July 16, 1978

The insurance industry calls them captives — companies set up by major United States corporations to insure their own special risks. They bask in tax-free Bermuda — an unlikely group to cause a stir in the international insurance market. But in the last year the captives have come to life.

They have begun to do some capturing of their own, selling insurance to companies unrelated to them and entering the sophisticated field of reinsurance, seeking Loyd's of London-style high-risk business.

In the process, a new crop of brokers, underwriters, risk managers, attorneys and insurance consultants has been attracted to the burgeoning business — and growing profits — centred in Bermuda.

In his New York office, Andrew Barile, a tall, tan and dapper reinsurance matchmaker who introduces willing insurers to available risks, has three open briefcases lined up on the floor. One is for London, one is for Chicago and one for Bermuda - his most frequent destinations on business trips.

Mr. Barile, the president of Andrew Edwards & Company, now conducts at least a third of his business as a reinsurance intermediary in Bermuda - "where the action is," he says.

Bermuda, of course, has seen plenty of insurance action for several years. With its tax advantages, major corporations have found it a convenient place to establish captives, which are usually run by independent insurance management firms. In just four years the captive insurer population on the island has swelled to more than 700 from 333, writing some $2.5 billion in premiums.

What is causing the captives to branch out now? A ruling by the United States Internal Revenue Service has been a major spur. The captives ran into a giant problem last year when the IRS questioned their status as independent insurance companies and the right of their parent corporations to claim certain deductions as business expenses, including premiums paid to captives.

Instead of folding the tents of these Bermuda concerns, many corporations decided to meet the problem head-on by transforming them into bona fide insurers — actively competing in the business not just for the tax advantages, but for the profits.

Whether the captives will successfully meld into the international insurance market depends on their ability to overcome a host of obstacles, including an uncertain American regulatory climate, their own lack of underwriting experience, dependence on their parent corporation for capital and the shaky political outlook for Bermuda. But they seemed determined to try.

The reinsurance sector, particularly, seems a fertile field. The captives can provide fresh capital to the inflation-strapped general insurance industry and take advantage of new markets in high-risk areas — including oil spills, nuclear accidents, malpractice and executive kidnapping and ransom coverage — that are opening. New York State's Assembly, for instance, has approved the establishment of a reinsurance exchange modelled on Loyd's of London as well as the easing of regulations on large and unusual insurance transactions that may well attract funds from the offshore captives.

A Look at the Captives

Captive offshore insurance subsidiaries offer a convenient way for a company to combat high insurance rates, gain cash flow, move money internationally and cover hard-to-place risks. The roster of multinational businesses involved includes such companies as the Gulf Oil Corporation, the Ford Motor Company, US Industries Inc., the Exxon Corporation and the Hanna Mining company.

Faced with the liability for the oil spills, for example, 34 oil companies formed Oil Insurance Ltd. Seeking a way to provide property-damage insurance for their nuclear power plants, several utilities joined forces in Nuclear Mutual Ltd. In yet another instance, Hanna Mining founded its captive, Erieview, to write kidnapping and ransom insurance for key executives.

Quite a few big league insurers started out as captives and, today, remain highly profitable subsidiaries of their parent companies. To name a few: Sears, Roebuck & company's Allstate, the Armco Steel Corporations' Ideal Mutual. In Armco's case the decisions to turn Bellefonte into a profit centre has paid off. Bellefonte's income quintupled last year, and this has helped to offset Armco's steel-industry losses, according to insurance analysts at Merrill Lynch, Pierce Fenner & Smith.

Through their parents, many captives have potential capital surpassing that of most commercial insurers. The Exxon Corporation's captive the Ancon Insurance Company had a 1977 net income of $54 million and is worth $237 million.

Sidney Pine, an attorney for more than half the captives in Bermuda says that simply by eliminating brokers' fees, commissions, marketing and advertising costs and administrative overhear, captives cut the costs of premiums, "by about 35 percent". And as Richard Shagrin, an official of Chase Manhattan Bank's insurance department points out, the captives help a company's cash flow. The premiums paid to the captives amount to "taking money out of the right pocket and putting it in the left", he says.

The corporation is free, then, to reinvest its premiums internationally and reap further gains. By expanding their captives' activities, parent companies may increase profits, dilute the impact of major risks and diversify their holdings. "The captive gives a company an opportunity to play with its own money," says Rita Epstein of the Risk and Insurance Management Society. "That's really the advantage."

Though the IRS ruling spurred the drive to write outside business, many see the rend as an acceleration of natural expansion given the increasing need for fresh capital in the insurance market.

The IRS, in refusing to view companies that insure only the risks of their parents as bona fide insurers, ruled that the parents; deductions for premiums and management costs were ineligible. Wilson Fadley, an I.R.S. spokesman in Washington, said, "Captives are part of one economic family — those who bear the burden of the loss are those who suffer the loss."

