1 March 2011 Insurance

The eye of the storm

Energy company BP has now said that the final cost of paying the clean-up costs and compensation relating to the Deepwater Horizon oil spill tragedy in the Gulf of Mexico will total some $26 billion. Some believe ongoing compensation claims could still inflate this figure. The incident has focused the spotlight on the use of selfinsurance and captives among corporates.

BP uses a Guernsey-based wholly owned captive called Jupiter Insurance for the majority of its insurance arrangements. Jupiter is, in turn, often fronted by AIRCO , a unit of American International Group, which allows it to write business in places such as the US, where BP has operations.

According to ratings agency A.M. Best, Jupiter made a profit of $740 million in 2009 and it was expected to make more than $1 billion in 2010. Jupiter does not buy reinsurance coverage, but its maximum payout for any one event is also limited to $700 million—not much help when facing the kind of costs that BP is facing.

While BP has the financial size to cope with such colossal payouts, few companies would. The Deepwater Horizon incident has had two main effects on the captives industry: it has served to inflate reinsurance premiums, although these effects have been more or less limited to the energy sector; and it has prompted many corporates, which also self-insure, to review the sturdiness of their own arrangements.

Reports at the time suggested that reinsurers bumped up prices by as much as 50 percent for offshore energy-related risks in the aftermath of the Deepwater disaster, the direct insurance losses from which were expected to reach $5 billion at the time. But it was also acknowledged that these hikes would have been much more substantial had BP purchased coverage in the commercial insurance sector.

“Some companies are reviewing their captive programmes and arrangements on the back of it, but it is too soon for any major restructurings to have occurred as yet,” says Peter Willitts, vice president, Bermuda Insurance Management Association.

“You have to understand that the reinsurance market for captives is highly fragmented. Specific risks such as workers’ comp or workers’ or general liability are not that affected by what has happened with the offshore oil industry. It has not made a dent on those. As such, since the Deepwater Horizon incident, we have not seen any great change and it has not affected our clients that much.”

Others agree. “Despite the huge adverse publicity, the effects have mainly been felt in the offshore energy sector,” says Charles Winter, head of risk finance at Aon Global Risk Consulting. “But it is certainly on people’s radars that huge events such as this can happen and people are reviewing things. There is nothing like a huge event like this to force people to review the detail of what they do.”

Captive managers also have other reasons to reconsider what they do, however. A big potential driver of change in this sector will be regulation. Some changes, such as Solvency II, are inevitable; others are sector-specific but less certain in terms of consequences.

Regulators in both the US and the UK have been reviewing the way they will require energy companies to insure themselves and may well set minimum liability limits that must be met in the private market. But any such changes could ultimately end up applying to other sectors as well.

“US regulators are looking at this and we may well see changes,” Willitts says. “But there are lots of areas they could be looking at when it comes to liability limits and the way those are covered. The devil is really in the detail of what they do. If they require limits of $1 billion, that would be a problem; if it is $100 million, that would be less so.”

Solvency II is a much broader issue, but it seems the devil is also in the detail with this. Winter says that the impending regulation has forced companies to pay close attention to the detail of what they do. But he adds that the forecast is a lot better than it was two years ago.

“It was all panic and doom and gloom two years ago, when it came to how Solvency II would affect captives,” he says. “It is not as bad now, but it is apparent that there will be more work to do and regulations to comply with. I think it will raise the barriers to entry when it comes to forming captives in the EU. You could need more scale and a better economic argument for it to work.”

Willitts says the captive industry, outside of specific energy-related risks, is relatively stable at the moment, having weathered something of a storm when the financial crisis first hit and some companies closed their captives. But there are still specific issues the industry faces.

“It is not as bad now, but it is apparent that there will be more work to do and regulations to comply with. I think it will raise the barriers to entry when it comes to forming captives in the EU. You could need more scale and a better economic argument for it to work.”

“In terms of broader trends, I would say that market rates seem to have steadied. Last year, Bermuda had 36 incorporations of captives, which is not a bad number. Captives are still being formed but only at a steady rate. Rates are soft and cash is tight, but there is no overarching general move towards captives. A couple of years ago, when many companies had real cash problems, we saw many clear out the till and close captives down to take the cash in them. That trend has now died down as well though.

