By Matthew Brodsky
Vermont announced that it experienced 32 captive formations in 2012. For most any other captive domicile, confetti would be falling from the rafters. For Vermont, however, 32 sits near its annual average of around 30. So is Vermont hitting a plateau?
The prevailing answer to that question among the captive world's top professionals is "no."
Growth is to be had in the captive industry, and Vermont specifically, in many forms. First, large and small corporations are still active in forming captives -- amazingly, considering that many Fortune 500 firms already have a captive or three. In Vermont in 2012, for instance, 28 of its 32 new formations were for pure captives, the most prevalent type of captive formation.
This continued activity is a function of the larger players forming new vehicles, perhaps in continuation of the trend of moving offshore vehicles stateside. And existing owners are also consolidating captives.
A new insurance subsidiary could also be a captive formed by a company newly spun off from a big corporation (with its own existing captives) -- a scenario recently encountered by long-time Vermont industry veteran Kathleen H. Davis, the chair of captive insurance for law firm Downs Rachlin Martin PLLC.
It also represents large companies' efforts to evolve current captives to meet new coverage needs and solve emerging business issues. (For more on this, see the evolution of captives story on page A16)
"We are seeing more of our existing captives looking to see how they can expand upon the success of what they've done with their captives in the past," said Jeff Kenneson, the Burlington, VT-based senior vice president of business development at global captive manager USA Risk Group.
This includes taking on more and more sophisticated coverages -- with employee benefits always in this list, as well as cyberrisk and credit exposures, for instance, suggests Nancy Gray, regional managing director-Americas at Aon Global Insurance Managers.
Are owners learning more about captives and becoming more familiar and comfortable with the tool? Or is that they face more and more challenges for which alternative risk transfer solutions make the most sense?
"The answer is probably a bit of both," Kenneson said.
Beyond the traditional players of formation, the middle market is gangbusters when it comes to captives. (For Vermont's recent activity broken down by industry and owner size, see the charts that start on page A20)
"That is by far where we're seeing the significant amount of growth," said Gray.
Much of this is the so-called 831(b) captives, whose name is derived from the section of the IRS tax code that allows smaller companies to establish captives with far fewer dollars invested. The 831(b)'s typical threshold is $1.2 million in premium, but captives are now forming with less. Some of this activity is controversial and driven by wealth management interests looking to simply avoid taxes. A lot of 831(b) activity, to be fair, also involves middle market companies that can cost-justify a captive with a sustainable business plan, say many.
The key is not so much how much premium a captive is writing, said Peter Kranz, senior vice president at Beecher Carlson Insurance Services, but its loss rate and expense load and how much premium is left over.
"You need to look at the numbers," he says.
Some lines of business can be very profitable, he noted, like property in the higher layers, surety, renters insurance/tenant liability and medical stop-loss.
For smaller companies where the numbers might not make sense, John Prescott foresees risk pools becoming ever more popular. Pools allow middle-market companies -- and perhaps even smaller firms -- to reinsure their risk and take some risk from other companies, solidifying their tax position, explained the Burlington-based partner at accountancy Johnson Lambert LLP.
Growth for all-sized parents is occurring in certain sectors more than others. In announcing its 2012 captive formations, the state of Vermont reported higher growth in construction, manufacturing and nonprofits.
"We also saw growth in the construction sector, placing one of our construction captives in Vermont. We are also seeing some renewed interest in transportation and then there's the ever-present medical malpractice sector that gives us a steady diet of opportunity," reported Kenneson.
"I would say that health care is clearly still a dominant industry that is looking to captive insurance," Davis agreed.
Changing health care regulations continue to drive as much formation as it does uncertainty. Wholly owned captives and group captives are in the works to self-fund stop-loss coverage -- essentially reinsurance for employer health care benefits. And in the health care industry itself, captive activity increases because of interest from hospitals consolidating doctors' groups and providers setting up risk retention groups, said Les Boughner, managing director of the Willis captive practice.
"It is a very efficient mechanism for providing malpractice insurance," he said of RRGs.
... With a Chance of Rain
However, the captive industry is not all conferences in Palm Springs and new prospects galore. There are uncertainties, some macroeconomic and some micro to the industry itself.
