Capitalizing on captives: domiciles for what may be the quietest, cleanest and least-visible industry are spreading through the United States.

Cabbies in Burlington, Vt., are among the few residents who know that their state is a major domicile for captive insurance companies. And despite minimal public awareness in Vermont and elsewhere, the number of states that license captives is on the rise.

The Burlington cabbies, of course, know about captives because they pick up people who fly in for the Vermont Captive Insurance Association's annual conference. Attended by some 1,200 people last year, the conference also helps hotels, restaurants and tourism in general, and it generates tax revenues for the state. Vermont, which has licensed captive insurers since 1981, is the largest captive domicile in the United States and one of the largest in the world.

Vermont's success has prompted other states in recent years to join in the rewards. More than 20 states now serve as domiciles to captive insurers and enjoy the benefits that the industry can bring. And it's hardly likely that the general public in those states has any idea what a captive insurer is, much less that their states license them.

"It's not a quick conversation, and it's hard to get your arms around it," said Dan Towle, Vermont's director of financial services in its Department of Economic Development, when asked about public awareness of captives. "When they form, most captives are not required to set up an office with a sign in front of their building. They are required by law to have a Vermont captive manager, which is basically an accounting office that runs day-to-day operations and keeps the books. So you wouldn't know that captives are here, or who they are.

"It's a quiet industry, and it's a clean industry," Towle added. "We like it to be a quiet industry because it fits Vermont."

Captives generate premium taxes and create high-paying jobs that add to state income-tax revenues. They also can help the tourist industry. "Most states require at least one board meeting a year in the state of domicile, and captives sponsor conferences," said Ken Carlton, a principal of Milliman Inc. and a consultant to captives since the late 1980s. "About 1,000 people attend a conference every summer in Vermont, and South Carolina has a couple of conferences a year."

In fact, interest in becoming a domicile has been growing so fast--and the disincentives are so minor--that all 50 states may eventually license captives. "We're certainly headed in that direction," Carlton said.

Attractive Alternative

Captives serve as an alternative to buying insurance on the open market. Rather than buy commercial insurance, companies with good risk management may opt to form their own insurance companies for the express purpose of insuring themselves, hence the name "captive." States serving as domiciles take on the tasks of oversight and regulation. Some depend on staffers in their insurance departments to handle the new tasks, while others hire professionals specifically to handle captives.

While captives require a new layer of regulation, it is usually not a big expense for a state. For example, Vermont, with 717 licensed captives at the end of last year, employs only 26 people for captive-related work. Twenty-one of them are examiners, whose salaries are mostly paid by examination fees, said Leonard Crouse, deputy commissioner of the state's Captive Insurance Division. The District of Columbia, a four-year-old domicile with 47 licensed captives, employs only four full-time professionals, though it wants to hire four more, according to Dana Sheppard, acting director of the Risk Finance Bureau. South Carolina employs 11 and augments them as needed with contract employees, department staff or consultants, said Eleanor Kitzman, department director.

To get started, states need to pass enabling legislation, but many have simply copied another state's law, Carlton said. Most then tweak the law each year as needed.

Small states stand to benefit most. Vermont, with a 2000 population of only 609,000, generated $20 million last year through its captive premium tax, about 2% to 3% of the general fund budget. "That's a big nugget," said Towle. "If I'm a big state, that's a drop in the bucket."

Vermont entered the captives business 24 years ago when people with homes in the state and involvement in the industry convinced legislators to pass domicile legislation. "At the time, captive business was almost entirely offshore," Towle said. "Colorado was the only domestic domicile. The thought was, let's pass it and see what we can do. Our first captive was B.F. Goodrich. "The rest is history," he added. "It's one of those industries that, for a state like ours, is almost too good to be true."

In 2004, Vermont's captives collected more than $10 billion ha gross written premium, close to the amount collected in the Cayman Islands.

Vermont's legislatures and governors, whether Democrat, Republican or independent, have helped the industry to flourish with consistent and attentive support, Towle said.

The industry supports about 1,400 jobs, most of which are high-paying positions with the state's 17 domicile management companies. Others are lawyers, bankers, accountants and actuaries. Within the past year, several captive managers moved to Vermont, including Ace, Liberty Mutual, HSBC and A.J. Gallagher.

Crouse said that Vermont keeps its standards high regardless of competition from other domiciles. It has had only two captives fail, both risk-retention groups that the state put into liquidation. One paid 90 cents on the dollar, and the other paid 100 cents. The state has periodically lowered its premium tax rate, most recently three or four years ago. Crouse said Vermont did not lower the rate for competitive purposes, but rather because premiums have risen so much over 15 or 20 years.

