As the appetite for captives diminishes, James Sullivan weighs up their future and investigates alternative risk management methods

In recent years captives have been one of the hottest products around.

The amount of business placed in captive entities grew substantially, spurred on by the hard market and concurrently large deductibles.

According to Aon, for example, the size of managed captives by premium increased from just over $12bn (£6.5bn) in 2002 to $20.2bn (£10.9bn) in 2004.

Yet predictably with the onset of the soft market, certainly in property if not quite as much in casualty, the attractiveness of the captive option has once again waned.

Companies detracted by the cost and bureaucracy involved in establishing alternative risk management structures are once again playing safe with the purchase of cover through more traditional means.

"There has been a lot of activity with existing captives placing more risk in the past couple of years, but that's beginning to soften now," says Nick Wild, a partner at JLT Risk Solutions.

But he says the softening cycle turning will not necessarily lead to a large-scale withdrawal from the captive sector: "As the market softens, those (captives) that have formed don't go away - they normally ride out a couple of cycles to assess the benefit."

He says that with the current soft market conditions and the erosion of some of the tax advantages for captives in recent years, alternatives are proving attractive for those companies still unwilling to return to the traditional buying pattern.

According to Wild, a particularly popular current alternative is the use of a protected cell company (PCC).

A PCC is essentially a corporate entity that holds assets in one or more segregated cells, in order to separate the assets in each cell from those in the others.

Stepping stone

In this way companies perhaps not large enough to form a captive in their own right may, for example, use captive-type structures.

"The protected cell company is an easier route and has lower costs associated with it," says Wild.

"It's a sort of 'suck it and see' approach. People use it as a stepping stone to setting up a full captive."

Based in the captive centre of Guernsey, Wild claims the domicile is "still doing very well ... there's been a lot of growth in protected cells, while pure captives have gone back a bit."

But he adds: "The statistics don't tell you everything. For example, although there are fewer captives, many companies with two or more have merged them into one larger entity, while others have closed down theirs and opted for a 'rent a captive' (PCC) approach."

Brian Soutar, chairman of Heath Lambert's captives division, also acknowledges the benefits of the protected cell route as an efficient means of managing risk: "Cell companies are a growth area because all your assets and liabilities are ring-fenced.

"You can also capitalise them through letters of credit, and you don't have to appoint directors and attend board meetings like you would do with a captive, so it's not as time-consuming."

Company attitude

Others believe that despite the benefits of PCCs, there is no hard and fast reason to abandon captives at present.

Stefan Ward, managing director of NIG subsidiary All Risk Management, stresses that it's all down to the individual company's attitude.

"If you are managing a captive it's in your interest to manage the risk because your investment income is at risk. So in order to make a profit you have to manage the risk properly. It's very much a cost-benefit analysis."

Nonetheless, he acknowledges that the costs of setting up a captive are significant: "It involves a lot of research and you have to pay a consultant. So it's a major step."

Ken MacDonald, group managing director of Aon's captive division, also agrees that there is no reason to lose faith in full captives at the moment.

"In terms of new foundations there has been a slowdown, but there is still growth," he comments.

MacDonald identifies the likes of Vermont, North Carolina and many European offshore domiciles as areas where captives still prove popular.

And he adds: "A lot of clients are sceptical about the soft market".

He suggests that many firms are anxious regarding just how low rates will go and how long the cycle will really last.

In this context, he says, it makes sense to appreciate the real value of captives.

"It has always been recognised that captives can contribute to good risk management, as they change the view of risk from a cost issue to a profit and loss issue."

And with the changing regulatory environment, particularly new rules for enterprise risk management in the States and the continuing effects of Sarbannes-Oxley, captives are also being seen by many corporates as a tool in addressing key compliance issues.

Direct writing

MacDonald also highlights the establishment of offshore entities to undertake direct writing as an option growing in popularity. "We've opened an office in Malta, which is proving attractive for new captive domiciles, and White Rock in Gibraltar is also very popular.

"It's a less costly alternative for companies to set up their own direct writer, so if they have a reinsurance captive they can use White Rock and bolt on a direct writer- that avoids the collateral requirements."

The soft market aside, regulatory pressures could yet cause more difficulties for the sector in the coming months, as MacDonald points out.

"In North America we're still waiting to see whether the Terrorism Risk Insurance Act (TRIA) will be renewed. Our guess is that it will, but if it were to disappear the question is whether a lot of these TRIA-captives will go."

The next few months could be very worrying indeed for the sector.