand may be offset by lower insurance industry growth as a result of the pandemic’s deeply adverse economic impact in the region.
In terms of insurance-linked securities activity, the report outlines the key areas for improvement to ensure adequate catastrophe protection to be more accurate insurance data, better modelling capabilities, and more refined statistics for alternative capital sources. For the latter, Fitch predicts that alternative capital will have an evolving role of importance in the Latin American reinsurance and insurance markets, providing the current limitations improve over time.
These limitations refer to the fact that Latin American captives have traditionally struggled with a lack of education in the sector. Therefore, education surrounding captive and risk management for local companies is one of the most important factors to help promote captive formation in the region.
Alejandro Santos, managing director of analytics and captive solutions for Latin America and the Caribbean at Marsh, notes: “In the last quarter, we saw increased activity for captive advisory and strategic reviews on captive retention portfolios. There are multiple factors affecting companies within the region, including a challenging market situation as well as an economic downturn in most of the region’s economies.”
Although this appears detrimental, Santos explains that this environment has been beneficial for alternative risk financing vehicles as companies turn their focus to captives, particularly for financial lines, including programmes like directors and officers (D&O) liability, which have placed market pressure on pricing and capacity.
This uptick in captive formations by parent companies based in Latin America is affirmed by Eduardo Fox, consultant, private client and trusts, Latin America, Appleby. He says: “The market has seen increases, sometimes in double digits, across all main industries of the Latin American region — particularly in the areas of energy, mining and certain professional lines such as D&O — as the hard commercial insurance market has impacted these sectors of the region.”
“Many Latin American companies have repositioned their captives to better utilisation within the group and professional lines they cover,” Fox explains, adding that the COVID-19 pandemic exacerbated existing challenging conditions, but also forced innovation and understanding by Latin American captive owners for the benefit and growth of the industry as a whole.
Both new and existing Latin American captive owners are utilising their underwriting capacity to fill gaps in coverage where no capacity is available in the international insurance market, or to insure risks where premium is considered too expensive, according to Adriana Scherzinger, head of international business and captive services, commercial insurance, Latin America, Zurich Insurance Group.
Scherzinger adds: “Across all regions, including Latin America, we have seen changes in the last years, with increasing commercial insurance rates and scarcity of capacity, as well as the trend to increase self-insured retentions and deductibles, and to set up alternative risk solutions. Captives are also becoming more involved in emerging risks such as climate change and cyber as a result of enhanced exposures.”
Following this increased interest in alternative risk financing, Fox notes that companies that do not yet have captive structures are exploring their formation, or are entering the rent-a-captive market. He adds: “From my specific experience, quite a bit of interest in the latter is coming from Mexico, although Colombia is still the most active and dynamic captive owner in Latin America.”
The fast-growing emerging captive market is particularly recognised in Colombia and Mexico, which Santos explains is attributable to a more advanced knowledge of offshore and captive markets, as well as the size, complexity and risk management maturity of the companies based in these two countries. However, he also recognises that captive opportunities are emerging across the region, as more companies are looking to position their risk profile in order to enter the captive world.
Fox identifies the most active captive owners in the region as “Colombia, Mexico and Panama, in that order”. In addition, he highlights that Brazil has the potential to be another leader in captive formations as the largest economy and largest insurance market in the region; however, it is currently hindered by the monopoly reinsurance company, Instituto de Resseguros do Brasil (IRB). Fox anticipates that since IRB has operated as a private company since 2013, Brazil is now better positioned to seize opportunities to revive its captive growth “in the very near future”.
He adds: “The four countries mentioned have the most developed and advanced understanding of the captive and offshore markets, providing them with a distinct advantage over the rest of the countries in the region. It has been our job at Appleby to continue pressing with training, education and business development visits, in order to close the gap and exponentially expand into all the other major economies such as Argentina, Peru and Chile.”
Transparency is key
Both Colombia and Mexico are aided as active captive owners by respective tax information exchange agreements (TIEAs) with Bermuda and other global jurisdictions to promote their offshore captive interests. Argentina and Chile also hold TIEAs with Bermuda as the domicile is a promisingly progressive regulator.
Promoted by the Organisation for Economic Cooperation and Development (OECD), a TIEA aims to foster international cooperation in tax matters through a standard of transparent exchange of information. This is to combat ‘harmful’ tax practices and facilitate transactions with transparency.
Fox explains that research of periodical tax reforms in the region identified a TIEA to be important in helping prospective Latin American clients. This is because, historically speaking, there was a general misunderstanding of offshore revenue acquisition systems, particularly in terms of the purposes and advantages of a captive for Latin American individuals, entities and governments.
“Since 2009 in Mexico, where we started the negotiations for the first TIEA in Latin America, the exchange of information and knowledge transfer was such that the understanding and trust in Bermuda and its captive insurance market captured the confidence of not only the Mexican insurance authorities, but of the OECD,” Fox adds.
Since the deployment of the Mexico-Bermuda TIEA, the OECD recommended the agreement as the model to follow in subsequent negotiations with other Latin American countries. Fox notes: “There have been bilateral TIEAs with Brazil (although this is pending final negotiations), Colombia, Argentina and Portugal, as well as finalising negotiations with Spain and Chile.”
