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At the insurance committee meeting held at the National Association of Real Estate Investment Trust's annual conference last fall, the subject of captives never came up. That should tell you something about how enamored REITs are with captives, self-insurance companies formed as vehicles to reduce and control premium costs.

Only a handful of REITs own captives licensed in domestic domiciles--the legal term for a captive's home state--but goodness knows how many more are researching these alternatives, just in case.

"REITs are a little bit different than standard companies, especially when looking at predictable risks, such as general liability and workers' comp," says Tom Stokes, managing director for Captive, Actual and Pooling Services at Willis of New York.

By their nature, REITs are highly regulated, public real-estate companies that own income-producing properties, such as hotels, office buildings, shopping centers, apartment buildings and warehouses. Traded on major stock exchanges, REITs are governed by strict Internal Revenue Service tax codes that stipulate they must distribute at least 90 percent of their taxable income to shareholders annually. That's certainly not a requirement for other industry groups that might consider a captive, such as a health-care institution or manufacturer.

There's another condition that REITs must comply with that can make captive management even trickier. As much as 75 percent of their income must come from rent or mortgage interest. REITs may already have other sources of revenue, such as property-management or asset-management income, that already account for that other 25 percent. It becomes a juggling routine to make sure their mortgage or rental portfolio is large enough to offset any other type of growing income.

And because a captive can return income through capital investments, it is liable to upset that equilibrium and exceed the 25 percent threshold. "That's why they're a little more wary," says Allan.

But hold on. It gets more complicated. "The biggest challenge is the constant flow of properties coming on and going off the portfolio," says John Meder, managing director of Palmer & Cay's Cleveland office, where he oversees the brokerage firm's real-estate practice. There are other charges, known as "allocatable charges," that Meder says would have to be carefully structured in order to be put into a captive.

Despite those difficulties, a few REITs have set up captives for very specific purposes. For example, Boston Properties, which primarily owns office properties in Boston, New York, Washington, D.C., San Francisco and Princeton, N.J., set up its captive in Vermont in January 2002. Named IXP Inc., the captive was initially formed to cover a portion of the REIT's earthquake insurance coverage for its San Francisco-area properties. It also covers Boston Properties' exposures to nuclear, biological and chemical risks.

With Congress extending the Terrorism Risk Insurance Act last December, more interest in captives could be stirred up among real-estate companies. But will that matter to the typically conservative REITs, which may still be just window-shopping?

"It can be a smart thing to do, but it depends on what your appetite is for risk," says Vernon Bowen, senior vice president for risk management at PREIT Services, a Philadelphia-based retail REIT, who has researched captives for some time now. "As I understand it, it's more than just the possibility of saving money. It's about stabilizing costs, so you're not affected by the ebb and flow (of premiums)," he says.

He anticipates property insurance rates are going to rise due to losses sustained from the hurricanes, and should it become more difficult to find insurance at what he considers a reasonable price, "the risk of a captive would be better off than paying the (high) premium," he says.

If Marsh's Allan is right about reducing the total cost of risk in a posthurricane property market, maybe Bowen should start checking the airfares to, say, Vermont or South Carolina. "We're seeing signs that the first part of next year, the property market is going to harden significantly," Allan says.

January 1, 2006

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