Lure of the Southwest

Arizona is one of the new, fast-growing domiciles. It launched its captive program in July 2002; this spring, it had 51 captives with four or five pending. Rod Morris, the captive administrator at the Department of Insurance, said the state employs only two fulltime professionals for captive work, but uses about 10 regulatory professionals part-time from the department. Most states use an independent captive division, "but we think having a check-and-balance system in the captive area makes good sense," said Morris. Arizona's department regulates $27 billion in insurance premium and employs more than 175, the largest among active domiciles. New York has a larger insurance department, but Morris does not consider that state an active captive domicile.

Arizona does not budget money to be an aggressive captive marketer. What's more, most parent corporations are in the East, and Morris suspects they prefer to domicile their captives in their region of the country. Most of Arizona's captives are in-state or from California, Texas, Washington and Oregon, with additional interest from the Midwest. The state does not impose a premium or income tax, has "very fair" capitalization requirements, and offers great experience among its regulators, said Morris. The state also offers licensing times as short as 10 days, a strong pro-business bias at the governor's level, and nine consecutive years of reduced taxes, he said. "And when it comes to the soft reasons for locating here, you can't beat us," Morris said. That includes world-class golf, several pro sports teams, the Grand Canyon, Sedona, inexpensive air travel, and a full range of hotels and restaurants.

In the beginning, the lack of a premium tax was probably the most important differentiator for Arizona, but Morris said other domiciles have started maneuvering to mitigate or eliminate that advantage. At first, Arizona attracted mostly smaller companies, but recently its customers have been much larger national and international firms. The state continues to attract lots of physician groups, hospitals and nursing homes due to the crisis in medical malpractice insurance, he said.

Encouraging Creative Approaches

The District of Columbia licensed its first captive in February 2001 and currently has 47 on its books. Progress was slow in the first two years, but has averaged about two new captives a month since then, said Sheppard. Bureau representatives and members of the district's captive association recruit by attending conferences such as Vermont's and the World Captive Forum. In many instances, captive managers bring clients to the district, Sheppard said.

The bureau, a part of the district's insurance department, has encountered competition in trying to hire four more examiners or analysts to review captives' annual and quarterly financial statements. That's because the Sarbanes-Oxley law on corporate conduct has caused accounting companies to step up their hiring, said Sheppard. The full complement of full-time bureau professionals will eventually be 10, he said.

To distinguish itself from other domiciles, the district last November replaced its original law with a new one that gives it more flexibility, in the segregated-account area. "Most of the jurisdictions require a sponsor captive to protect the cells, and it has to be another insurance company," said Sheppard. "We did away with the sponsor concept. Now any captive can form one or more segregated accounts. No other domicile will permit that. It gives us a leading edge in that area, and there's lots of interest in it."

Another feature of the new law allows segregated accounts to be separate legal entities, and a couple of companies have taken advantage of it. "We work with clients to understand what they want to do," said Sheppard. "We might recommend something slightly different, a structure that works for both parties, but we won't turn a client away just because we don't like a particular proposal. We like new things. In the alternative market, people are constantly coming up with new ways of doing things."

Interest also has been high recently in risk retention groups, primarily in medical malpractice for physicians, hospitals and nursing homes, and in construction liability among home builders in California and Nevada, said Sheppard.

The district has plenty of attorneys and accountants, and the bureau has approved 25 captive managers. But the bulk of the business so far has gone to only a few professionals, with three of the managers handling 80% of captive companies and two attorneys representing 75%, Sheppard said.

While 78% of Vermont's captives are pure, D.C. reports having 23 risk retention groups, 11 association captives, and only seven pure captives. It also has licensed four agency captives, a branch captive and three with segregated cells. Its captives are typically small, typically generating only $4 million to $5 million in gross premium. Last November's new law capped premium taxes at $100,000, which should prove an incentive for larger companies.

Pro-Business Perspective

With 119 licenses issued in less than five years, South Carolina has recently been the fastest-growing domicile. It ranks behind only Vermont and Hawaii in the total number of captives, according to Jim Kinder, president of the S.C. Captive Insurance Association. Last year, the state issued 40 licenses, be said.

What makes South Carolina competitive is a flexible but solid regulatory environment, seasoned and knowledgeable staff, a well-developed infrastructure of service providers, a low cost of entry and an attractive location, said Kitzman. While the state is very active in recruiting captives, it is not focused on winning any kind of licensing race, she said. "We're not looking to necessarily have the most captives as to have quality captives," said Kitzman.

