Captive Differentiators
Captives are different, as I keep telling regulators, rating agencies and journalists. Some of them (regulators, rating agencies, and especially journalists) persist in slipping into the error of saying that captives do this or do that. By saying that captives “do” things it is clear to me that the writer or speaker does not understand the differences between captives, or has a mistaken idea that all captives are the same.
The only thing one can correctly say that captives (taken as a general class) actually do is to underwrite insurance business. Everything else they are said to "do" is done by managers (including risk managers and in-house management) and shareholders.
Captives are far from being homogeneous, except in the sometimes incredible statistics emanating from domiciles or managers, both of whom have a vested interest in showing how many captives they have licensed or manage. A M Best has done a good job of putting the captives they count into some 20 classes according to what they do, but they only count the ones they rate, less than 200. There is more to differentiating between captives, though, as I am going to demonstrate.
The big differences The differences between captives can often be broken down into pairs (either this or that, for example either single or multiple owner). I further divide the pairs into three main categories. These are
Ownership and control The main one is single-owner versus multiple-owner.
Modus operandi The main one is direct versus reinsurance mode.
Tax position The main one is the tax position of the owners : for-profit versus not-for-profit.
From these three you can already see how important the differentiators are. Already it is clear to me why it is meaningless to lump all captives into the same category when talking about them in general.
What they mean I ordered the differences (or biases) into three columns. The left-hand column represents "standard", or most often observed features. The middle column represents the “other”, sometimes the opposite of the standard feature. Some of the ones in the left-hand column I consider higher up the captive "best practices scale" than the ones in the middle column. The comment column contains clarifiers or just plain comments.
Read from left to right as “this versus that” or “this or that”. The initials “MO” stand for modus operandi, meaning how they operate.
| Ownership and Control | ||
Single owner | Multiple owner, group-owned | There are a lot more single-owner captives. The multiple-owned ones are usually larger. But the MOs are very different. |
If group-owned, a member-owned or association captive that is not a mutual or RRG | A true member-owned captive that is a mutual or RRG | There are more group captives that are simple stock companies, even if they operate like mutuals. Sometimes the association itself owns the captive, which is a third type. |
Insureds are owners | Agent or producer-owned reinsurance companies ("PORCs") | PORCs aren't captives, but are often counted as captives |
Stand-alone captive | A cell | Most segregated cells operate like little captives but with very different ownership and control features |
For-profit owner | Non-profit owner | US non-profit owners have tax and operating positions much different from their for-profit counterparts |
Not health-care (owners and main line of business) | Health-care | Health care captives usually write mainly long-tail liability business and are heavily influenced by actuaries. |
US ownership | Non-US ownership | Home-country tax, accounting and consolidation rules influence how captives work and look |
Small (<$10 m annual premium)
| Large (>$50m annual premium) | Larger captives tend to resemble commercial insurance companies, and are sometimes considered more reliable just because they are so large. This is a misunderstanding |
| If small, uses 831(b) exemption | If the captive does, it is probably used for estate planning or tax avoidance | |
| Not managed by one of the big three broker-managers. | Managed by Aon, Marsh Willis. | I put this differentiator in the "ownership and control" category because these three manage more than a third of all captives. |
Modus operandi | ||
Startup | Mature | Contrary to popular belief, there are a whole lot more mature captives than start-ups; nevertheless startups get all the attention |
Offshore | Onshore | Most captives are offshore, which sometimes means onshore captives are erroneously considered in the same light as offshore captives. |
In a “captive domicile” with special regulations | Regulated like a commercial insurance company | Most captives are domiciled in jurisdictions with “favorable” regulations. Some captives, however, accept local commercial insurance regulation. Those in Switzerland, for example. |
Direct writing | Reinsurance | There are more reinsurance-writing captives, but they suffer from the demands of fronting companies. |
Writes mainly (or some) low frequency high-severity business. | Writes mainly low-severity, higher frequency business | Among risk managers, this is the big differentiator. It also has a lot to do with how much capital the captive has. |
