David Hertzell looks at some of the issues that captive owners and managers are now addressing

As every practitioner is well aware, we are still in the hard phase of the insurance market cycle, contending with higher deductibles, tougher terms and higher premiums. Activity in the captive sector reflects the insurance cycle to some extent, but also has a dynamic of its own. As a captive is a long term risk management tool, it remains in use to a greater or lesser extent regardless of the broader insurance cycle. However, the volatility of the recent swing from soft to hard markets will not be quickly forgotten by risk managers, who will be anxious to protect their budgets against any such event in the future. As expected and predicted, there has been an upsurge in captive activity and interest as the insurance market hardened. This has brought some issues with it which need to be considered by captive owners and managers alike.

Given that the captive industry responds to changes in the overall insurance industry, and that many captives are a link in the insurance chain and rely upon both fronting and reinsurance, one key issue is the health of the commercial insurance and reinsurance sector. Insurers and reinsurers have benefited from reasonably benign economic and loss conditions. Higher prices, tougher terms and the absence of major catastrophes have improved underwriting profitability. However, 2003 saw a strengthening of reserves, as the full extent of the second wave of asbestos claims in particular became apparent. It is far from certain that real balance sheet recovery has yet been achieved. Nevertheless, some analysts are predicting a softening of the market by 2005 as underwriters once again begin to focus on market share at the expense of underwriting results. Insurer and reinsurer security is likely to remain a concern for captive owners and managers in the foreseeable future.

Whatever happens in the overall insurance cycle, it is likely that market movements in the future will be different between different business lines.

While there are some signs that the market is stabilising, or even perhaps softening a little in areas such as property or motor, it still remains hard for liability risks such as D&O, employer's liability and professional indemnity. There is of course a reason for this. The commercial market has found these risks difficult to write, as they are influenced by social trends and attitudes, changes in legislation, and claim inflation in the time between the payment of the premium and the payment of the claim.

Writing such business in a captive does not make it inherently profitable, particularly if there is corporate pressure to save premium costs. Such risks can be attractive for a captive, but both owners and managers need to be fully aware of the ramifications of writing and reserving a 'long tail' account.

The writing of D&O risks by captives in particular has sparked quite a debate. On the face of it, there are some advantages. The problem is predominantly US-based (although there are of course some high profile cases such as Equitable Life and Banesto in Europe), so for a captive to issue a D&O policy where there is limited US exposure could represent a good underwriting risk. There are, however, some inherent dangers and conflicts.

First there is a commercial conflict involving the directors, who will want cover from the ground up to avoid personal exposure. This will be very expensive, and it makes much more sense from a corporate perspective to write the risk with a large deductible. The directors are of course unlikely to be comfortable with that solution.

Second, there is the potential conflict between the directors and the shareholders who ultimately own both the parent and the captive. It is well established that a company may fund the cost of purchasing D&O insurance to protect its directors. However, it is not perhaps quite so well established that a company, through its captive subsidiary, should be funding all or part of any compensation paid. Shareholders who bring large D&O claims are not likely to be pleased to learn that their claim is being paid by a captive, further reducing the shareholder value they were suing about in the first place.

Cell concerns continue

In the UK, much of the recent growth in the captive market in response to the harder insurance market has been from the mid-cap sector, as a high proportion of FTSE 250 companies already had captives. Very often, mid-cap companies will consider entering the captive marketplace via a cell in an established protected cell company. The great advantages of this are flexibility and annual costs savings. While these advantages are real, there is nevertheless anecdotal evidence that many mid-cap companies opt for a single owned captive despite the higher costs. This seems to be because, having made the decision to set up a captive, the risk managers or board of the parent wish to retain control, recognising that they are involved for the long term. Additionally, in a PCC all 'risk gaps' must be collaterised, either with paid up capital or some other form of security such as a letter of credit.

Risk gap is the difference between the maximum sum assured under the policy and the assets available to pay that sum. Clearly, such a risk gap could be considerable, particularly in the cell's early days. In a single owned captive, providing the regulators approve and the parent has a strong balance sheet, some of the risk gap may be funded by issued but uncalled or partly paid share capital. The obvious benefit is that less of the parent's working capital is required to fund the captive programme.

