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By MATTHEW BRODSKY, senior editor/Web editor of Risk & Insurance®

The year 2009 was one of the best in the new millennium for the Vermont captive insurance domicile. There were 39 new captive formations last year.

Those 2009 figures are especially amazing considering the softening in the traditional insurance market has not abated. Typically, corporations head toward that traditional market when rates are cheap and hold off on launching new captives.

The year 2009, then, could be signs of good things to come. Another positive aspect of captive formations last year was its breadth in terms of types of captives formed and sectors involved. There were 28 pure captives formed in 2009, as well as one industrial insured captive, one sponsored captive, four special purpose financial captives and five risk retention groups.

In terms of what sorts of companies were creating captives, they were all over the board. Healthcare firms set up six new captives in 2009. But other companies that opened shop in Vermont include Comcast, Morgan Stanley, Swiss Re, Turner Construction and Peabody Energy.

The 2009 additions made 878 the total number of captives in Vermont by year-end. After looking at such a positive scorecard for the Vermont domicile, the question invariably arises: How can the jurisdiction be so successful, year after year?

We at Risk & Insurance® decided to ask that question, and a couple of others, to some folks in the Vermont captive business who have a unique and well-informed perspective. These are the captive managers who help to run many of those 878 captives.

WHY CAPTIVES?

Before we get into what makes Vermont a success, perhaps we should delve a little deeper into what caused that spike in new formations last year. Why did companies set up captives in such a down economy and soft insurance market?

Typically, captive owners use their vehicle to increase their retentions or fill coverage gaps, explained Nancy Gray, regional managing director-Americas at Aon Global Insurance Managers.

"During soft market conditions, companies may not need to rely on their captives to fill gaps but they continue to provide coverage for the deductible layers," she added.

Soft market or not certain niches are still "underserved," pointed out Robert M. Gagliardi, director of U.S. operations for captive management services at Chartis Insurance.

Or as Kevin Heffernan, divisional vice president at Artex Risk Solutions Inc. put it, "There are always some items that keep a risk manager or CFO up at night. These are the coverages that people are looking for captives. They may be wind deductibles or SIR limits on present policies."

For Elizabeth Steinman, managing director at HSBC Insurance Management (USA), she doesn't see down markets as markets that started to improve in 2009.

"As markets started to recover, pent-up demand for captives began to emerge," she said.

No matter the market, the reasons for forming captives don't change.

"The reasons to form a captive remain the same--primarily control: control of claims, control of premium dollars, control of the risk program," she explained.

A captive is also a great idea for a company that insists on control over its loss control. "We are seeing captives established now to take advantage of good loss control.Many captive owners have little or no claims and have questioned why they purchase commercial coverage," said Derick White, president of Strategic Risk Solutions Vermont Inc.

Gagliardi stressed the long-term benefits that owners seek, not just in risk management and cost of risk but in terms of money-making as well.

"What we see happening today is that companies are also looking to create insurance solutions for their customers and business partners to produce a profit. These profit streams are valuable contributors to the captive's overall goals while providing an insurance product for their partners, which they may not have had access to previously," Gagliardi said.

It is seeking that revenue that could explain why more owners will be using their captives for customer risks, agreed Gray. "Customer risks allow them to utilize their captives to generate revenue for their organization rather than being a cost center," she said.

And let's not forgot about the captive owners getting ready for that rainy day, or in this case, a hardening market.

"Some companies realize that a captive will be very useful when the market turns, but it probably does not make sense to take on more risk for traditional lines, so they look for alternative ways to use the captive in the meantime, and this way they can get some benefits now and are ready to respond immediately when things start hardening," said Patrick Theriault, vice president and managing director, captive management services, at Wilmington Trust.

WHY VERMONT?

One of the reasons HSBC's Steinman believes that captive owners continue to choose Vermont is because of that 878 number. With more captives than any other U.S. jurisdiction, and being the third largest domicile globally, "Vermont's captive insurance industry and regulatory environment are well-established," she told us.

It's not just a reputation of being well-established. The folks in Vermont back up their "gold standard" advertising slogan.

The domicile, for one, has a vibrant market for vendors.

"There are multiple options for captive managers, actuaries and lawyers," said Les Boughner, the executive vice president at Willis in charge of the North American captive and consulting practice.

Vermont also lives up to its gold-standard reputation for regulation.

As SRS' White put it, "The regulators are knowledgeable and consistent; the captive managers, attorneys and other service providers are high quality; and the existing captive programs are well run."

OK, White might be biased. (He is, after all, a famous ex-regulator.) But don't just take his word.

