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Article written by Malcolm Cutts-Watson as a member of the Labuan FSA’s International Advisory Panel. Read the article in the Labuan Resource Centre here
The start of a new year is always a good time to reflect on the previous year and assess the opportunities and challenges that might arise in the forthcoming year. Following a year of severe natural disasters and highly publicised cyber breaches, it is understandable that organisations are reviewing their risk financing strategies and in particular the role their own captive (re)insurance company can play in managing risk.
Review of 2017
2017 year end captive statistics were not available at the time of writing, but I predict the trends of 2016 will have continued into 2017. So we can expect new captive formations to be on a par with 2016’s number of 616 (disappointingly only eight of these are Asian owners). This will bring the total number of captive vehicles worldwide to around 6,750, albeit many of entities contain cells (effectively mini captives) so the true number is closer to 7,500. So, there is continued steady growth despite the insurance market remaining soft (which anecdotally is an inhibitor to captive formations).
Interestingly, the majority of owners of newly formed captives fall outside the Fortune 1000 and is dispelling the myth that captives are only for large corporations. My assessment is that captives are formed for strategic reasons rather than purely arbitraging the insurance market.
The number of territories offering bespoke captive legislation continued to increase, with over 70 domiciles now in play. More choices for the consumer but this increased competition could lead to a risk of lowering regulatory standards and inadequate local business infrastructure.
The off (and mid) shore jurisdictions continue to demonstrate greater innovation and flexibility to deliver new products and services. The role of captive technology in the insurance-linked securities (ILS) and longevity risk space continues to grow and we are witnessing the evolution of captives beyond simple risk retention. Currently ILS structures provide 10% of the global reinsurance capacity, and this is expected to reach 15% in 2018.
Any review of the year would not be complete without consideration of regulatory and fiscal regimes! Globally there is a shift to risk-based regulatory regimes and captives have not been immune. The upside is increased confidence in the resilience of the captive model through improved solvency (i.e. capital) and an enhanced governance and management of business risk. The downside has been additional capital commitments, increased running costs and additional bureaucracy. Given consumer protection and the collapse of financial markets are perils that rarely apply to the regulation of captives, the secret appears to be applying a regulatory regime that is proportionate to the risks captives pose. In the case of the EU, the Solvency 2 regulation applied to captives appears to be overkill and the supposed proportionality to be applied by regulators, illusionary. The end result has been a number of captive exits.
The full implications of the OECD’s BEPS initiative are beginning to reverberate around the globe. There is now a recognition that this measure has “legs” and territories and corporations are having to review their business models and amend as necessary to achieve compliance. This, and the need to adopt other global standards, may be behind the recent announcement by the Governor of the Central Bank of Malaysia and the Chairman of Labuan Financial Services Authority (Labuan FSA), Datuk Seri Muhammad Ibrahim where he advised the Labuan International Business and Financial Centre (Labuan IBFC) needed to reinvent itself and that the BEPS initiative would influence the Labuan IBFC’s business model. Again, the secret seems to be to effect sufficient change to achieve compliance without impairing the nimbleness and innovative thinking of the finance centre.
Preview of 2018
Basically, it is more of the same. The above review gave some hints as to the direction of journey.
Will the insurance market harden as a result of 2017 disasters? January 1 renewals suggest not. There is still plenty of capital to support risk takers and improved penetration rates in emerging markets are generating profitable business. Expect to see a better understanding, and improved modelling of risks. With this information, insurance buyers will be able to determine the optimum balance of risk to be transferred or retained. Increased retentions will drive captive growth.
Growths of US captives will slow due to tax challenges over the pricing and coverage offered by smaller captives (the so called 831b captives). However continued use of cells in protected cell captives will drive growth in the SME sector.
I expect to see more Asian-owned captives incorporated. Growth will be driven primarily by China, and in particular investment in non-Chinese located assets. I still stand by my prediction regarding Chinese captives; 200 captives generating USD20 billion premium in 10 years’ time. But other countries in the region are also demonstrating an increased awareness of risk management and the total cost of risk and this will lead to captive formations.
Domiciles that fail to respond to the changing governance landscape will lose business and ultimately become irrelevant. To be a successful and future-proofed financial centre, accreditation of global standards of conduct is essential. We have just seen the release of an EU blacklist of unacceptable financial jurisdictions and this will lead to diminished business from that region. Expect similar announcements from supranational organisations.
Continued scrutiny as a result of the BEPS initiative will lead to pressure on finance centres to adopt improved transparency and eliminate carve outs in fiscal policy. As discussed, Labuan IBFC has recognised the need to evolve. Paradoxically, more US States will pass captive specific legislation, offer light touch regulation and attract indigenous business as they appear immune from global scrutiny.
A barrier to the growth of off (or mid) shore captive jurisdictions are territorial restrictions on exporting capital and premium. Should these trade embargos be lifted, possibly through some form of Asian regional trading and mutual tax agreements, then this would be a catalyst to new captive formations.
The importance of the capitals markets to insurance risk will increase with the continued success of ILSs issued out of a captive structure. The reinsurance market no longer views this as a threat but as a complementary offering, comparable to how insurance markets now view captives. To date, risk transferred to investors via ILSs has been predominantly natural catastrophe cover, look out for new risks being offered to the capital markets. The use of captives to remove longevity risk from pension and annuity providers will continue apace.
Now, for the exciting part.
I see captives providing the perfect risk financing structure for territories facing similar natural perils. There are examples of this in the Caribbean, South Pacific islands and African nations. Risks are pooled into a captive vehicle and excessive risk cost efficiently transferred out to reinsurance or capital markets. The captive delivers a low cost robust operating platform and a solid governance framework (essential if a supranational organisation is financing the venture).
Another development that excites me is the use of a captive vehicle to facilitate micro insurance, making insurance protection available for the first time to a large sector of the market that previously had not been in a position to buy cover.
Using mobile phone apps and block chain technology it is now possible to collect small value premiums on a weekly basis without incurring heavy distribution costs. In turn, a simple-to-understand insurance policy can be issued, with claims settled automatically using predetermined trigger points.
Again, the captive offers a low cost operating platform and a strong governance framework. This type of product would be especially valuable for farmers and tradesmen in emerging territories and could form part of an impact investing offering which is gaining increasing traction in the wealth management world.
The global captive industry is robust and healthy with many opportunities to expand. However the standard captive model may need some changes so that it can face up to external scrutiny. To me it comes down to adopting a captive business plan that:
- States the rational for, and strategy of, the captive and lays out a road map to fulfil
- Demonstrates fair pricing of the risk
- Delivers substance
- Provides proper governance
- Assesses the value the captive generates
After four decades in the industry and business, I continue to be amazed at the resilience and creativeness shown by the captive community. I see no reason why this should change going forward!