Growth, Emerging Risks, Innovation, and Taxes Among Captive Hot Topics

Fueled by the hard commercial insurance market, the captive insurance industry continues to demonstrate significant growth. As it does, however, industry participants must navigate a number of key issues and developments such as market developments, regulatory changes, and tax issues.

Those "Hot Topics in Captive Insurance" were the subject of an expert panel Tuesday during the Captive Insurance Companies Association (CICA) 2022 International Conference.

"We've really seen captive growth expand through the pandemic," said Paul Shimomoto, partner at Goodsill Anderson Quinn & Stifel.

Nancy L. Gray, regional managing director—Americas for Aon Captive & Insurance Management, acknowledged the unprecedented captive growth in 2021 on the heels of another year of significant growth in 2020 but said the number of new formations doesn't tell the entire story. In the face of a hard commercial market and challenging risks, the past 2 years have also seen expanded use of existing captives and more cell formations, Ms. Gray said.

Before the commercial market began hardening in 2019, "The soft market was so prolonged you were seeing some companies start to close down, some smaller group captives," said David Provost, deputy commissioner in the Captive Insurance Division of the Vermont Department of Financial Regulation.

In contrast, in 2021, "The big number was the net growth," Mr. Provost said. "Very few captives closed down last year in Vermont."

“I think '22 is going to be another big year," Ms. Gray said, citing the number of captive feasibility studies Aon is currently working on and the number of clients that are involved in captive insurance discussions.

"What's interesting with this hard market cycle, there's not one industry sector that we're seeing grow," Ms. Gray said. "This time, it's across every sector."

Cyber risk is probably growing fastest in terms of lines of coverage in captives, Ms. Gray said, with property coverage ranking second.

"The closest thing we had to a trend in Vermont was we saw a number of segregated cell companies form for cyber, specifically by [managing general agents]," Mr. Provost said.

Captive redomestications are a fairly constant factor in the industry, with a few every year, Mr. Provost said. Over the course of Vermont's history as a captive insurance domicile, the state has probably seen 100 captives move in from other domiciles and a similar number move out, he said.

"We see that all the time," Mr. Provost said. "We have a few redomestications every year for a variety of reasons." With the number of states that now have captive laws, some captive parents whose captives are domiciled outside their home states might decide "We might as well go home," Mr. Provost said.

Captive insurance has consistently been fertile ground for innovation. Among the latest examples are moves to allow captives to use parametric contracts in assuming or ceding risk. An amendment to Vermont's captive law would allow Vermont-domiciled captives to engage in parametric risk transfer.

"It's one more tool and a pretty neat one for specific circumstances," said Mr. Provost.

In terms of a regulatory approach to captives using parametric contracts, Mr. Provost said, "I think the most likely scenario is that the captive will be ceding the risk instead of assuming it, so we'll treat it like reinsurance."

While parametric-based risk transfer contracts offer the advantage of speedy payouts after an event compared with traditional indemnity insurance, there is an issue of basis risk—the possibility that the parameter triggering a payout in the contract doesn't align properly with the insured's loss experience.

Joel Chansky, consulting actuary at Milliman, Inc., noted the importance of considering basis risk in parametric risk transfer deals.

"The interesting thing with parametric is you could hit the trigger and get a check and not have a loss," Mr. Chansky said. "Or you can get wiped out and not hit the trigger." So, it's necessary to be careful in defining the triggers underlying parametric contracts, he said.

Mr. Chansky also discussed the impact of inflation on captives' reserving and setting premiums.

"Rating and reserving in an inflationary environment are very interesting," he said. Persistent high rates of inflation could leave captives under-reserved, Mr. Chansky said.

"If inflation is persisting at 5 percent to 7 percent, you want to revisit those reserves," he said.

The panelists also discussed current tax issues in captive insurance. Mr. Shimomoto noted the Internal Revenue Service (IRS) continues pursuit of so-called micro-captives, small captive insurance companies opting to be taxed under Section 831(b) of the Internal Revenue Code, which allows them to be taxed only on their investment income.

While the IRS has been aggressive in challenging micro-captives in Tax Court, those cases have done little to shed light on what the IRS might consider an appropriate micro-captive structure, Mr. Shimomoto suggested.

"I don't think any of the recent court cases have helped us figure out what is or isn't important," he said.

The panel also discussed the IRS's efforts to obtain captive records from the Delaware Department of Insurance to determine whether they are legitimate insurance businesses. Delaware has challenged the effort, citing the state's confidentiality statute.

While the IRS successfully defeated Delaware's challenge in a lower court, the state has appealed that judgment.

"It seems like the IRS, rather than trying to fight one captive at a time, they're trying to go at it systemically," Mr. Provost said.