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Key Trends Identified in the Captive Market - Captive Insight 2015

02 December 2014

 
“Key Trends Identified in the Captive Insurance Market”
 

Ask any captive manager why they appreciate their industry and they will inevitably answer that the work is interesting and challenging as the industry is ever changing. With that in mind, the management of Global Captive Management, Ltd., one of the world’s largest independent captive managers with over 70 captives under management and based in the Cayman Islands, were asked to comment on the changes they have seen in 2014 and where they see trends going into the next year.

 
Group Captives
 

Jennifer Reid, Vice President at GCM with 10 years at the firm, oversees a broad spectrum of single parent and SPC structures in addition to specializing in group captive structures. Ms. Reid notes that while premiums and members shrank dramatically in the 2008 and 2009 years following the market downturn, 2013 and 2014 have seen a dramatic increase in the number of members within the group captives GCM manages. Upticks in premium rates within the U.S. have seen Companies again look towards stabilization of their premium rates within the group captive structures. And with a focus on risk management, groups have realized significant dividend returns on their contributed loss fund premiums which is also appealing to those in the traditional market. Ms. Reid noted that brokers are beginning to look at companies which, in the past, may have been deemed too small to join a group captive structure. Reduced retention levels and modified risk sharing methodologies are all being explored.

 

Even in a softening market, Group captives will continue to appeal to those industries that are not properly catered for in the traditional market.

 

Segregated Portfolio Companies

 
Monique MacDonald, Senior Vice President at GCM, has over 16 years of experience in the Insurance Industry in the Cayman Islands and has been with GCM for 10 years.  Mrs. MacDonald oversees on-going operations and client management, including new captive formations.
 
Mrs. MacDonald notes that an increasing number of GCM’s   captives are expressing interest in converting to or forming a Segregated Portfolio Company (“SPC”) structure.  These newly formed or converted captives cover a variety of industries and insured risks, including healthcare, retail, annuities, and surety bonds.  One factor for this impetus is the desire to offer segregated portfolio structures to affiliated entities or third parties who would like to procure risk coverage through a captive structure with the added benefit of reduced capital requirements for the cell (since it would only have to fund its own risks) and shared operating costs.  And even though the cells within an SPC are not separate legal entities, the SPC structure legally separates both the assets and risk of one cell from another. 
 
Other entities utilize a SPC structure so that they will be well positioned to form a Portfolio Insurance Company (“PIC”) once the regulations are finalized.  The PIC concept is the Cayman Islands’ version of incorporated cell companies whereby a new or existing SPC can incorporate a PIC on behalf of a relevant cell or segregated portfolio.  The PIC, instead of the segregated portfolio, would then conduct the relevant insurance business.  Unlike the traditional segregated portfolio or cell, a PIC will be a separate legal entity (i.e., an exempted company limited by shares).  
 
Healthcare Captives
 

Mrs. MacDonald further notes the U.S. Healthcare industry has been in a state of transformation with mergers, acquisitions, joint ventures and even alliances of large, medium and small size systems.   These changes at the parent level can dramatically affect the structure of their related captives.  In the past year, GCM has seen captives merge following the merger of their parent systems with the result being placement of combined risk coverage  in the surviving captive.  GCM has also had a captive transform into an SPC in order to offer coverage to third party entities with which it has formed an Alliance.   The effect of these transformations is that healthcare systems can collaborate to enhance their risk management initiatives, share coverage of insured risks, enter into group purchasing agreements, and generally leverage their strengths and captive programs to better deal with a changing healthcare industry.    
 
U.S. Tax Developments
 
Ian Bridges, Vice President at GCM, has over 12 years of captive management and U.S. tax advisory experience.  Mr. Bridges manages a number of for profit and not for profit owned captives and liaises directly with clients on matters of tax concern.  Additionally he is tasked with the further development of the GCM brand in the United States in States such as South Carolina and New Jersey.  Mr. Bridges points out a number of important U.S.  tax developments in 2014 below, emphasizing his interest in the impact of these developments on 2015. 
 