Last year, the department's captive division generated $1.5 million in premium taxes and another $200,000 in tees. Kitzman said a dedicated portion of premium taxes funds the captive program. Economic activity related to captives generated an estimated $8 million in taxes, she said. The state has approved 12 captive managers, eight of which are based in South Carolina. Also on its approved list are 94 accountants, 100 actuarial firms, five law firms and several banks. Some 46% of the captives are pure, 42% are risk-retention groups, 6% are special-purpose captives, 3% are sponsored (rent-a-captive) and 3% are special-purpose financial captives. The captives range in size from a small RRG with $1 million in net worth all the way up to special-purpose financial captives worth hundreds of millions or billions of dollars. According to Kinder, this latter category is particularly attractive to small and medium-sized life companies that use it to move Regulation Triple X reserves off their books by securitizing the risk.

The state has been a pro-business environment since elected leaders eight years ago embarked on a path of deregulation in traditional insurance lines, and Kitzman said the legislature is very receptive to what the captive industry needs. "The major captive business is evolving, so legislation has needed to evolve," she said. "Each year, we've needed to go back to the legislature with modifications, and we've been very successful."

Active Vermont Captives
By Type

Risk Retention Group    14%
Industrial Insured       5%
Association              3%
Pure                    78%

Note: table made from pie chart.

Source: Vermontcaptive.com

Key Points

* Captive domiciles help to build the private sector and tax base by attracting high-paying jobs.

* Domiciles boost tourism through conventions, required in-state meetings and elevating interest in the state.

* Small states benefit most in that captive growth provides a proportionately greater impact.

Who's Who in Captives

CAPTIVE--An insurance company that primarily insures the risks of its owner and is actively managed by the owner and/or insureds. Assets of the captive are generally owned by the insured.

ASSOCIATION CAPTIVE--A captive that underwrites the risks of members of an industry or trade association.

RENT-A-CAPTIVE--A captive insurance company that provides access to captive facilities without the user needing to capitalize its own captive. The user pays a fee and must provide collateral.

SPECIAL-PURPOSE VEHICLES FOR RISK SECURITIZATION--Reinsurance companies that issue reinsurance contracts to their parent and cede the risk to the capital markets by way of a bond issue.

RISK-RETENTION GROUP--An owner-controlled insurance company authorized by the Federal Liability Risk Retention Act of 1986. An RRG will allow members who engage in similar or related business or activities to write liability insurance for all or any portion of the exposures of group members, excluding first-party coverages such as property, workers' compensation and personal lines. The statute allows a group to be chartered in one state, but able to engage in the business of insurance in all states in which it registers.

PURE CAPTIVE--Insures only the risk of the owner or the owner's subsidiaries.

Sources: South Carolina Department of Insurance, Vermont Department of Insurance, Illinois Captive & Alternative Risk Funding Insurance Association

The Captive Effect on Traditional Insurers

When significant businesses opt out of buying traditional insurance in favor of alternative means, as they have for nearly three decades, what is the ultimate outcome for insurers? Does it mean at some point the traditional market implodes?

To Rod Morris, captive administrator at the Arizona Department of Insurance with 35 years of insurance experience, that conclusion is not a prediction, but rather a matter of reality. "The best businesses don't have any alternative but to be smart enough and sophisticated enough to look at what the traditional market does to them," he said. "Eventually you reach that critical mass when there won't be much left but adverse selection."

Ken Carlton, an actuary and a principal at Milliman Inc., said the growth of captives will not necessarily cause commercial insurance writers to wither. A lot of major insurers have captive divisions, he said. They may provide services to new captives, thereby deriving fee income without taking on any risk. "It's been evolving over time," he said. "There's been a marked change in how commercial insurers do business."

"I don't see the captive arrangement as a competing model to the traditional marketplace," said Jim Kinder, president of the South Carolina Captive Insurance Association. "Sophisticated buyers will always seek alternatives. So while you may have a reduction in commercial premium, you have also a corresponding reduction in the liabilities. Traditional insurers gain because they have a lower overhead, and they can rate for adverse selection"

Eleanor Kitzman, director of the South Carolina Department of Insurance, said captives have little effect on the traditional industry because many are writing coverage that commercial insurers won't provide. Otherwise, the business taken away from traditional insurers by captives may cause commercial writers to become more competitive in their business models and pricing, she said. Once a captive is formed, however, the insured is less likely to re-enter the marketplace, but Kitzman said there can be exceptions, especially among smaller buyers. For example, if medical malpractice prices drop, some insureds might be tempted to go back to their traditional insurers, she said.