- Wide array of options available to captives interested in legacy transactions
- Mature captive domiciles common target of legacy specialists
- Offloading legacy liabilities can be a valuable tool for captive owners
- Education and awareness of legacy solutions holding back further adoption
The legacy market is a proving a popular solution for captive owners looking for a full captive sale, and for those wanting rid of specific risks or certain underwriting years.
There are challenges that can occur when a company decides to utilise a legacy transaction, such as bifurcating collateral in instances when a captive only wants to remove certain policy years.
General liability, workers’ compensation and auto liability are common lines of business transferred from captives to the legacy market.
A captive generally has four options when it comes to a full captive sale or removing certain liabilities.
A captive generally has four options when it comes to a full captive sale or removing certain liabilities.
The first is a commutation, which occurs with reinsurance captives and liabilities are sold back to the original fronting insurer and the reinsurance agreement is effectively ended.
“If they do that for all of the different fronting insurance programs that they’ve had, then there’s no more liabilities left, and they can close the captive down,” Matthew Latham, alternative risk transfer leader in the financial solutions group at Marsh, said on GCP #94.
A loss portfolio transfer (LPT) can also be utilised, which is a financial reinsurance transaction whereby loss obligations already incurred are ceded to a reinsurer.
A novation is considered when a third-party insurer takes over the liabilities of a captive’s policies, which previously would have been a three-way agreement between the original fronting insurer, the captive and the reinsurer.
One of the largest novation transactions including a captive was Lyft’s agreement with Enstar subsidiary Clarendon National Insurance Company pursuant to legacy auto liability business written between 1 October, 2015 and 30 September, 2018 for consideration of $465m.
The Lyft captive then provided retrocession coverage to Enstar in excess of a $816 million limit.
The final option is a full sale of the captive, usually to a specialist legacy insurer, where all the liabilities associated with the company, not just the insurance liabilities, are transferred to a third party, which then becomes the new reinsurer to the fronting insurers.
This often occurs when there has been M&A activity at parent level, and the new business owners might already own a captive, or they decide a captive is not part of their long term group strategy.
“Typically, those people who are purchasing it will obviously offer a discount to the current value of the captive, because they are either going to have to merge it with another entity they have, or they are going to have to go through a commutation or novation process to run down the liabilities,” Latham said.
A captive owner might also want to utilise the run-off market for strategic reasons. For example, a company might have found a better deal in the commercial market for a certain risk.
Tough commercial market conditions may have resulted in some captive owners keeping hold of their captives for longer with the aim of negating rising insurance premiums.
“You’re always going to get some opportunities that will come up through change of ownership at corporates, where you then effectively get moribund captives, but I accept that with a hardening environment that’s going to be less likely right now,” Tom Booth, CEO or DARAG told Captive Intelligence.
“At the same time, I would say it is a net benefit to us the fact that there are more captives being set up for the hard market and programmes expanded, because that’s going to feed into more business for us later.”
DARAG has just concluded a novation agreement between an undisclosed Benelux based captive, the captive’s policyholder and DARAG’s German insurance carrier DARAG Deutschland AG.
Despite the hard market, those speaking to Captive Intelligence have indicated that they are seeing an ever-greater number of captive owners looking to the legacy market for solutions.
“We are seeing an uptick, and quite frankly, we’ve got a list of about 15 or 16 opportunities that we’re actively working on right now,” said Thomas Hodson, president and general counsel at Genesis Legacy Solutions.
“I’m not sure we have ever been this busy.”
Despite the number of captives utilising the legacy market increasing, Adam Horridge, vice-president, legacy transactions at Swiss Re believes the market is not being utilised as frequently as it could be by captive owners.
“I think it’s a bit of a shame because I see exit solutions as a healthy part of the insurance lifecycle,” he said.
“It does not mean it is a failure, it just means the company is evolving and lightening their load, and recycling capital towards new ventures for where they want to grow.”
Hodson said that Genesis Legacy Solutions is seeing a growing number of risk retention groups (RRGs) seeking legacy solutions.
“For example, members that formed an RRG 20-25 years ago for medical malpractice may now be getting better rates in the commercial market, or the members are retiring, so they need an exit solution,” he said.
Hodson said this year he is seeing a lot of nursing homes related risks entering the legacy market.
Genesis Legacy Solutions provides reinsurance solutions and self-insurance solutions, deductibles and SIR reimbursement through a Vermont-domiciled sponsored captive.
Brian Johnston, CEO at Genesis Legacy Solutions, said that the sponsored captive structure allows the company to be “very nimble” because setting up a new cell to provide reinsurance for a new programme is “very simple” to do.
“It’s also less expensive because if you were to provide reinsurance through an admitted licensed insurance company that has to file statutory annual statements every year, it gets very expensive,” he said.
Johnston said the company is not only focused on Vermont activity.
“We’ve got opportunities to buy captives in Bermuda, one in Montana, and we have dealt with other captive domicile states in the US as well,” he said.
“We’ve also looked at a couple of captives in Cayman, so we’re pretty broad in our targets geographically.
“If we offer reinsurance to any company outside of the state of Vermont, that’s going to be a collateralised obligation.”
Hodson said that for captives, acquisitions are the main bulk of his company’s business.
“When presented, the opportunity may start as an LPT inquiry, but once we get into the details through due diligence, the cost of the LPT may lead us to suggest to the potential client that a sale is far better for them as an exit solution,” he said.
