IRS Targets Micro-captives
Growth of the captive industry could be devastated if Congress moves ahead with a proposed law that would make it financially unfeasible for micro-captives to be formed.
In February, the Senate Finance Committee considered a preliminary bill that would add restrictive language to the regulation of 831(b) captives, or micro-captives, which are formed with less than $1.2 million in premium. The 831(b) tax election allows captives that qualify to be taxed on their investment income only.
“If you take 831(b)s out of the captive market,” said Dan Towle, director of financial services, Vermont Agency of Commerce and Community Development, “I don’t think there would be any growth in the marketplace. … All of the flash you have heard about huge growth [of captives] is all based on 831(b)s.”
He noted that 831(b) captives are “not a core market for Vermont.”
“Everyone is trying to fix a problem that no one can define,” he said. “We can’t put forth a solution if you can’t articulate the abuse you are seeing. — Dennis Harwick, president, Captive Insurance Cos. Association
On Feb. 10, the Senate Finance Committee briefly introduced the mark-up of a bill that would increase the 831(b) premium amount to $2.2 million, indexed for inflation, as well as add “very restrictive language” that would hamper the formation of micro-captives, said Dennis Harwick, president of the Captive Insurance Cos. Association, which held its international conference in Orlando, Fla., on March 10-11.
“It came from the IRS, which has this position that there is abuse going on,” he said, noting that the IRS has an “antipathy toward captives.”
On Feb. 3, the IRS listed captive insurance among its “abusive tax shelters” on the IRS “dirty dozen” list of tax scams. It cited “abuse involving a legitimate tax structure [involving] certain small or ‘micro’ captive insurance companies.”
The abuse comes in, it said, when “unscrupulous promoters persuade closely held entities to participate in this scheme,” which involves creating onshore or offshore captive insurance companies that should be used for insurance purposes but instead are used to shelter income for a wealthy entity by using “implausible risks for exorbitant ‘premiums,’ ” according to the IRS.
In the Senate Finance Committee, the restrictive language of the proposed bill was temporarily excised, pending more information about captive abuses from the Department of Treasury, but industry insiders are concerned the language will be reinserted. Sen. Chuck Grassley, R-Iowa, is the “moving force” behind the legislation, Harwick said.
“What they were trying to push through the legislature would kill the small captive industry entirely.” — David Snowball, captive director, State of Utah Insurance Department
David Snowball, captive director, State of Utah Insurance Department, said the proposed bill would require that no single owner have more than 20 percent of the premium, and that the captive can’t “assume” reinsurance or risk distribution pools.
“What they were trying to push through the legislature would kill the small captive industry entirely,” Snowball said.
Utah, he said, probably has more than 200 micro-captives, of the 417 captives domiciled in the state. He and others noted, however, that no one tracks the number of 831(b) captives, as it is a tax elective that is taken after the captive is formed.
“Most of the captives out there are legitimate captives,” Snowball said. “They are trying to take advantage of some tax opportunities but they fit within the guidelines the IRS has established for a good captive.”
States most likely to be affected by a change in IRS regulations would be Utah, Delaware, North Carolina, Tennessee and Nevada, among others.
Deca Penn, regulator for the British Virgin Islands, said the proposed change in the law is “a little concerning, but we are just monitoring because there is not much we can do. It’s difficult to say right now because the IRS has not put into place anything concrete.”
The majority of BVI captives are 831(b)s, said Alicia Green, marketing manager, BVI Finance.
“We would like them to leave the situation as it is right now,” Penn said, noting that proposals for captives domiciled in BVI have “to suggest there is a legitimate business.”
Harwick noted the National Association of Insurance Commissioners is trying to develop language for the legislation that would address IRS concerns about abusive captives and isolate offenders from captives formed for legitimate insurance purposes.
The process is difficult, he said.
“Everyone is trying to fix a problem that no one can define,” he said. “We can’t put forth a solution if you can’t articulate the abuse you are seeing. … It’s frustrating shadowboxing perceived abuses that no one has really defined.”
