While 2008, for the most part, was a dismal year for new captive growth–with some prominent captive domiciles seeing their new-formation numbers significantly down–the current climate is actually an ideal time to launch such a facility.
Most in the industry see this slowdown as a byproduct of the overall international economic downturn. During 2008, we saw failures among insurers, banks and investment brokerages–and all play a critical role in the operation of captives.
A little more than a year ago, the captive industry experienced a hiccup in new formations. This was due to proposed new Internal Revenue Service regulations, which were an effort to basically turn back the tax court clock 20 years for single-parent captive arrangements.
The industry as a whole rallied, changing the mind of the Treasury Department. As a result, the proposed regulations were withdrawn–after that, it seemed like new formations were back in business.
Looking at the current landscape, however, there seems to be even more unease in the insurance marketplace. Now that organizations are reporting huge losses, taking write-downs on investments and laying off employees, insurance buyers are questioning the wisdom of infusing capital into a captive while the insurance industry continues to experience a soft market.
We sense that many companies are nervous about making any moves outside of their business model at this time, for fear of the unknown. After all, it's human nature to freeze when fear is present.
During December of 2008, USA Risk Group formed 13 new captives in seven different domiciles. The vast majority of the formations were due to the volatility in the insurance marketplace and the desire of our clients to gain some control over their risk management functions.
These clients determined that forming their own insurance company would protect them to some degree from insurer failures. In some instances, a captive does protect them from banking failures, while in other cases it brings a sense of focus to protecting assets and guarding against investment brokerage house failures.
Because the unknown consequences of not acting were not an option for these clients, they took action in hopes of controlling their circumstances.
Moving into 2009, we continue to see interest in specific sectors that always seem to have issues with the procurement of insurance. We continue to see formations for hospitals, physician groups and nursing homes–as we have for the past decade for liability coverages.
Given the long-tail nature of this type of coverage, this sector of the market has seen insurance companies come and go. By forming a captive or risk retention group, these entities are able to get away from the whims of the market and take better control of their risk management functions and cost of risk.
Although not sector-specific, the captive industry continues to see interest from hard-to-place risks. While this area was dominated by manufacturing companies early on, in recent years there has been a shift to consumable goods and agricultural entities.
The risk exposure of putting goods to market and product recalls have increased over time. We have seen interest from several food processors over the past few months–stemming from the recent contamination scares from spinach, tomatoes and peanut butter.
We are seeing more interest in property coverages, along with facilities prompted by the Terrorism Risk Insurance Act. And with the ever-pending bill before Congress to expand the Liability Risk Retention Act to include property exposures, we may see even more property coverage moving into the captive arena.
A relatively recent entrant into the captive space has been Real Estate Investment Trusts–known as REITs. These entities are able to reap the benefits a captive can provide in the way of insurance coverage, while maintaining their REIT status for tax purposes. This is done by structuring the program so that non-real estate income doesn't run afoul of the REIT income rules.
With the new Obama administration in office and the perceived "less business-friendly" approach it may take, we may see more companies investigate the 831(b)–small insurance company–election to take advantage of this beneficial tax treatment and lower tax burden on profits and ultimate distributions.
We also believe there is an undercurrent of thinking that the soft market is coming to an end. There are individuals who dispute that opinion and support their position with reasonable assumptions and indicators.
Of course, like every other cycle before this current one we're now in, no one will know for sure if the market is about to harden until it actually happens. It's a lot like the stock market in that respect.
But for those of us who believe that the soft market is at least waning, if not on its last leg, we offer this support for that theory.
In its most basic form, a soft market is the result of too much competition in the market with too much capital in the system.
Likewise, a hard market is the result of less competition in the market with somewhat scarce capital, relatively, to support the business underwritten.
As was mentioned at the start, the international financial markets are in chaos, which is creating some capital-raising issues (decrease in capital), while several large household-name insurers have run into difficulties and are being downgraded (decrease in competition).
Given all this volatility, the insurance consumer feels less and less control over their insurance and risk management functions. A primary reason for the formation of a captive, in fact, is that the buyer wants to take more control.
Our more recent formations observed this trend and wanted to get ahead of the curve. They were drawn to the stability and the control of running their own insurance mechanism. By forming their own captive they are more able to dictate their coverage in terms and price, to a certain extent.
By forming now, they are able to negotiate better terms with fronting carriers and reinsurers, and start establishing good relationships with those players so that when the market does harden, those same companies will have a track record with these captives to continue negotiating with them in a good faith effort.
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