Marsh: Captives Well Capitalized But Need To Stay Flexible

While captive insurance companies exhibit strong levels of capitalization, their owners must remain flexible if they are to meet the changing demands of the insurance and financial markets, according to Marsh Ltd.

"It is clear that captive managers and other captive professionals must continue to innovate and identify methods to ensure that captives continue to be an extremely effective risk financing mechanism as has been the case for over 40 years," Marsh said in its third annual Global Captive Benchmarking Report.

The Marsh report found higher "premium to capital ratios" among offshore captives than those located onshore in the United States and the European Union. According to the report, transfers within organizations are the most popular use for investment assets. Letters of credit were found for collateralization, ahead of trusts and escrow accounts.

The report focused on single-parent captives. The series began in 2008, with a study that looked at structures, retention levels and lines of cover. Last year, Marsh surveyed methods of financial analysis and the effects of the location of the parent company. "This year we focused on the use of capital and collateral within the captive insurance companies themselves," said Jonathan Groves, Marsh's captive consulting leader for Europe, the Middle East and Africa.

Captives "are doing pretty well" on capital, Groves said. Most captives carry more capital than is required to meet minimum solvency requirements. This healthy profile tends to be true even in jurisdictions where capital requirements are relatively high.

Groves was impressed by the cautious investment approach Marsh found among captives. There was a preference for bonds and a strategy of rolling investment profits back to parents.

Tim Prince, a financial analyst at A.M. Best Co. in London, said the Marsh report offers a fair assessment."The captives we see are generally quite well capitalized," Prince said in an interview. "They'd only enter the rating process if they were well capitalized."

Prince also points to a conservative investment strategy among captives and the use of such techniques as making loans back to parents.

"Captives tend to be conservative in their investment strategies, with liquidity and capital preservation key considerations as captive owners and regulators alike look to ensure sufficient funds are available to pay losses that may arise," the Marsh report said.

Groves identified three categories of captive location: offshore, U.S. onshore and European Union onshore. The "vast majority" of captives are offshore, in such jurisdictions as the Cayman Islands, Guernsey and the Isle of Man. The U.S. onshore sector has grown so much in the past 20 years that "it's getting very close to stamping on the heels of the offshore jurisdictions," Groves said.

The report pointed to growing concern among captive owners in the EU about the likely increase in regulation arising out of Solvency II, which is due to bring in an new regulatory regime for insurance and reinsurance in the EU at the end of 2012.

"The expectation is that the major [EU] domiciles will provide a 'carve out' exemption for captives" under Solvency II, the report said.

Pollyanna Deane, a partner in the corporate and regulatory insurance team in the London office of international law firm Berwin Leighton Paisner LLP, said she believes the largely monoline nature of captives could create complications under Solvency II, which will reward diversification of risk. Insurers that do not diversify their risks could face higher capital requirements, Deane said.

Deane, who regards this problem as "solvable," is encouraged by moves by the national regulators of Ireland and the United Kingdom to allow firms to build and use their own models. This regulatory response came after complaints from the captive sector about potential capital pressures from Solvency II, she said.

Jurisdictions that opt for this modeling approach "will be able to have captives in more or less similar form" to present captives, Deane said. But younger EU members that adopt the Solvency II structure intact "will probably kill off any captive industry that might have otherwise nascently been there, because I don't think Solvency II in its standard form is easy to mix with the current captive regime," she said.

While risk managers tend to see underwriting risk, rather than investment risk, as the priority for captives, Groves said, there is a growing sense of the importance of investment income to captives. Perceptions in this area have sharpened since the onset of the credit crunch, he said. Over the past two years, he noted, corporate treasurers wanted to ensure that their captives were not generating investment losses.

At the same time, a feeling grew that the surplus cash that might exist within a captive should be put to the best possible use. It makes more sense for a captive owner to remain alert to the demands of the market rather than simply to seek to hold onto cash, Groves said.

The new interest in investment income for captives was something of an "unexpected challenge" for risk managers, and they have responded well, Groves said. A useful option includes lending the cash to the parent company or to another subsidiary within the corporate group, he said.

To hear the complete interview with Jonathan Groves go to http://www.ambest.com/media/media.asp?RC=175277

(By Robert O'Connor, London editor: [email protected])