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Like many young marriages, the relationship between U.S. corporations and their captive insurance companies is full of promise.

In the beginning, at least, there is passion, planning for future financial stability if not wealth, and the joys and responsibilities of procreation. But like all young relationships, there are also bumpy periods. And one of those rough spots might be on the way for domestic captives, at least in the short term, after several years of harmony.

And right now it looks like the young onshore industry in 2008 has its share of challenges. For one, a softening general insurance market will begin to place a strain on group captives in particular, as falling prices in the standard insurance market entice some members of those captives to abandon them, at least temporarily, to seek lower pricing.

And there will be plenty of well-heeled underwriters out there doing their best to interfere.

"Group captives have much more exposure to the underwriting cycle than a single-parent captive would just because there is a buy-in from their constituency," says Steve Chirico, a senior financial analyst with the Oldwick, N.J.-based ratings agency, A.M. Best Co. Inc.

"Group captives are a collection of small, middle-market buyers. When the market gets soft, I think there is a lot of pressure to compete with the market," says Brady Young, managing director and president of the Burlington, Vt.-based Strategic Risk Solutions Ltd., a captive management company.

Another threat to the momentum of what has been a very good couple of years for domestic captives is proposed changes to the way that the Internal Revenue Service could tax corporations that include the liabilities of their domestic captives on their tax returns.

Proposed regulations unveiled by the IRS in September 2007 would no longer allow U.S. corporations to write off the loss reserves of certain single-parent captives for tax purposes. Rather, the federal government's tax collectors would ask that companies recognize a loss paid by a domestic captive only when it is actually paid out ... in cash.

Keep in mind that it is only those captives whose liabilities are included on a parent company's consolidated financial statements that would be affected. But you don't have to have mastered quantum physics to gauge the potential impact.

The cash payment of a loss will in some cases represent a fraction, sometimes a small fraction, of the value of accrued losses that a given captive could be carrying on its balance sheet in any given year: in other words, corporations could be saying "bye-bye" to major tax breaks.

Those in the industry argue either that the IRS must be looking at onshore captives as squirrelly home-based tax shelters, or that the feds just don't understand the basics of insurance accounting.

"It effectively reverses the insurance tax treatment afforded to properly structured captive insurance transactions by the courts for decades," argues the Washington, D.C.-based Captive Insurance Companies Association in a recent written public statement on the issue.

A GLASS HALF FULL?

And the predictions for what the proposed regulations could mean to the domestic captive industry are as wide-ranging as the ideas about how the IRS should be treating single-parent insurance captives.

Richard Goff, a senior executive with the Taft Companies and the president of the Self-Insurance Institute of America Inc., an industry group based in Simpsonville, S.C., says the domestic captive industry is doing great now but could suffer a quick and, he thinks, fatal decline if the IRS proposal becomes law.

"The domestic captive industry today is simply bullish, and if the IRS continues with proceeding in bringing these proposed new regulations on line, it will kill the domestic industry," says Goff.

And then there is the middle view.

"Will it kill the captive industry? No," says Strategic Risk Solution's Young. "Will it be a setback if it passed? Yes."

As things stand, the onshore industry has been doing quite well when compared to the more traditional captive locations like Bermuda and Cayman. Part of that is that the tax breaks that corporations could once find offshore have eroded. An additional piece of the equation is that it makes more sense for increasingly conservative companies to house their captives closer to home.

"A lot of companies, their attitude is, 'We can do what we want to do, why go offshore?' The answer is, 'You don't have to,' " says Young.

A third chunk of the equation is that ownership of an offshore captive tends to spark the idea that the company is operating some Caribbean shell game, as if the company and its executives are something less than forthright.

"Even though Bermuda and Cayman are legitimate places to do business, if you are in Middle America, there is still a perception that offshore is bad, it's politically incorrect. It just kind of raises eyebrows," Young says.

And now, we'll hear from someone who thinks a little more optimistically about the IRS proposal.

"I think it's going to be very good for the industry," says Jason Flaxbeard, a senior managing director in the Denver office of Beecher Carlson.

But before you deride him as a Pollyanna, listen to his logic.

"If you think about the reasons people start captives, I think taxes is No. 5, it's not No. 1, is it?" says Flaxbeard. "So, I think this is an opportunity to go back and look at numbers one through four and see what you can do with those."

Flaxbeard also says that the new IRS regulations will create their own subset of work among captive managers as parents spend bucks on outside help in coming to terms with the new rules.

"I think you'll find people trying to bounce into some kind of consulting mode when it comes to the IRS issues," Flaxbeard says.

In truth, companies create captives to manage difficult risks, not necessarily to make money or to create a tax break, he says.

"The mission of a captive being a little bit different than that of a commercial insurance company, issue No. 1 (for a traditional insurance company) being make a buck," says A.M. Best's Chirico.

To date, for example, one of the chief drivers in creating a domestic captive has been the need to seek shelter from the ravages of medical-malpractice premiums.

"Not only has it been wild swings, sometimes there hasn't been capacity at all. You just can't find coverage," says Chirico.

"In terms of lines of business, med mal is really the largest line of business. The size of that line of business is going to have a fairly large influence on all other results," chimes in Eric Nesbitt, a senior financial analyst at A.M. Best.

Other leading lines that find sanctuary in captives, according to A.M. Best, are automobile-physical damage, private-passenger automobile liability and commercial multiperil insurance.

THINGS ARE SLOWING

Because captives are so specialized, managing their performance against the cycles of the market in general is a tricky, if not impossible science. But this much we know, as the general market softened in 2006, captives saw their growth start to slow.

Researchers with A.M. Best say that, in 2006, the domestic captive industry recorded its slowest growth in net premiums written over the past five years, with that increase reaching just 2.7 percent.

And captive managers say they have their work cut out for them in 2008, as they will have to sell members of group captives on the long-term benefits of staying in their captive as standard-market premium prices fall and underwriters come calling with good deals.

"You say, 'Look guys, you view this as a long-term thing, and how much do you value stability ... are you going to abandon ship and jump back in the market?' " says SRS's Young.

But to many captive participants, having that option is what it's all about, especially for single-parent captives who have a lot of flexibility in decision-making and don't have to put things to a group vote. By creating their own captive, they can use it to create capacity and seek out a better price when the market is offering it.

"You have the option of choosing what you buy the coverage for," says Chirico.

In this transitioning market, Chirico, like Flaxbeard, says that captive managers are going to be a lot more active in educating owners about why they formed a captive in the first place.

"I would say there have been a lot more education opportunities taken advantage of, a lot more information flow in terms of producing reports on the progress of the captive. If I am the captive manager, that's what I'm doing," he says.

Goff says, if the IRS doesn't goof things up, and as the industry matures, captive owners and managers will continue to innovate to find new uses for captives, identifying fresh risks that can be housed there.

"I think we will begin to see a lot more balance-sheet-driven risk being driven through captives. There is plenty of corporate risk that is a contingent liability or footnoted that the industry has not addressed and does not have the appetite to address," Goff says.

DAN REYNOLDS is senior editor of Risk & Insurance®.

March 1, 2008

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