First, the big picture. The re-election of President Barack Obama and all the policies that that brings (including the aforementioned health care reform), the continued tepid American economic recovery and the economic uncertainty everywhere else has business concerned, to say the least. The property/casualty insurance market itself, with so much capacity out there, is still not conducive to go-getting economic activity in captives.
"In my opinion, formations are a function of general economic conditions and insurance market conditions in particular," said Kenneson. "The prevailing general economic condition is uncertainty. The uncertainty created by the lackluster economy, budget issues and Obamacare just to name a few. The insurance market condition is the continuing soft market. We are seeing some hardening of the market in select regions and for select coverages, but overall the marketplace is still soft."
And particular to captives in Vermont, the challenge is that upwards of 35 other states have captive legislation on their books. Competition is fierce and getting fiercer.
At Willis, a global player in the captive management space, their experience has not been so much a movement away from Vermont as an aggressive push by other domiciles, reported Boughner.
From the Mid-Atlantic to the West, players in the captive space are building up their infrastructures and making a strong marketing push, said Boughner.
Many of these other domiciles focus on smaller captives, 831(b)s and even "micro" captives built into the segregated cell framework, said Kranz.
"There is no question that proliferation of domiciles is a challenge," Prescott said.
One of the more confounding issues confronting Vermont and the U.S. captive market in general, both on and offshore, is confusion around a certain provision of Dodd-Frank, the so-called Nonadmitted and Reinsurance Reform Act (NRRA). Essentially, the provision could be construed -- or misconstrued according to most -- to require some captives to pay procurement taxes if they are located outside of their parent company's home state and writing direct business.
In explaining why Vermont could be particularly vulnerable, Davis simply pointed out that Vermont is home to few large companies, although small and mid-size companies can and do form captives.
Then again, this is nothing new. According to Kenneson, a self-procurement tax "has been around forever." Yet the latest episode encourages some states to get more aggressive with marketing themselves as a "home state." And now that the clichéd cat is out of the bag, it is up to each state to determine how, if at all, they will apply it.
"The fear is you have 50 different states," Prescott said.
A few states have leveraged the uncertainty around NRRA to a degree. He pointed to one state, Missouri, which has already seen a couple of captives formed or transferred because of NRRA. One client company moved a captive from New York to New Jersey, with NRRA being the primary driver.
Davis has heard anecdotal reports of a few companies moving, and only a couple that her practice works with considered a move. None of them finished the process.
Nancy Gray of Aon suggested that the issue has impacted captive formations in Vermont. Some large corporations are considering their home states as domiciles as a result.
Kranz at Beecher has seen more conservative captive owners slow down their activity, though he stressed that the "wholesale domestication" that some people feared has not happened.
Boughner has seen only one client directly affected, and they set up a branch captive in their home state instead of shutting down their Vermont captive.
"I haven't seen anyone not do a captive because of Dodd Frank," he added.
In any case, all sources spoken to for this piece agreed that the NRRA does nothing but add some confusion to the picture, no matter how many people speak out against its application to captives, even if the people speaking out are the law's original legislative authors. That's because -- as Kenneson alluded to -- it opens the door to states who want to leverage that confusion to push the home-state card.
But despite these storm clouds dotting the sky, Vermont overall has nothing to fear.
Having seen 32 captives formed in 2012 is nothing to sneeze at given the penetration and maturity of the market.
Each time she thinks that every company that needs a captive must already have one, more large companies are setting up pure vehicles, said Davis. And there is always the next great need for owners of all sizes to form a captive. What seems like a threat always can turn into an opportunity.
In 2012 and beyond, try the Affordable Care Act as an example. Health care risk management has historically been a big driver in captive formation and the changes the act will foment will align with that historic motivator.
The captive industry in general has its energy back too, Prescott said. All of the experts interviewed for this story -- all of them service providers of one form or another -- were bullish about the prospects for the captive industry.
And Vermont continues to get the first look from many companies looking to form captives. It's got a big edge in regulatory experience and developed infrastructure. It provides a consistent and flexible place to grow captives, and other domiciles will have a tough time matching that.
MATTHEW BRODSKY is the editor of Wharton Magazine.
April 12, 2013
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