Own management | Contract management | While most captives are run by contract managers, owners of the larger ones often perform some or all the management functions in-house. |
Takes risks | Low risk | Higher risk taking implies more free capital. Most captives don’t take much, or enough risk. |
If Reinsurance MO, takes gross cession | Takes net cession | Gross cession captives have more reinsurance to place than net cession captives. But fronters are pushing net cession these days. |
Changing business plan (without any mention of this difference). | Stable, unchanging business plan | Most captives' business plans are modified frequently. For this reason nothing is so misleading as a time-series comparison of all captives or of one to another |
If a cell, a closed cell (shares no risk) | Open cell (shares some risk, usually the credit risk) | Open cell MO is the standard rent-a-captive MO. It is going out of fashion, though. Promoters of cells nowadays are pushing closed cells. |
Doesn't write terrorism | Writes terrorism to gain access to TRIA or Pool Re | Most don't |
Writes or reinsures employee benefits | Doesn't | Only a few do, but owners of those that do are among the most advanced of today's captive owners. |
Writes some liability, long-tail | Writes only property, short-tail | Writing long-tail business is a sign of long-term commitment |
Writes some WC (EL) | Doesn't | Writing employee business, especially if written directly (as, for instance with high deductible buy-back programs) is another indication of long-term commitment |
Risk manager negotiates reinsurance | Captive Manager does it | Those who do are carrying on the "do-it-yourself" tradition of the captive pioneers, but may not be getting the best deal. |
Risk manager on the captive’s board, or is president | RM not an officer or director | The RM is the best link to the shareholders' interests, even if he has his own risk financing agenda. |
Breaks even | Makes significant profits | High profits may be a sign of a successful captive to finance directors, but more often is a sign that members are being overcharged. See similar comment under combined ratio, below. |
Does not pay dividends | Pays dividends | Most captives don't, especially if run close to break-even |
Investable assets >$10 million. | Less than $10 million | This differentiator is used by some investment managers as the threshold for their involvement |
| Guarantees are mainly LOCs | Guarantees mainly using reinsurance trusts | Both tie up assets in lower-yielding instruments. LOCs by far the most common. |
Some free assets | Most of its assets tied up in collateral | Captives used to have considerable free assets; these days those that still do are in a better position than those that don't |
| Solvency 2 “compliant” | Taking little notice of Solvency 2 | As of 2011 European captives will all be affected. S2 will have major effect on capital, retention, annual costs |
Uses an investment manager | Doesn't | Where they don't, the costs may be lower, but so, generally, is the total return. In some unmanaged cases, the captive’s security is considered to be lower. too. |
Expense ratio <15% | >30% | Includes costs of fronting, but not reinsurance. Low expense ratios are “good” but not always. |
ROE <10% | >15% | Mature captives with high net equity often show lower ROE than younger captives. High ROE is one sure sign of overcharging (see breakeven differentiator, above) but may also be a sign of high risk-taking |
Combined ratio close to or equal to 100% | Either >100% or <50% | This is the big differentiator of captives from commercial insurers. Where the ratio is too high there will be trouble from the captive’s shareholders, where too low, from its insureds. See also “break-even”, below. |
Clear mission statement | None, or wooly-worded | Often the “mission statement” isn’t written, but if the implication is that it is “providing the best insurance deal for its insureds” rather than something like “making reasonable profits” the captive is on sounder ground |
Own data system | Depends on someone else's | Better information about their exposures and losses are what differentiates captives from commercial insurers. |
Rated | Not rated | A M Bests or S&P rating is a sign of confidence in a captive |
Comes to WCF | Never does | Those who come find out a lot about how their captive compares to others! |
And, Finally…. Active | Dormant | There are a lot of inactive captives, notably offshore. They are usually counted in the “statistics” of captives. |
Tax position | ||
Owner takes (gets) deduction | Doesn't | Non-US-owned captives mainly get the deduction, but you would be surprised at the number of US-owners of captives who don't. Non-profit owners, for instance. |
Writing >30% unrelated business | Writing less, or none | There are a lot more captives not writing any unrelated business. |
If offshore and US-owned, doesn't make the 953(d) election | Makes the election | Many US-owned offshore captives don't, notably those owned by non-profits. |
Breaks even | Makes significant profits | Owners of breakeven captives have far fewer tax concerns |
Loanbacks to owners | No loanbacks | Tax and regulatory people dislike loanbacks but they are a common feature of advanced captives |