“The benefits of having a TIEA, or at least the recognition by the OECD through its Multilateral Convention against profit shifting, have been tremendous, and are immensely helpful in our business development efforts. The doors just open and extend the welcoming mat many times.”
Latin America and COVID-19
Customers and brokers in the Latin American region are facing increasing challenges due to the impact of both COVID-19 and the hardening market, which requires them to manage incubating risk, increased deductibles, greater risk retention and increased reinsurance premiums.
The OECD describes Latin America as the most affected emerging and developing region in the world in its report, ‘COVID-19 regional socio-economic implications and policy priorities’. This statement is regarding gross domestic product (GDP) growth contraction, which the OECD predicts could potentially leave many Latin American countries with negative growth and GDP per capita levels similar to those of 2009.
The organisation further estimates that up to 2.7 million micro and small firms were vulnerable to closing down during the pandemic as they lacked the resources to absorb the crisis, which was exacerbated by the ‘digital divide’.
In another report entitled ‘Latin American economic outlook 2020’, the OECD identifies that COVID-19 hit the region during a period of severe structural weaknesses. Therefore, the economic impact of the pandemic is expected to deeply complicate the macroeconomic outlook for Latin America in the coming few years.
This sentiment is echoed by Santos, who explains that at the beginning of the pandemic, many companies had to simultaneously address issues on the production side, disruptions to the supply chain and overall economic downturn. Since then, firms are now reviewing their risk management philosophy. Elsewhere, adaptation of the Latin American private sector to the ‘new normal’ has created innovation in planning and strategy, knowledge sharing and exchange of ideas between industry members.
Santos adds: “As has happened in other regions, retention strategies, alternative risk transfer structures and, above all, the desire for a better, optimised cost of risk and risk management maturity has put captives on the radar for Latin American companies. This is evident through the increased number of feasibility studies and strategic retention reviews that have been done in the last few months.”
Zurich’s Scherzinger explains that the pandemic and subsequent disruption exacerbated an already-present interest in captives by more and more companies, including medium-sized firms, in the region to address a broader spectrum of risks.
“Captive involvements are an important market factor within the international commercial insurance world, and have become even more important during pandemic times,” she says.
As more companies look to implement captive structures in the aftermath of the pandemic’s disruption, Scherzinger notes that smaller prospective captive owners in Latin America have the option of cell captives, which reduce the entry barrier with a lower cost profile compared to a standalone reinsurance captive at lower retention levels.
“Cell solutions afford a customer many of the same advantages as a captive, such as: retaining underwriting profits; direct access to reinsurance markets; increased coverage and capacity; earning investment income on reserves; and greater control over claims,” Scherzinger adds.
A good mix
Regulation has historically been a factor in preventing growth in Latin America’s captive industry, although some governments are now taking a substance-over-form approach with general anti-avoidance rules. These rules aim to clearly define substance in the view of tax authorities for taxpayers. This approach was recently codified in Colombia, Peru and Brazil to ensure captives are formed for business rather than tax purposes, with acceptable business purposes including risk retention, actual risk transfer and protection.
There has been an effort to move towards the promotion of transparency and exchange of information, as well as an evolving focus on anti-deferral rules to prevent the accumulation of wealth without appropriate insurance coverage, especially in Chile and Peru.
Marsh’s Santos describes the regulatory landscape of Latin America as “a good mix”. He identifies that some countries have relaxed their reinsurance regulations that were historically restrictive for foreign players such as captives, while others have developed new or modified regulations that indirectly affect captives.
For the latter, he points to the 2020 tax reform in Mexico, which implemented anti-profit shifting recommendations by the OECD. This includes changes to the definition of permanent establishment, new guidelines for taxing foreign transparent vehicles, and updated controlled foreign company rules.
Fox takes a more optimistic view, noting that: “Bermuda and a few other offshore jurisdictions have implemented, and continue to implement, regulatory measures and adjustments that have improved the reputation and adaptability of our markets to international regulatory changes, for example Solvency II. Bermuda is among the best and most appropriately regulated jurisdictions in the world, with a sui generis reputation as a highly cooperative international financial centre.”
Looking forward, Fox predicts that “once we see scientific advance in controlling or mitigating the effects of COVID-19 and more economic certainty in the world, we should emerge from it all stronger and better equipped to revive the Latin American captive market. We could cautiously but optimistically aim at clear progress and growth in Latin American captive formations, beginning in the last quarter of 2021 and exponentially growing after that”.
“We in the industry have certainly started to make serious plans and form business development teams of common-interests participants — such as law firms, actuaries, captive managers, insurance and reinsurance advisors and brokers — and we are very hopeful for a brighter perspective in the very near future,” he adds.
Scherzinger agrees: “We are seeing more interest from customers looking to better manage their increasing multinational exposures and I expect to see increased captive utilisation across Latin America. Complex, cross-border insurance programmes could be managed through digitalisation, but partnering up with excellent service providers will remain crucial.”
Santos affirms that the expected rebound over the next 18 months is likely to create many opportunities for companies interested in forming a captive to satisfy their alternative risk management evolution, particularly in Brazil and Chile.
“In the coming months, some geopolitical developments may affect the establishment and operation of captive risk structures. Mexico and Colombia will remain as the most active countries for captives, but other countries in the region will continue to show increased interest in these types of projects,” Santos concludes. ?