Domiciles
Booth said most DARAG US captive business comes in the form novation transactions from Bermuda, Cayman or Vermont captives, as well as other jurisdictions in the US.
“We also do acquisitions, or mergers using our Bermuda carrier, with these generally being where the lion’s share of our business comes from,” he said.
The domiciles that have a high number of captives are generally the ones that are the most favourable towards legacy transactions.
“Ultimately, they understand the benefits for them proactively managing their capital and allowing their constituents to do so,” Ryan Heyrana, senior vice-president, legacy solutions at Brown & Brown, told Captive Intelligence.
Brown & Brown launched an in-house captive offering for legacy solutions earlier this year because it identified it as an increasingly valuable risk, balance sheet and capital management tool for captive clients.
The location where the captive is domiciled could impact what a captive owner can and cannot do with respect to a legacy transaction.
“For example, to what extent can the corporate novate or legally transfer policies from the captive to an external insurer?” Horridge said.
“Does the other insurer need to be domiciled in the same location and regulated by the same regulator or can the corporate transfer to an offshore insurer?”
Legacy benefits
One big driver for captive owners to sell their legacy business is to free up or accelerate liquidity.
Booth said that whilst there are parallels with the mainstream legacy market in the sense that some transactions are predicated on releasing capital, however, that capital is generally rating capital, whereas for a captive it is “cold hard cash”.
“In this environment where we’ve got hardening rates, captive owners often want to expand their programmes, and it allows them to retain more of the ongoing business because they can release collateral from prior years,” he said.
Another benefit is that the captive owner does not have the burden of managing reserves, some of which could take years to pay off.
“Especially if they’re caught up in litigation,” Horridge said. “As a result, they’ve got an accelerated financial exit, and the corporate releases the capital associated with those reserves.”
Heyrana said one of the big motivations from captive owners who decided to utilise the legacy market is the removal of the “operational drag”.
He said retail clients might have dedicated risk management departments “if they are lucky”, but they’ll likely have a finite number of risk team members to manage a book of liabilities.
“From an operational perspective, it is just too much to handle properly especially given that insurance is not their core business competency,” Heyrana said.
“Companies are seeing the value in being able to parse off older liabilities, which are more at risk of neglect and leakage, and focus on the newer years with higher claim count, more emerging risks and so forth.”
The regulatory burden is sometimes a motivation for captive owners looking to sell their captives.
“Whether it’s capital requirements or IFRS17, for example, you hear auditors and accountants doubling or tripling the fees because of the governance required,” Horridge said.
“That significantly increases the cost of holding a captive so avoiding those costs and accelerating away from them is part of the motivation.”
Booth said that as a result of substantial changes to the interest rates, DARAG can now execute legacy transactions at more attractive price for captive sellers.
“We can now make a reasonable return on the reserves, whereas previously we were getting very little,” he said.
“Our upfront cost is definitely lower than it was prior to the interest rate change.”
Workers’ compensation, general liability and auto liability have been the main focuses for DARAG when it comes to captive legacy transactions.
“One of the extra benefits for us, depending on the captive, is that they are relatively low limit per occurrence policies, which means that there’s generally low volatility,” he said.
Hurdles
A regular complaint of specialists in the legacy market who are targeting captives is a lack of awareness of the solutions available amongst captive owners but also brokers and captive managers.
“These exit solutions are not well known generally in the market, sometimes amongst insurers and reinsurers as much as captives,” Horridge added. “It’s not a common product that they think about.”
Heyrana said that has been a focus of his since starting his new role at Brown & Brown.
“Since starting in this role in March of this year, it has really been an education campaign, not only for our retail customers but also for our retail brokers whose primary focus is the efficient structuring of insurance programs,” he said.
One hurdle when it comes to legacy transactions occurs when there is an ongoing programme with a fronting carrier and the client only wants to sell off a certain number of policy years.
In this instance, it can be difficult bifurcate the collateral between the years that are parsed off versus the years that the company would like to retain in the captive.
“You can solve 99.9% of the customer’s problems, i.e. you can remove the volatility or take over the operations of the runoff and the claims oversight,” Heyrana said.
“But unless there’s a clear bifurcation of the collateral from the fronting carrier between what is retained by the corporation or captive, and what is ceded off to the legacy market, it’s very hard to pin a number as to the collateral that needs to be replaced by the legacy market.”
Hodson said for statutory lines of business in the United States, like worker’s compensation, if a company wants to write it through a captive program, it needs to be done on an excess basis or as part of a fronted program, where the captive would utilise an admitted, licensed carrier issuing the policies and then reinsuring the risk back to the captive.
Hodson noted that these transactions are typically collateral intensive, meaning the captive must provide collateral to the fronting carrier for the reinsurance that is being ceded to it.
He said the number one question captive owners ask the fronting carriers is when they can get their collateral back.
“Often, captive owners don’t understand that for captive programs, each year stands on its own and the collateral is stacked year after year,” he said.
“Releasing the collateral is entirely up to the fronting carrier. Fronting carriers are typically conservative with the amount of collateral that they require relative to the liabilities, so collateral stacking can get expensive for the captive.”
In such instances, Genesis Legacy Solutions will come in and either work directly with the fronting carrier to replace the collateral or take a position behind the captive as a retrocessionaire.
“We can either replace the collateral or provide back-to-back collateral, which would effectively free up capital that the owner of the captive can then apply to future years’ collateral requirements,” he said.