“The industry is in a kind of status quo at the moment. The professional lines are really soft and have seen a downward trend, but they have also flattened out at least. The main lines that are still suffering are highrisk lines: trucking and people who work on ladders or roofs. They are tough still.”

Willitts says the biggest issue he is observing in the industry at the moment is a tension between reinsurers and captive owners on collateral— something he says is also reflected in the wider insurance industry.

“The hottest item in the industry at the moment is collateral,” he says. “Insurance companies want to tighten credit, but other companies equally don’t want cash tied up. That is a really big issue for both parties.

“What it means is that whereas people used to shop on price or the terms of coverage, they now shop based on collateral. The problem with captives is that the incumbent reinsurer has a huge advantage as they will have many years of reserves or collateral posted. So they usually win. But that is still where the real tension exists in the market at the moment.”

This is something that Winter has also observed. “When rates have gone as soft as they can, then other areas end up on the negotiation table,” he says. “The issue has been around for a while and I suppose it is something else brokers can differentiate themselves on. Certainly, some companies want to reduce the amount of cash they have tied up in captives.”

In terms of preferred domiciles for captives, Bermuda remains the number one domicile, but some other locations, notably US states such as Vermont, are seeing a growing number of formations.

Some 33 new captives were formed in Vermont in 2010, fewer than Bermuda, but the most pertinent comparison used is how many captives in each domicile are active and how much premium income they carry. Despite surpassing the 900 mark of registered captives, Vermont only had 576 active captives as of December 31, 2010, dealing with more than $17 billion of gross written premiums.

A direct comparison is not possible, but Bermuda had 885 active captives with $18.8 billion in gross written premiums in 2009, according to figures published by the Bermuda Monetary Authority (BMA) in August last year.

The location of captives could come to the fore even further if captive managers are reviewing their operations following the BP incident. Winter notes that many other US states are now competing in terms of what they offer as domiciles for captives. But Solvency II could well help reverse this process, with offshore jurisdictions faring better because of less tough regulatory requirements.

“There is no clear trend or migration happening just yet, but Solvency II could aid some of the offshore domiciles because the regulatory hoops you will have to jump through to form a captive will be lower,” he says.

He also notes that, perhaps perversely, Bermuda could suffer because it has done so much work to be among the first tranche of jurisdictions to be granted regulatory equivalency.

“There is a debate going on in Bermuda at the moment around whether equivalency will benefit the island or not. While it might help the offshore reinsurance industry, it could harm the captives industry. It has been suggested that some classes of business could be excluded from equivalency, but no real solution has been found just yet.”

It seems that rather than harming the use of captives, the Deepwater Horizon incident has served to focus minds on the way captives are used and some of the regulatory issues surrounding them. There certainly seems no question of them being used less as a result.

Winter actually sees the opposite occurring. While some of the big traditional drivers of captives formations—such as high M&A activity— have disappeared for now, other drivers are emerging. “We are seeing captives being used for new types of risk increasingly,” he says. “Employee benefits and credit risk are the main two—that is certainly a departure from the traditional property/casualty risk they have been used for.”

Which could suggest we could be seeing captives used even more going forward. In a white paper by ACE Risk Management, a division of the ACE Group, entitled Darwinism at Work? How the Current Economy and the Market Impacts Captives and Risk Managers, authors Carol Frey and Linda Kane examine the threats and challenges associated with captives, such as the consideration of non-captive options, the potential for collateral relief through a loss portfolio transfer, as well as the challenges that risk managers face when managing multiple captives.

But their conclusion is a bullish one. “The primary and most important purpose of a captive is to assume predictable risks as well as unique or enterprise-related risks, which otherwise could not be supported or for which coverage was priced conservatively or unavailable in the traditional marketplace,” says Frey.

“In some cases, these exposures can be more challenging to commute or transfer, especially if a fronting structure is involved. One consideration is a novation to transfer liabilities from one captive to another, in an effort to consolidate management costs and liabilities.”

Frey concludes the paper with confidence that captives will continue to survive and evolve in order to fulfil an organisation’s unique business needs. “Captives can support a global enterprise. Captives are not predatory, but can live side by side with, and even enhance, traditional insurance products—all to support the health and prosperity of the parent organisation. These evolutionary characteristics are sure to outlast the current economic downturn and will undoubtedly drive the next generation of captives.”

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