From CICA’s perspective, he said, all captives must be legitimate insurance companies, with valid underwriting, risk transfer, risk distribution and “arm’s length pricing.”
“If it’s really just to transfer wealth,” he said, “our industry is very uncomfortable with that because it’s being called insurance and it’s not. … A bad apple hurts everyone.”
Capital Flows Into CAT Bonds
AACapital is increasingly flowing into property catastrophe bonds, with an industry record — $8 billion — being issued just in the fourth quarter of 2014.
Overall, total risk capital outstanding as of year end, was $22.868 billion, the highest level of outstanding risk capital the market has ever supported, according to a report by Guy Carpenter.
In addition, the reinsurance broker noted that “persistent year-on-year growth issuance” indicates that the market is maturing and stabilizing.
“The continued influx of third-party capital from new and existing market participants also favorably impacted ILS [insurance-linked securities] pricing for protection buyers,” according to a year-end report by Guy Carpenter.
“The continued low interest rate environment encouraged institutional investors (such as pension funds and hedge funds) to seek the higher yields offered by natural CAT notes.”
CAT bonds are also increasingly being used by insurers of the last resort to transfer some of their peak exposures to the capital markets, according to a rating agency A.M. Best.
Insurers of the last resort are those that include Fair Access to Insurance Requirements (FAIR) plans, quasi-state-run insurance companies and beach/windstorm plans.
According to a report by A.M. Best, these entities have welcomed the growing availability of insurance-linked instruments such as CAT bonds, insurance-linked funds and industry loss warranties (ILWs).
“Given an increase in exposure to loss for insurers of the last resort, CAT bonds have provided another alternative for these entities to cede part of their peak exposures as a complement to the traditional reinsurance market,” said Asha Attoh-Okine, managing senior financial analyst of insurance-linked securities at A.M. Best and author of the report.
“Catastrophe bonds also provide multiyear coverage as opposed to most traditional reinsurance programs,” he said.
Approximately $5.6 billion in CAT bonds were issued by seven of these entities from 2009 through Sept. 30, 2014, according to the A.M. Best report.
The two main perils covered were hurricanes and earthquakes occurring in the respective regions that the bonds were placed.
Hurricanes accounted for approximately $4.53 billion, or 81 percent, with earthquakes taking the other $1.05 billion, or 19 percent, for these entities during the period reviewed by the ratings agency.
“The increased use of these insurance-linked instruments is due to growth in investor demand,” said Attoh-Okine.
Below Average Activity
As insurers and investors consider CAT bonds, however, it may be important to note that 2014 was a relatively quiet year for natural catastrophes, according to Munich Re. This year may not be.
“Though tragic in each individual case, the fact that fewer people were killed in natural catastrophes last year is good news,” said Torsten Jeworrek, a Munich Re board member.
“And this development is not a mere coincidence. In many places, early warning systems functioned better, and the authorities consistently brought people to safety in the face of approaching weather catastrophes, for example before Cyclone Hudhud struck India’s east coast and Typhoon Hagupit hit the coast of the Philippines.
“However, the lower losses in 2014 should not give us a false sense of security, because the risk situation overall has not changed. There is no reason to expect a similarly moderate course in 2015. It is, however, impossible to predict what will happen in any individual year.”
Nonetheless, usage has expanded a great deal in recent years.
Guy Carpenter cited deals that include Turkey’s Turkish Catastrophe Insurance Pool, Mexico’s FONDEN and New Zealand’s EQC.
“Most large U.S. insurers of last resort, such as CEA, Citizens, North Carolina Joint Underwriting Association and the North Carolina Insurance Underwriting Association (NCJUA/NCIUA), and Texas Windstorm Insurance Association, are utilizing capital markets capacity including collateralized reinsurance and catastrophe bonds,” it said.
A.M. Best’s Attoh-Okine noted that investors are “attracted to these products given the low-interest environment for fixed income securities of similar quality and the perceived minimal correlation to the general financial market.
“Sponsors have also continued to increase the use of CAT bonds and other insurance-linked instruments to cede their peak exposures.
