Slicing the Alternative Pie.

While Vermont anticipates the licensing of its 500th captive, new domiciles are vying for a share of the alternative-market business.

The captive insurance industry is seeing a flood of new interest--both from companies seeking to set up captives and from states looking to get a piece of the action.

The industry is constantly evolving, as are the opportunities and regulations that surround it. In the race to get involved in this industry, states and companies are creating new uses for captives in an effort to find the next big market. But the trick for states is making sure their regulatory infrastructure is strong enough to accommodate captives, while the companies looking to set up captives have to make sure they abide by the rules that are already in place--both on a state and a federal level.

Vermont--the leading captive domicile in the United States, and No. 3 in the world, according to A.M. Best Co. data--recently hosted the Vermont Captive Insurance Association's 16th annual conference. State regulators who spoke at the conference warned that while the outlook for growth in the industry is very good, captive domiciles must be sure their regulatory infrastructures are prepared to keep up.

"I think the next year or so will be the busiest time we ever saw, based on market conditions and what I am hearing from managers," said Leonard D. Crouse, director of captive insurance for Vermont's Department of Banking, Insurance Services and Health Care Administration. Crouse was among the speakers at the conference, which was held in Burlington, Vt., on Aug. 8-10.

Vermont, which was expecting to announce the registration of its 500th captive soon, should be able to continue its recent pace of adding 20 to 25 captives a year, Crouse said.

Laying the Groundwork

Crouse said the current hardening trend in the traditional insurance market, with its attendant higher premium rates, should mean good business for alternative markets. But he cautioned that the growth in the captive industry, along with the interest shown by many other states in hosting captives, may bring problems.

"We certainly welcome competition from other states," Crouse said. "But we would say, if you want to be successful (as a captive domicile), don't move too fast. Build up a reputation and do it right."

Vermont's insurance commissioner, Elizabeth Castle, said the "landscape in the United States has changed" dramatically in the past 20 years, as there are now more than 20 captive jurisdictions. "Fundamentally, I think this is a good development," Costle said.

But she warned that a state considering becoming a captive domicile must not let economic development lead the way.

"Captive legislation can be good for economic development, but you have to have the regulation to back it up," she said. A state must have the willingness to be firm and diligent in its regulatory oversight of captives and never forget that financial strength is the most important feature for a successful captive, she said.

According to A.M. Best Co.'s 2001 edition of its Best's Captive Directory, published in association with Tilling-hast-Towers Perrin, Vermont had 381 captives at year-end 2000, followed by Hawaii with 73 and Colorado with 21. Worldwide, Bermuda had 1,405 captives at the end of 2000, according to A.M. Best data. Cayman Islands hosted 535, followed by Vermont, then Guernsey with 370.

New Kids on the Block 

As Vermont celebrated its 20th year as a captive domicile and eagerly anticipated the registration of its 500th captive, more than 20 other states, most modeling their legislation on Vermont's, are looking for similar success.

The nation's capital is one of the new kids on the block, having registered its first and only captive in November 2000 and finalized its captive regulations early this year. But Washington, D.C., is sitting on a potential gold mine of a niche in the captive industry.

Lawrence H. Mirel, the district's insurance commissioner, said his department hopes the estimated 6,000 associations based in and around the district will provide a rush of captive business in the near future, "We have all those associations in the area that could be a great source of business," he said.

In fact, the district's lone captive is an association-run entity--the American Medical Association's National Capital Reciprocal Insurance Co. "It was created by the medical association to provide medical malpractice and other coverages for physicians," Mirel said. "I think they plan to do some other interesting things for the medical profession through some new offerings."

Derick White, assistant director of captive insurance for Vermont's Department of Banking, Insurance, Securities and Health Care Administration, agreed that Washington is in a good position for future business. "The District of Columbia may become a leader in the niche for associations," White said. "If D.C. can capture just 10% of that potential market, they'd become one of the biggest domiciles."

Mirel said he agreed with Vermont Gov. Howard Dean, who in his opening speech at the conference touted states as small and flexible enough to accommodate captive business, as opposed to the federal government, which is too big and bureaucratic.

Costle also defended state regulation. "The captive industry would be very small under federal regulation," she said. "Big insurance lobbies have the stage!'

Tax Challenges

Even if states retain control of captive regulation, abiding by the federal tax codes still will be a challenge for captive managers and regulators alike.

Tim Collins, technical adviser on captive insurance for the Internal Revenue Service, stressed that the IRS considers the motivation behind a captive risk transaction when evaluating its propriety on a tax basis. "We look at capital adequacy, claims-paying and the existence of a financial guarantee from the parent, which is a smoking gun," he said. "Basically, if you wanted to be treated like an insurance company, you have to act like an insurance company."

Mark Anderson, a partner with KPMG, said the captive market is changing rapidly, and along with it the tax rules. "We probably had more federal changes in tax law involving captives this year than at any other time," he said. "Taz results are just one of many variables to be taken into account when contemplating risk transactions. There's no harm in trying to structure it in the most tax-advantageous way possible."

The primary concern for the insured in a captive transaction is whether the transaction is tax-deductible, Anderson said. "These issues are not in black and white. The case law involved is still being developed," he said.

Staying Competitive

Once a captive is established, it can be used for several purposes other than that for which it was created, a panel of experts told an audience at the Vermont captive conference.

The alternative uses vary depending on the particular needs or challenges faced by their parents. Carl Groth, managing director of enterprise-risk strategies for Willis Risk Solutions, said some of the uses are in an experimental stage. "We're just starting to see some of these uses," Groth said. "Some of these are a whole new game."

Robert Curtis, senior vice president of MG Risk Finance, said enterprise risk is one of the most common ways in which captives are used. "We are starting to see a lot of activity on enterprise risk," he said.

Buyout of liabilities is another area where captives come in handy, Curtis said. "Everyone wants to figure out a way of mitigating their exposure to downturns in the stock market. Also, there are environmental, asbestos and other such exposures."

William S. Troy, director of alternative-risk services for Safety National Casualty Corp., said captives also can be used to convert a qualified self-insured program to a captive, so the parent can gain access to accounts in contiguous states and avoid multi-state approval processes.

A fronted loss-portfolio transfer, which involves closing out liabilities, obligations and activities of a self-insured program, and a fronted excess workers' compensation policy, which allows the captive to act as a "buy-down" reinsurer, are other uses for captives, Troy said.

Reactivation of a dormant captive in a hardening market is another good strategy, Troy said. One of the advantages of bringing a dormant captive back to life, he said, is that it can be used to smooth out hard and soft insurance cycles.

The Next Big Market?

But the industry has its eye on one use for captives in particular--employee benefits.

Vermont's captive director Crouse said he expects a host of other companies to jump on the captive bandwagon to fund employee benefits.

"It's been a hot topic for four or five years," Crouse said. "I truly believe employee benefits will be a driving force in the next year or two in the captive industry."

Jim Ostertag, retired risk-management specialist for Columbia Insurance Corp. of Herndon, Va., said the federal government will allow captives to write employee benefits if at least 50% of their business is done outside of their parent industry.

Ostertag, who was also vice president of Columbia Energy Insurance Corp., was involved in the creation of Columbia Insurance, which set a precedent by winning approval from the U.S. Labor Department to underwrite long-term disability insurance.

Columbia Energy's winning of an individual exemption from the Labor Department to fund employee benefits through a captive was a watershed event for captives.

"We believe the financial-reporting requirements of a captive inherently make it a more efficient way to fund employee benefits than a traditional self-insured plan," Ostertag said.