Captives proved their long-term importance as businesses held steady through the recession, writes Paul Allen. But Solvency II and other regulatory reforms could shake up its future

In the wake of the financial crisis, scrutiny of balance sheets and awareness of counterparty risk is higher than ever. With capital low and pressures on costs high, the desire for companies to insure their own risk has risen.

One likely beneficiary will be the captive industry, which offers much-needed security and return on investment. And with more than 5,000 companies, and capital estimated at more than $50bn, captives are already big business.

But while the insurance sector has weathered the financial storm well, the cataclysmic exception of AIG has highlighted the need to develop insurance that avoids concentration of risk with a single supplier. At the same time, recessionary pressures have dampened demand and checked the growth of the captive market.

“In the run-up to the financial crisis, the captive market remained healthy, with new domiciles coming through,” Willis Global Captive Practice’s chief marketing officer, Dominic Wheatley, says. “Some of that activity has been sub-inhibited as insurers are sticking with tried and tested routes, but the failure of major carriers is not necessarily a driver.”

“It is definitely not easy to make a compelling case for setting up a captive today,” adds German Insurance Buyers Association (DVS) president Stefan Sigulla.

“With scarcity of capital and soft premium rates, perspective is dominated by short-term returns on invested capital, rather than by the strategic value of the captive.”

Experts agree that the effect of the financial crisis on captives is both limited and temporary, merely accelerating trends that existed before 2008. They point instead to 2001/02, when property and casualty (P&C) rates began their enduring slump. Unlike the global markets, the insurance sector remains well capitalised, suppressing rate movement. “There’s probably been a slowing of interest in captives because commercial cover has been easier to get hold of in the market,” Aon’s head of risk finance, Charles Winter, says.

“Factors that drive business to captives are not as strong. At the same time, use of captives by those who already have them is constant.”

The fallout from the volcanic ash cloud and the Deepwater Horizon oil rig explosion could be a rate-hardening catalyst. In the meantime, traditional drivers for captive formation are holding the line. “While there’s not much pressure for alternative risk transfer, there is still a flow of formations,” AM Best’s head of market analysis, Yvette Essen, says. “A major event will spur that formation, but it may have slowed slightly as companies are more concerned about running their day-to-day business.”

ITV risk manager Graeme Lee says that risk management has matured. “In this financial crisis, as opposed to that of the 1980s, there has been less of an appetite to rush to the cheap underwriting market. People have learnt their lesson; they’re now saying ‘let’s focus on the fundamental underlying losses’.”


A hard market and captive growth may have a causal link, but how strong is it now? “We don’t subscribe to that,” says Willis Global Captive Practice chairman Malcolm Cutts-Watson. “In 2007-08, there was a soft market and steady growth. In 2009, overall growth was static.

People have become conservative. If we hadn’t had the financial crisis, we would have seen continued small growth.” Captives have held steady by reinsuring a large proportion of their risks and building up a strong reserve base. There is clearly a distinction – and an effect that can be linked to the crisis – between existing and new captives, and what has driven their formation. “Those already possessing captives continue to see their strategic value and have tended to optimise them – through consolidation, in case’s where they had several – rather than to shut them down,” says Sigulla. Lee adds: “Captives are easy to set up, not easy to shut down. You’ve got run-off to deal with, and it’s not cheap.”

KPMG estimates that as many as 30% of captives are not underwriting. This is a result of a buoyant M&A market before the crisis began, which has left companies operating multiple captives. Winter suggests that as the markets recover, consolidation is likely. “Risk managers have, by and large, held on to their captives,” Airmic captives group technical director, Paul Hopkin, says. “The pressures are to do with capital allocation. Chief financial officers and treasurers are saying ‘I need all the capital I can get’, making sure captives aren’t overcapitalized – which most of them are – or converting captives into a protected cell.”

“[Captive formation] depends on the economic situation of the captive’s parent,”

Dublin International Insurance & Management Association (Dima) chief executive Sarah Goddard adds. “The cost of capital is an important factor, as is capital allocation within a group. There are alternatives to letters of credit, such as trusts, which can prove a more economic solution in certain circumstances.”

Given that captives often have capital profits sitting in them, and capital is generally scarce, there have been fears that since the crisis managers have been using them as cash cows. “There is a lot of capital in the insurance market.