“Lately,” he said, “we have seen a decrease in spread [price] for the same level of risk for CAT bonds, providing sponsors cost relief when compared to the traditional property catastrophe reinsurance market.”
“Catastrophe bonds also provide multiyear coverage as opposed to most traditional reinsurance programs.” — Asha Attoh-Okine, managing senior financial analyst, A.M. Best
His report noted that other areas that might benefit from the use of alternative risk transfer instruments include terrorism risk exposure; assigned risk non-property plans facing inadequate pricing/capacity issues (e.g., workers’ compensation, auto, accident/health), and the National Flood Insurance Program, which provides flood insurance to approximately 5.5 million U.S. properties with total insured values exceeding $1 trillion, and growing.
While alternative products reduce credit risk for the insurer, the main drawback for CAT bonds and ILWs “is the lack of reinstate features when compared to the traditional reinsurance program,” he said.
Reinstate implies the restoration of the reinsurance limit of an excess property treaty to its full amount after payment by the reinsurer of a loss as a result of an occurrence.
“Another criticism for the use of these instruments,” he said, “is whether investors’ participation will continue in case of property catastrophe insurance market disruption as result of a huge catastrophe event or if we start seeing a continuous increase in returns for other fixed income instruments.”
According to Attoh-Okine, if a major hurricane or other natural disaster triggers one of the CAT bonds, the sponsor of the bond will be reimbursed for the loss amount up to the amount of the CAT bond.
In such a case, investors will lose part or all of the principal amount and the corresponding interest proceeds.
Such vehicles also improve coverage terms (transforming programs from per occurrence to annual aggregate responses) and provide leverage “to keep traditional capacity sources honest and to facilitate their willingness to adjust coverage terms that may not have been feasible without the use of capital markets-based risk transfer capacity,” it said.
“At the time of loss, governments may be spared these enormous costs and they may have enhanced flexibility to finance economic and social development or reduce taxation.
“Because entities such as windpools tend to be limited in geographic scope and/or peril, with more of an affinity for single limit/aggregate coverage, they present an attractive profile to collateralized reinsurers and catastrophe bond investors.
“Competition and excess capacity for this business has significantly reduced price and in just the past year, the growth in both limit purchased by these entities and share of overall limit placed into the collateralized market has been significant.
“As an example, profiling limits purchased by U.S. windpools in 2014 compared to 2013, catastrophe bond limits increased by almost 50 percent while rated and collateralized reinsurance limit purchased grew by approximately 30 percent, leading to a total growth in coverage of roughly 35 percent. In addition, the collateralized market share of the limit purchased has outpaced the growth in rated carriers’ increased participations … .”
$110 Billion in Losses
According to Munich Re, overall losses from natural catastrophes totalled $110 billion in 2014, down from the previous year’s total of $140 billion, of which roughly $31 billion (previous year $39 billion) was insured.
The loss amounts were well below the inflation-adjusted average values of the past 10 years (overall losses, $190 billion, insured losses, $58 billion), and also below the average values of the past 30 years ($130 billion overall / $33 billion insured).
At 7,700, the number of fatalities was much lower than in 2013 (21,000) and also well below the average figures of the past 10 and 30 years (97,000 and 56,000, respectively). The figure was roughly on a par with that of 1984.
The most severe natural catastrophe in these terms was the flooding in India and Pakistan in September, which caused 665 deaths.
In total, 980 loss-related natural catastrophes were registered, a much higher number than the average of the last 10 and 30 years (830 and 640). Broader documentation is likely to play an important role in this context, since, particularly in years with low losses, small events receive greater attention than was usual in the past.
The costliest natural catastrophe of the year was Cyclone Hudhud, with an overall loss of $7 billion.
The costliest natural catastrophe for the insurance industry was a winter storm with heavy snowfall in Japan, which caused insured losses of $3.1 billion.
More than nine of 10 (92 percent) of the loss-related natural catastrophes were due to weather events.
