A chain-smoking gentleman invented a new way to manage corporate risk in the 1950s. Fred Reiss’ revolutionary idea led companies to form their wholly owned insurance carriers and carry risk on their own balance sheet, but under the insurance legislation. This enabled them to more easily transact cross-border transactions, form insurance technical reserves and put pressure on the domestic retail insurance market.

Since then, this idea has become a multi-billion dollar industry and in excess of 6,000 captives serve their owners in mitigating volatility inherent in their business. The US led this initiative and European companies started to form captives on a wider front in the 80s. As domestic insurance legislation was not geared up to these specialised ventures, captives were more often than not formed in small countries like Luxembourg, which adopted their insurance law to fit captives. Alternatively, these corporate owned insurers were formed offshore in locations such as Guernsey and the Isle of Man. In the early days, tax considerations were one of a multitude of criteria for forming a captive, but this reason is less important in today’s transparent and regulated world. Today you will more often see that captives are being formed in the home jurisdiction of the owner.

The price for capacity in the insurance market moves up and down in cycles of roughly seven years. When a hard market approaches, corporate buyers of insurance tend to set up their own captives to escape the strangling pressure from retail insurers. However, these captives are rarely abandoned in soft markets, since the captive owner by then has realised the vast benefits of their insurance vehicle. They realise that they, for instance, can house un-insurable risk in their own company and that they have access to the global reinsurance market instead of just discussing with their local insurer. By syndicating their risk, they will find specialised underwriters in far-away countries, who are keen to take on a part of their exposure.

Captivating growth
Today, you will find not only the global Fortune 500 company with a captive, but increasingly if not small, but definitely medium-sized companies operate a captive successfully. You will also find associations, universities, municipalities and state-owned entities among captive owners.

The large incumbent insurers have thousands of co-workers and one could believe that operating an insurer would be too cumbersome for an investor not part of the industry.

However, the vast majority of captive owners outsource the management of their companies to professional service providers, which provide a tailor-made service and use the economies of scale to bring down friction cost.

Looming threat
One major threat to the industry is the overwhelming regulatory burden that financial service companies are faced with. The up-coming new European solvency regime, Solvency II, has certainly an impact when it comes to new captive formation. The captive community challenges law makers and claim that their insurers are not a threat to the public since they typically only insure their parents’ risk.

Despite various dark clouds on the horizon, the industry is growing at a healthy pace. By learning how the insurance market operates, the large buyers of risk transfer will take a more efficient decision than if they just rely on the domestic retail market.

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