It’s not the same worries that you have in the M&A and venture capital markets. Insurance is quite easy to get in and out of,” Mazars’ head of financial services tax, Howard Jones, says.

“Because captives are well reserved, it is common for companies to ask for loan-back. But you can’t raid the captive,” Essen adds. The size of the loans are small, and in most cases reversed because capital is able to generate a decent return within the captive.

Much more significant are the cost savings that captives can provide. Risk managers can make adjustments to reduce risk, as Lee explains, while chief financial officers have greater visibility on cashflow. “The captive is cheaper to put predictable losses through.

That’s why smaller companies are doing it. We could self-insure in many ways, but we chose a captive – not for tax, but because it’s a good mechanism. We can take a loss; we can be bullish. That hasn’t changed, while the economy has.” Hopkin adds that captives benefit from a climate of tighter cost controls because they control the purse strings.


Different captive operations – namely protected and incorporated cell companies (PCCs and ICCs), with lower set-up costs and fewer regulatory burdens, are appearing and branching into emerging markets such as Latin America and the Middle East. Many are positioned from fledgling locations with access to reinsurance markets, including Bahrain, Malta, the Isle of Man and, in the future, Jersey.

The financial crisis has also made risk managers look for opportunities outside their P&C base. Opportunities are arising to write third-party risks including travel, extended warranties, credit insurance, and directors and officers insurance, while in 2010 interest in commercial and customer insurances, especially around the middle market, has risen as entrepreneurial activity takes off.

Captives are being used to manage pensions and employment benefit trusts as companies spin off insurance benefits to other parts of their business. There are also moves into structured finance deals, particularly as confidence in other finance vehicles remains frail. In the UK, PCCs are emerging for the fund markets. The irony of the emergence of captive vehicles to leverage the financial markets is not lost on Cutts-Watson, who claims that if the special purpose vehicles that caused the financial crisis had been run like captives, their shortcomings – inappropriate asset selection and inappropriate valuation of those assets – would have been noticed.

When companies can no longer buy insurance and ‘wash their hands with it’, major corporates are taking greater responsibility for their own risk, while small to mid-cap players, despite facing severe capital headwinds, are considering the captive option. “The middle market has woken up to the fact they are losing out on structures that bigger corporates have been using. Lower-cost opportunities, such as ICCs, are available,” Wheatley observes.

But Goddard notes that growth in the captive space is not limitless. “The captives market is well established, so there are not necessarily a huge number of corporates for whom a captive would be a solution that either haven’t set one up already, or have decided not to.”


Against the backdrop of falling credit ratings, captive formation has another advantage.

“Unless they are specifically looking for a credit rating, captives don’t need to attain all of the criteria required by an agency,” Goddard says.

In the future, the main entries to market will not be simple captives. Their successors will offer the shorter-term solution that smaller companies require in times of economic strife.

“PCCs are the preferred route at the moment. They have the same advantages as a captive, but are lower cost and quicker to set up,” says Essen, adding that larger companies could be looking at PCCs either for a one-off, financial, or environmental risk. Rather than use their main captive, a pure captive tends to house conventional risks; a PCC can be used for specialist ones. Aon’s White Rock, with operations across the EU, is an example.

Willis maintains that the introduction of ring-fenced ICCs in 2006 should boost business enquiries, as they eliminate legal issues that often arise with PCCs.

Ultimately, captives have not suffered disproportionately at the hands of the financial crisis. Their importance as a long-term, strategic play has come to the fore. But the looming spectres of Solvency II and reform of controlled foreign companies threaten to negate some of the captives’ profit-retaining benefits. “Solvency II doesn’t fit or recognise the main role of the captive. The challenge is to make that transition as painless as possible,” Winter concludes.

According to most observers, including Essen, Solvency II is the biggest issue facing captives. Many questions are unanswered.

“Solvency II will raise the bar. What does proportionality actually mean? Is the captive worth continuing? Will captives be squeezed but of Europe?” Essen asks. “It is more the uncertainty of the regulatory agenda, not the burden of regulation itself which is affecting the captive market. The benefits of setting up a captive in the current environment have scarcely changed. Instead, they are merely hidden from view. When they emerge, they will look quite different from three years ago.”