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The hard market we experienced in the last few years led to the formation of many captives and risk retention groups to serve areas like medical malpractice and residential contracting general liability. Much of this activity was state and industry specific. This growth also helped fuel the expansion of some new captive domiciles, such as Montana.

Much use of the risk retention group (RRG) structure was made due to the lack of fronting carriers (in actuality, the lack of any carrier in many cases). There was little activity on the large corporate side for captives during this time; most activity was in the middle market. Most big companies that want captives already have captives.

REGULATORY DEVELOPMENTS

A pure front or the use of some truly alternative financing vehicle may require deposit accounting, however, there is still a wide variation among carrier treatment of such deals.

U.S. captive domiciles seem to be trying to out-compete each other, but not all of these captives will be acceptable to many issuing carriers in the marketplace.

We may see the continued creation of numerous direct writing RRGs that have structural or other issues that would keep them from ever being supported by the reinsurance market.There is some large single-parent activity in these domiciles. A number of domiciles are trying to accommodate their captives by giving them the flexibility to write third-party or other types of business.

REINSURANCE ROLES

Some of the new reinsurers formed since Sept. 11, 2001 have begun to enter the captive market. Despite additional capacity, the large primary admitted carriers in this market are still keeping much of their risk net. The reinsurers have been very active in reinsuring RRGs and other such entities. Most of their activity has been in this group area, not in the area of large single-parent captives. Large single-parent captives are rarely served by the standard treaty reinsurance market. However, this business has now come under attack from admitted carriers in the softening market.

We can expect these reinsurers to be more aggressive in seeking reinsurance opportunities behind admitted programs. There have even been some rumblings about the return of such things as multiple-year in-the-money aggregate stops, which now have numerous accounting and regulatory issues associated with them. What we have yet to see is reinsurer-led creation of new alternative primary vehicles. The increased scrutiny on "fronting" and the amount of risk transfer in deals is new, and it bears watching to see if any of the products that new entrants may try and offer will be acceptable in this area.

THE MGA CAPTIVE MARKET

We are starting to see the return of the managing general agent captive market, where an MGA, managing general underwriter, or program manager that underwrites and sources business also has a captive that takes risk. There are some new entrants that are focusing on this area.

In the past, these facilities had issues with reinsurance credit quality, both from the third-party reinsurers that were used aggressively, and from the captives that were involved. Many people were blinded by the gross premium, and ignored the fact that these deals have complicated administrative and financial needs. The ratings agencies seem to have noticed this, so this area will bear watching. The need to monitor collateral and premium writings on a daily basis, plus the other demands of MGA-outsourced underwriting programs, require a discipline that is easily lost in the soft market.

SECURITIZATION

Securitization seems to have found a role in the property-catastrophe business, along with flexible capacity such as sidecars. However, the applicability of these structures to most captives is not feasible, except for perhaps the very largest. There were numerous attempts to securitize captive collateral in the soft market, and there have been some rumblings about a return of that market. The amount of time spent on terms and financial and accounting reviews for a deal to pass muster is significant, and will continue to be.

SELF-INSURANCE

Self-insurance is usually a growth leader in a hard market, and this last cycle was no exception. However, as the market softens and conventional polices become available, self-insurance, particularly on a group basis, faces competition from the standard market or captive structures. There are a number of self-insured workers' comp groups seeking to restructure themselves as a group captive for competitive reasons.

We are also seeing increased scrutiny and review of self-insured individuals and groups, as regulators see what happens if they are not structured properly. In some cases, the joint and several liability issues have become an obstacle to self-insured programs. Self-insurance is also the area most prone to optimistic pricing and reserving, and there have been a number of failures in the last few years. This will increase regulation and make self-insurance similar to some insured structures. We should see continued growth in group captive and middle-market captive vehicles.

The large Fortune 500 captive will look to optimize its financial structure, perhaps though assuming some benefits or other business. There will be new entrants, with the first wave focusing on deals involving managing general agents where buyers don't need to make a significant primary carrier infrastructure investment. Self-insurance will continue to grow, although more moderately than in the past.

TOM KOZAL is senior vice president, alternative markets, of Arch Insurance Group.

March 1, 2008

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