"The response time from the (captive) department is fantastic. They listen and they make quick decisions. Big does not mean slow in Vermont," said Chartis' Gagliardi. "On a business plan change that might be a little difficult, you can call the department, have a 10-minute discussion and know when you hang up the phone if the plan works or it doesn't."

For Julie S. Boucher, U.S. captive solutions practice leader and managing director at Marsh, how Vermont handled the retirement of Len Crouse and the promotion of David Provost two years ago says a lot.

"The change occurred without any interruption, and I think the market is looking for that kind of robust stable environment," she said.

Such top-flight regulatory support, according to Heffernan, is "even more important considering the financial constraints state governments face."

"Other places don't have full-time regulators," said Andrew Sargeant, chief operating officer of USA Risk Group. With Vermont's crew, on the other hand, he said, "there's nothing they haven't seen."

It helps that the regulators have the bipartisan support of the lawmakers and political leaders in the state. The legislators understand that they need to provide the resources and staff to the captive department, said Boucher, and they know that, even though the Vermont captive law is a model for all onshore domiciles, it can still use a "tweak" here and there to help captive owners achieve their goals.

"Combine this with the infrastructure in place in Vermont, the commitment of the legislature and the fact that it is onshore, and maybe even throw in the VCIA and the biggest (captive) conference in the world, and you have what is the safest domicile option out there by a mile at a reasonable cost," Theriault said.

HOW ABOUT 2010?

"We are optimistic about the trajectory of the captives industry. For example, some clients have indicated they are ready to take captive projects off the back-burner," said HSBC's Steinman

White shares her positivity.

"I sense that 2010 will be similar to previous years, just bigger," he said, adding that he foresees a final year-end tally north of the 39 formations licensed in 2009.

Gagliardi agrees too, forecasting that, whereas companies last year were a little hesitant to put capital into a new venture, they will have more confidence in the economy this year.

Though Gray sees growth in the Vermont domicile in 2010 being in line with what it was in 2009, with formations being "back to normal levels," she added the caveat "provided that there is not another major event that could derail this growth."

For instance, according to Gray, captive experts are "carefully monitoring" Obama budget plan proposals, which could increase federal taxation for some onshore captives that cede business to offshore affiliated entities.

Willis' Boughner sees a possible impact for the global captive business from Solvency II in the European Union.

"Without special treatment for captives, the impact could be profound," he said.

USA Risk's Sargeant added a bit of caution too, suggesting that 2010 could see "slow-to-medium" activity. When it comes to risk retention groups, he said, don't expect too much growth here at all, because RRG activity is more closely tied to hard markets.

Still, let's think positively about captive growth in 2010.

As Boucher at Marsh suggested, there's nothing to suggest that 2010 won't be a good year. "There's a lot of opportunity, and there's a lot of interest," she reported.

Where in particular will that growth occur?

Some will happen from the "trickle" of large corporations moving offshore captives to onshore, observed Boucher.

"In our conversations with customers, we are hearing a lot of interest in single parent captives, and agency and program captives," Steinman added.

White predicts continued growth in the "basic" lines: workers' comp, general and professional liability, and property. But he also sees growth opportunities with medical benefits being written through new cells in sponsored captives.

Whereas some captive managers predict growth in traditional areas, other managers spot new trends.

Boughner, for example, sees current activity in TRIA captives and smaller captives that take an 831b election. Heffernan also sees more activity in those controversial 831b's, whereby a captive can be taxed on its investment income only, as long as the company receives less than $1.2 million in annual premium.

"A lot more people are becoming aware of using these," agreed Sargeant.

"I think the majority of the growth will come in customer-related and nontraditional lines, with some of this tied to changing exposures as a result of rapid technological change," said Gagliardi.

We already heard from Gray about owners using captives for customer risks as revenue generators. But she also told us that growth could come in the middle market.

Marsh's Boucher was right there with her, detecting interest from midsize and small companies.

"There continues to be a fair amount of interest with small to medium-size organizations (at least the ones that have managed to remain profitable), including privately held organizations," observed Theriault.

Our captive managers were a bit split when it came to owners using captives for employee healthcare benefits, with some (like White) saying they're sensing activity and others suggesting that perhaps owners are awaiting the effects of the Obama healthcare reform before moving forward.

Yet with captives and alternative risk transfer in general becoming less alternative and more mainstream, an industry "gold standard" can expect to see interest from all sorts of companies, of all different sectors and sizes.

"I think organizations across the board are doing it. We have not noticed one key driver, like healthcare was very recently," said Theriault.

May 1, 2010

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