A striking feature was the unusually quiet hurricane season in the North Atlantic, where only eight strong — and thus named — storms formed; the long-term average, calculated from 1950 to 2013, is around 11.
In contrast, the tropical cyclone season in the eastern Pacific was characterized by an exceptionally large number of storms, most of which did not make landfall.
One storm in the eastern Pacific, Hurricane Odile, moved across the Baja California peninsula in a northerly direction and caused a loss of $2.5 billion (of which $1.2 billion was insured) in Mexico and southern states in the U.S.
In the Northwestern Pacific, a relatively large number of typhoons hit the Japanese coast, but losses there remained small thanks to the high building and infrastructure standards in place.
“The patterns observed are well in line with what can be expected in an emerging El Niño phase,” said Peter Höppe, head of geo risks research at Munich Re. “This characteristic of the ENSO (El Niño Southern Oscillation) phenomenon in the Pacific influences weather extremes throughout the world.”
Water temperatures in the North Atlantic were below average and atmospheric conditions such as lower humidity and stronger wind shear also inhibited the development of tropical cyclones. Even events like the severe windstorms and heavy rainfall in California in December following a long drought fit in with the El Niño pattern.
Höppe added that most scientists expect a light to moderate El Niño phase to persist until mid-2015.
“Following the below-average incidence in 2014, this could increase the frequency of tornadoes in the USA. If the El Niño phase does, in fact, end towards the middle of the year, there would be no cushioning effects from the ENSO oscillation in the main phase of the tropical storm season.”
The reinsurer added one last point — that the greatest losses in North America over the past year stemmed from cold temperatures. Heavy frost in many parts of the USA and Canada, along with blizzards, particularly on the East Coast, caused losses of $3.7 billion in 2014 alone, of which $2.3 billion was insured.
Munich Re’s point is a rather sobering one — what if 2015 is a very different year than 2014 in terms of catastrophes?
The catastrophe bond market will soon find out.
2015 General Liability Renewal Outlook
There was a time, not too long ago, when prices for general liability (GL) insurance would fluctuate significantly.
Prices would decrease as new markets offered additional capacity and wanted to gain a foothold by winning business with attractive rates. Conversely, prices could be driven higher by decreases in capacity — caused by either significant losses or departing markets.
This “insurance cycle” was driven mostly by market forces of supply and demand instead of the underlying cost of the risk. The result was unstable markets — challenging buyers, brokers and carriers.
However, as risk managers and their brokers work on 2015 renewals, they’ll undoubtedly recognize that prices are relatively stable. In fact, prices have been stable for the last several years in spite of many events and developments that might have caused fluctuations in the past.
Mark Moitoso discusses general liability pricing and the flattening of the insurance cycle.
Flattening the GL insurance cycle
Any discussion of today’s stable GL market has to start with data and analytics.
These powerful new capabilities offer deeper insight into trends and uncover new information about risks. As a result, buyers, brokers and insurers are increasingly mining data, monitoring trends and building in-house analytical staff.
“The increased focus on analytics is what’s kept pricing fairly stable in the casualty world,” said Mark Moitoso, executive vice president and general manager, National Accounts Casualty at Liberty Mutual Insurance.
With the increased use of analytics, all parties have a better understanding of trends and cost drivers. It’s made buyers, brokers and carriers much more sophisticated and helped pricing reflect actual risk and costs, rather than market cycle.
The stability of the GL market also reflects many new sources of capital that have entered the market over the past few years. In fact, today, there are roughly three times as many insurers competing for a GL risk than three years ago.
Unlike past fluctuations in capacity, this appears to be a fundamental shift in the competitive landscape.
“The current risk environment underscores the value of the insurer, broker and buyer getting together to figure out the exposures they have, and the best ways to manage them, through risk control, claims management and a strategic risk management program.”
— David Perez, executive vice president and general manager, Commercial Insurance Specialty, Liberty Mutual
Dynamic risks lurking
The proliferation of new insurance companies has not been matched by an influx of new underwriting talent.
The result is the potential dilution of existing talent, creating an opportunity for insurers and brokers with talent and expertise to add even greater value to buyers by helping them understand the new and continuing risks impacting GL.