Mr. Bridges begins by noting it did not take long into the year before there were some significant developments.  In January a majority of the U.S. Tax Court in Rent-A-Center v. Commissioner, 142 T.C. 1 held in in favor of the taxpayer that workers compensation, automobile and general liability premiums, paid to its captive insurance company on behalf of other wholly-owned subsidiaries, were deductible for tax purposes as insurance premiums.  One of the many issues in the case was the concentration of risk within a small number of approximately 15 affiliates not to mention a limited parental guarantee on the captive’s deferred tax assets.  The Tax Court disagreed with the Service in that there was adequate risk distribution based on the number of store locations, employees and vehicles and not just the number of insured entities as outlined in Revenue Ruling 2005-40 and Revenue Ruling 2002-90.  Interestingly the IRS did not appeal the case.  In Mr. Bridges’ experience small to medium sized companies looking to set up a captive insurance solution often have issues with meeting the IRS’ risk distribution safe harbors. 
 
This case could have a significant impact on the future formations of captives who are seeking to meet the IRS’ view of risk distribution in so much that a pooled risk facilities may become obsolete since companies may now be able to rely on a more actuarial view of risk distribution, as prevalent in Rent-A-Center, rather than the IRS’ safe harbors.
 
Revenue Ruling 2014-15 was issued by the IRS in May.  In the ruling the IRS concluded the reinsurance contract between a third party insurer, for a noncancellable accident and health policy purchased by an employer’s Voluntary Employee’s Beneficiary Association, and the employer’s captive subsidiary qualified as insurance. Insuring certain employee benefits in a captive is often seen as a solution to increase the distribution of risk within a captive.  Employee benefits, and specifically retiree health benefits, continues to be of growing interest to many new captive formations and this revenue ruling should certainly generate even more interest. 
 
July 1, 2014 was the effective date for the Foreign Account Taxpayer Compliance Act (“FATCA”) withholding on fixed, determinable, annual and periodical income payments to non-participating Foreign Financial Institutions (“FFIs”), Non-compliant Non-financial Foreign Entities (“NFFEs”) and recalcitrant account holders. 
 
Mr. Bridges noted it was critical for off shore captives to reduce their exposure to FATCA withholding and as such GCM captives engaged various tax providers to assist with this compliance.  In so doing most of GCM’s captives, which had not made the “on shore” election under Internal Revenue Code Section 953(d), were determined to be passive NFFEs and were required to provide their U.S. withholding agents including banks and fronting companies  Form W-8BEN-E.  Due to the timely receipt of the forms to date by the U.S. withholding agents there have been no incidents or FATCA withholdings for GCM clients. 
 
Investment Income
 
Peter MacKay, Chairman of GCM, and with the Company since its inception in 1982, notes one of the key issues affecting captives of all sizes, regardless of domicile, is how to garner sufficient returns from loss reserves and premiums in the current ultra-low yield environment. Costs continue to rise while returns on assets continue to be challenged on the back of the historically-low interest rate environment. GCM has seen an increasing number of captives reviewing their investment policy to ensure that they have the right strategy in place to maintain acceptable returns while maintaining their conservative risk profile.
 
Whereas bonds have previously been used for income, matching income receipts against claim payouts, they must now be viewed as capital preservation vehicles. A captive portfolio fully invested in fixed income securities would be negatively affected in a rising rate environment, as bond prices will fall.
 
This change in investment strategy has taken on a number of forms ranging from captives increasing their exposure to equities as a percentage of their overall portfolio exposure, to captives also investing in lower investment grade fixed income securities which yield a higher investment return. Investment managers have also been trending towards shorter duration fixed income securities which will be less sensitive to any future interest rate increases.
 
From an equity standpoint, some investment managers are championing equity investments which will provide regular investment returns by way of dividends payments.  
 
As captive manager, GCM is always assessing the affect that any changes to the investment strategy have on our captives’ collateral requirements and availability of liquid assets for settlement of claims.
 
GCM has also seen a trend of investment managers providing tailored investment platforms for small to medium sized captives who previously would not have had the required asset base to invest in these portfolios. This has allowed these captives to boost returns as the returns currently available from fixed term deposits are minimal at best.
 
The Road Ahead
 
Overall, the insurance and captive market continues to evolve as risk management programs are continually enhanced by efficient and effective alternative risk solutions. 2015 will see continued change as captives continue to work with their services providers to enhance the solutions they provide to their insureds, all while striving to maintain cost efficiencies and improve their bottom lines. The ability to change is what makes the captive industry interesting and challenging to those that work within it.