The captive board and managers must be conscious of the credit risk this represents, particularly if they have subsequently agreed loans back from the captive to the parent.

Cell formations nevertheless continue apace and are being used for a wide variety of increasingly sophisticated financial solutions. The fundamental concept of a protected cell company (that a creditor of one cell has no recourse to the assets held in other cells) has yet to be tested in court.

However, as the proponents of protected cell companies point out, the fact that such legislation is being adopted in the US, which is not noted for its lack of litigation, does indicate that the concept is fairly robust.

It is worth remembering though that in the UK (and many other jurisdictions) there is third party rights legislation which allows an injured party to 'stand in the shoes' of an insolvent company and to bring an action against its insurers directly. This could give rise to a direct claim against a captive insurer or cell.

In theory those claimants would have rights against the assets of the cell and the core capital, but it is likely that the core capital would have been kept to a minimum, partly to prevent such claims, which would otherwise 'decapitate' the protected cell company and affect the capital requirements of all the other cells. If the claim led to the insolvency of the cell as a result of inadequate security over risk gap funding, the actions of the directors involved would come under scrutiny and possibly too the regulator. Thus, while a protected cell is a very flexible solution, there are constraints.

Fronting debate

So what about the much discussed fronting crisis? While it is true that the number of insurance companies who are prepared to offer fronting facilities to captives as a main business line has declined, and so, inevitably, prices have risen, there is still a market interested in providing this service. However, as the hard market drives captive owners and managers to consider writing more difficult risks, so fronting companies become more careful and selective.

Much of the fronting debate originates in the US with its multitude of state-based regulators. In the UK, fronting facilities are only required for certain classes of business, such as road traffic and EL business and only then if the captive is based outside the EU. Captives based in Dublin or Gibraltar can write business throughout the EU if required.

Fronting options, costs and the services provided should be regularly reviewed by both owners and managers.

Growth in regulations

Finally, regulations are a growing concern for the insurance industry throughout the world. Action has been driven by perfectly laudable concerns regarding terrorism, money laundering and tax evasion. Financial scandals are harmful to the industry and to the domicile where they occur, and nobody can criticise the establishment of a good bedrock of regulations to provide an operating framework.

There is a concern, however, that in seeking to satisfy governments and international standards organisations the captive industry will stifle the entrepreneurial spirit for which it is famous. Regulators will have a difficult job in the coming years to balance the increased costs and complexity of regulation with their desire to ensure that their domicile remains an attractive option for captive owners. It would not be surprising if a degree of regulatory competition were to emerge, perhaps even replacing tax as the reason for choosing a particular domicile.

The hard market has provided a new impetus to the captive industry. It will be interesting to see how it copes with the increased complexities and risks.

David Hertzell is chairman of AIRMIC's special interest group on captives and an operations partner of law firm Davies Arnold Cooper, E-mail: dhertzell@dac.co.uk


Non-traditional insurance programmes have been structured for over 40 years. ART continues to be a growing area, and in today's uncertain business climate, problems in securing appropriate coverage, terms and conditions in the traditional property and casualty market place have spurred many buyers to seek alternative forms of risk financing.

Fundamental to the ART offering is the understanding that it is an approach as opposed to an individual product, which brings with it numerous challenges for clients. An ART programme should be evaluated objectively, leaving clients with several considerations and areas of investigation including the likelihood and size of risk within their organisation, how easy and costly is the transfer, which approach to managing risk is the best, and the appetite and ability within the company and its shareholders to retain risks.

Whether the solution fits in the broad category definitions of risk transfer, risk financing or a blend of the two, ART programmes are not exempt from the issues which concern clients that buy more traditional insurance products. Insurer and reinsurer security, costs and level of coverage remain important considerations for clients as they select the most appropriate programme for their needs.

So after nearly half a century, what does the future hold for ART? How will the impact of new regulations and accounting standards affect the market? Are businesses getting what they require from their programmes, and how is ART evolving to meet future needs? As a provider of non-traditional insurance and reinsurance programmes for over 10 years, ACE is delighted to join Strategic Risk magazine in answering these questions through its special examination of the ART market.

Jonathan Groves, ACE Risk Management International.