And today’s business environment presents many of these risks:
- Mass torts and class-action lawsuits: Understanding complex cases, exhausting subrogation opportunities, and wrangling with multiple plaintiffs to settle a case requires significant expertise and skill.
- Medical cost inflation: A 2014 PricewaterhouseCoopers report predicts a medical cost inflation rate of 6.8 percent. That’s had an immediate impact in increasing loss costs per commercial auto claim and it will eventually extend to longer-tail casualty businesses like GL.
- Legal costs: Hourly rates as well as award and settlement costs are all increasing.
- Industry and geographic factors: A few examples include the energy sector struggling with growing auto losses and construction companies working in New York state contending with the antiquated New York Labor Law
David Perez outlines the risks general liability buyers and brokers currently face.
Managing GL costs in a flat market
While the flattening of the GL insurance cycle removes a key source of expense volatility for risk managers, emerging risks present many challenges.
With the stable market creating general price parity among insurers, it’s more important than ever to select underwriting partners based on their expertise, experience and claims handling record – in short, their ability to help better manage the total cost of GL.
And the key word is indeed “partners.”
“The current risk environment underscores the value of the insurer, broker and buyer getting together to figure out the exposures they have, and the best ways to manage them — through risk control, claims management and a strategic risk management program,” said David Perez, executive vice president and general manager, Commercial Insurance Specialty at Liberty Mutual.
While analytics and data are key drivers to the underwriting process, the complete picture of a company’s risk profile is never fully painted by numbers alone. This perspective is not universally understood and is a key differentiator between an experienced underwriter and a simple analyst.
“We have the ability to influence underwriting decisions based on experience with the customer, knowledge of that customer, and knowledge of how they handle their own risks — things that aren’t necessarily captured in the analytical environment,” said Moitoso.
Mark Moitoso suggests looking at GL spend like one would look at total cost of risk.
Several other factors are critical in choosing an insurance partner that can help manage the total cost of your GL program:
Clear, concise contracts: The policy contract language often determines the outcome of a GL case. Investing time up-front to strategically address risk transfer through contractual language can control GL claim costs.
“A lot of the efficacy we find in claims is driven by the clear intent that’s delivered by the policy,” said Perez.
Legal cost management: Two other key drivers of GL claim outcomes are settlement and trial. The best GL programs include sophisticated legal management approaches that aggressively contain legal costs while also maximizing success factors.
“Buyers and brokers must understand the value an insurer can provide in managing legal outcomes and spending,” noted Perez. “Explore if and how the insurer evaluates potential providers in light of the specific jurisdiction and injury; reviews legal bills; and offers data-driven tools that help negotiations by tracking the range of settlements for similar cases.”
David Perez on managing legal costs.
Specialized claims approach: Resolving claims quickly and fairly is best accomplished by knowledgeable professionals. Working with an insurer whose claims organization is comprised of professionals with deep expertise in specific industries or risk categories is vital.
“We have the ability to influence underwriting decisions based on experience with the customer, knowledge of that customer, and knowledge of how they handle their own risks, things that aren’t necessarily captured in the analytical environment.”
— Mark Moitoso, executive vice president and general manager, National Accounts Casualty, Liberty Mutual
“When a claim comes in the door, we assess the situation and determine whether it can be handled as a general claim, or whether it’s a complex case,” said Moitoso. “If it’s a complex case, we make sure it goes to the right professional who understands the industry segment and territory. Having that depth and ability to access so many points of expertise and institutional knowledge is a big differentiator for us.”
While the GL insurance market cycle appears to be flattening, basic risk management continues to be essential in managing total GL costs. Close partnership between buyer, broker and insurer is critical to identifying all the GL risks faced by a company and developing a strategic risk management program to effectively mitigate and manage them.
This article was produced by the R&I Brand Studio, a unit of the advertising department of Risk & Insurance, in collaboration with Liberty Mutual Insurance. The editorial staff of Risk & Insurance had no role in its preparation.