Insuring Third Parties

And so tax attorneys counselled captives to start insuring unrelated risks. "If the captive has as much as 20 to 25 percent of outside risk written, it can suffer a financial risk that is no longer identical with the parent," Mr. Pine said. Thus, the captive may become a bona fide subsidiary of the parent company, with the attendant tax advantage.

Since captive operations in Bermuda remain secretive and unregulated, it is hard to pinpoint how many concerns actually have begun to write unrelated third-party risks — risks in no way tied to their parent companies. Mr. Barile, the insurance matchmaker, estimates that only 15 percent of the captives are writing outside business. But Mr. Pine says: "All or most all of the captives are either insuring or seeking to insure outside risks."

The captives are clamouring, as one consultant said, to get reinsurance. The unparalleled "insurer's insurer" is Lloyd's of London, which in turn reinsures a good part of its risks with other insurers around the world. "Risks just flow," says Felix Kloman, the president of the risk planning group of Connecticut. "It's like bookies laying off debts."

The National Broadcasting Company, for example, went to Loyd's to insure its $85 million rights to televise the 1980 Moscow Olympics, according to one broker, who asked not to be identifies. Loyd's, he continued, then distributed small chunks of the risk to captives in the Bermuda market.

"The wheel reinsurance market is very incestuous," says Robert Baker, the president of the Security Reinsurance Company, a Bermuda subsidiary of the Continental Insurance Group. "We all reinsure each other."

But in their eagerness, captives may not always write business of the first order. Established reinsurers tend to be suspicious of foreign deals as well as exported American business. If it's a good reinsurance agreement "why would they have to peddle it abroad?" wonders Paul Ingrey, vice president of the Prudential Reinsurance Company.

Economic conditions in the United States, though, have changed things, in the view of some experts. Due to a capital shortage, United States reinsurers nowadays cannot always afford to cover good American risks. These must seek shelter abroad.

"The business going to London is better than it was 10 years ago," Mr. Baker said. If the business is good in London, by extension it's good for the captives, which may reinsure risks of a quality that might not otherwise be available. "There can be no doubt the kind of business we write is the same kind of business acceptable to Loyd's," says Leslie Dew, a former deputy chairman at Loyd's who now services captives.

Some in the insurance industry caution that the development of captives as full-fledged participants in the international insurance market may be rough going, at best. Bermuda-based captives often have a lack of underwriting and administrative expertise. Parent companies, moreover, may underestimate the financial and long-term commitments required.

To compete effectively in the international insurance market, captive management must develop special facilities, staffed by professionals with talent and a degree of autonomy. Now, responsibility for the hundreds of captives based in Bermuda is divided among numerous professional managers and seven major insurance brokerage firms, including American International Group, Johnson & Higgins Ltd., and March & McLennan Ltd.

Whether these firms and managers successfully will ease their captives into international insurance activity is yet to be seen. One young manager notes that his firm's involvement in this transition is minimal. "the most important aspect of our management is the accounting service we provide," he says. "most parents do control the policy, which is normal. But we like to play down the aspect of parental control."

On the other hand, Brian Hall, the president of Inter-Ocean Management, said in a recent interview in Bermuda: "We do provide resident decision-making powers here in Bermuda. Otherwise, it is a sham We would not want to run a post-office-box operation." Intern-Ocean Management, a joint venture with Johnson & Higgins Lts., manages close to 90 captives.

Pooling Forces

To help captives make the most of their new ventures, risk managers are experimenting with a variety of buying plans. Rather than go it alone, most Bermuda-based captives opt to join forces.

Last year, Gulf Oil induced Mr. Dew to move to Bermuda and underwrite third-party risks for its captive. INSCO, and six other companies. The "pooling arrangement" allows captives to share the capital costs, underwriting and administrative staff required to write commercial treaties.

As a first step, some captives form "closed pools" to reinsure only each other's risks. One such, the Corporate Insurance and Reinsurance Company Ltd. (CIRCL) started in December 1977 with $10 million in authorised capital. Membership consists of the National Steel Corporation, the Archer-Daniels-Midland Company, the Charter Oil Company, Emery Industries, the International Harvester Company, the Minnesota Mining and Manufacturing Company, Ideal Mutual and Hanna Mining.

CIRCL's bright-red lacquered door stands out at the end of a long, sombrely decorated hall in the Washington Mall in Hamilton — one of Bermuda's few office buildings. Next to the door hands a plaque that read, from the top, "Horizon Insurance Company, Marine Transport Company, Tennco Internatinoal Ltd., Erieview Insurance Company, Oceanview Insurance Company, Seaview Insurance Company Ltd. and CIRCL."

"We're thinking of setting up a management company for 10 captives that can go to market to buy and place reinsurance," says Richard Thompson, who manages all the firms on the plaque.

This formula has proven a popular way for captives to go beyond the confines of a closed pool and assume reinsurance directly from the commercial market.

Still pending, however, is the impact of the 1977 IRS ruling, which is retroactive and pertains to domestic as well as foreign captives. Parent companies, meanwhile, continue to take the deductions and hope that, by accumulating third-party risks, their captives will pass muster with the IRS.