1 January 1970

The value of experience

There’s no denying it, the Bermuda captive industry is currently enduring a spot of turbulence. The prevailing ill winds of the global financial crisis seem to have blown the Island’s settled insurance industry slightly off course. Consider the rise to prominence of the alternative domiciles, sensing a dip in dominance. Or the winding-up orders facing a number of middle-ranking captives. Or even the threat from onshore of new legislation designed to clip the industry’s wings. But not for nothing has Bermuda sat perched at the top of the tree for all these years. Steady, focused application of the principles of business that made it the market-leading domicile should see it through again. But at what cost?

"In response to the insurance market, companies are now looking for effective use of their capital and to reduce their costs."

A recent phenomenon raising eyebrows within the Bermuda Insurance Managers Association (BIMA) and the Bermuda Monetary Association (BMA) is the number of captives that have received a notice of dissolution from their parent companies. The feeling among the onshore contingent is that the current soft insurance market and the residual effects of the financial crisis are squeezing lines of capital previously available to them. Their only option appears to be to cash in on their Island investments. Peter Willitts, president of the BIMA, explains: “In response to the insurance market, companies are now looking for effective use of their capital and to reduce their costs.” It’s a situation not just confined to the Island. Domiciles all over are seeing parents shut down captives to release capital or, in some cases, ratchet down operations to reduce running costs. But what is really happening here? The answer is a search for efficiency.

“Where companies have previously held on to captives that weren’t overly active,” continues Willitts, “they are reducing capital to aminimum or liquidating them. While that may affect the overall number of licensed captives on the Island, the underlying message is that those that do remain are part of a very active body.”

The sectors that are being hit hardest by the economic slowdown are typically the ones that are shedding their captives. So property, construction and professional liability carriers seem to be the ones purging the most.

There is a view currently being mooted around the industry that while it’s a sad indictment to have to shut down captives in the current market, there’s nothing to stop a company setting up a replacement when things pick up. After all, the current regulations surrounding captives, which are favourable in many jurisdictions, and the expertise of the workforce would make it a relatively straightforward exercise.

This seems to be an opinion shared by some notable new arrivals to Bermuda. “We have seen six managing general agents and six brokerage firms start up in recent weeks,” says Willitts. “This would suggest that the insurance industry is very much alive and kicking.” Indeed, despite the recent culling, 42 new captives were set up in 2009.

They were split fairly evenly among the different classes, which themselves went through a recent reclassification process. The suprise is that of the captives that fall into Class 1, i.e. those that are wholly owned by the parent or its affiliates, a number were set up to insure risk in property, professional liability and trucking—areas that have felt the full force of the downturn. What this suggests is that there are some companies out there that are hard-wired to take on board the risk.

Rules for engagement

But how will these same companies react to the proposed legislation, chief of which is the imposing Solvency II equivalency currently being prepared by the BMA? Solvency II, due to come into effect in2012, is an EU-based update of regulatory requirements for insurance firms. Its stated intent is to harmonise each member state’s insurance legislation into one single market. The equivalency legislation in Bermuda is an attempt at regulating the Island’s insurance industry to ensure it can fit in with the new directive and maintain its presence on the global stage.

No one in Bermuda knows quite how it will play out when it arrives, but it already has a few teething issues to overcome. “It is difficult to see how we can achieve equivalency, as we have a reinsurance market that needs to be controlled one way and a true captive market that needs to be controlled in another,” says Willitts.

Rick Irvine, a tax partner with PricewaterhouseCoopers, also notes how Bermuda is unusually susceptible to the effects of equivalency. “One question that Solvency II equivalency raises is whether Bermuda will apply Solvency II to all its Class 4 or Class 3 companies, which are typically commercial books versus captives. I believe it’s leaning toward commercial companies only.”

"The issues with the economic meltdown had very little to do with the captive market and a lot to do with the failure of onshore regulatory regimes in understanding what was going on."

Another area of concern for the Bermuda captive industry caused by the move toward equivalency revolves around the fact that a proportion of captive parents are based in Europe. This means that some parent companies may decide to cut their losses and pull out of the Bermuda market altogether. It will certainly have some impact. Irvine explains: “If an EU member is subject to Solvency II and there is no exemption for captives, then it creates a situation where the reason the captive exists is purely regulatory. In other words, captives based in Bermuda are there partly to escape regulatory rules imposed by the Financial Services Authority or the National Association of Insurance Commissioners, so if Solvency II becomes the threshold in the EU, you’re back to square one.”

Solvency II is just one of a few pieces of onshore legislation that may have an impact on captives. Of the major ones, there is the Neal Bill, which seeks to target related party reinsurance transactions between US insurers and those outside the US. In addition, the Levin Bill, known as the Stop Tax Haven Abuse Act, and the Foreign Account Tax Compliance Act are giving tax specialists a lot to think about. Even though they are not targeting captives directly, they have been written in broad enough terms to have some impact.

Irvine, however, holds the view that these laws are perhaps unnecessary. “I believe that common sense will ultimately prevail and recognise that the issues with the economic meltdown had very little to do with the captive market and a lot to do with the failure of the onshore regulatory regimes in understanding what was going on.”

In the meantime, it’s business as usual in Bermuda. The rising number of decisions to close captive operations may have attracted media attention, but when you have been as successful as Bermuda has, you learn to take the rough with the smooth. Willitts shares his optimism. “The thing that attracts companies to Bermuda is specific bits of the market and opportunities. So what’s in trouble? The property market and professional liability market. We’re picking up deals in both these areas. We recently welcomed a captive that relocated from Hawaii, which was pleasing. I think it would be fair to say that we’re in decent shape, all things considered.”