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Issue 9 -- October 29, 2003
The other day someone sent me a message asking whether I was aware of captives’ shareholders beginning to look at the capital tied up in captives. At first I thought it was an oft-repeated theoretical question about the cost of capital, and wondered whether he meant the captive's shareholders or the shareholders of the captive's shareholders? These theoretical questions harken back to the old “shareholder value” days. When asked the theoretical question about cost of capital tied up in a captive, I usually respond that it is a moot point. It’s moot because most efficient captive owners have found ways to loan back most of the assets into the business, either with or without deductibility for tax purposes on the front end being jeaopardized by such loanbacks. Upon further reflection, though I think there may be a capital issue. What the issue is today is the growing obligation placed on captives’ owners to freeze assets in reinsurance trusts, which are replacing letters of credit as the preferred collateral for fronting companies. As I have written in these columns before, it seems to point towards a kind of “revenge of the commercial insurers” against captive insurance that is emerging in the form of a credit squeeze. The more they demand higher and higher collateralization, aided and abetted by overly-zealous captive domicile regulators that insist there be no residual underwriting risk, the more capital captive owners have to tie up in reinsurance trusts. The captive owners will, following this conspiracy theory, get discouraged and give up, or not start their captive insurance companies. The more capital they have to tie up in the trusts (from whence they cannot loan it back into the business) the lower the returns. The trouble with these trusts is that the type of assets is restricted to government bonds and the like, whose returns of 2-3% could well be questioned by "shareholders" – whether the captive’s or the parent’s shareholders. These days, though, their questions about return on capital may also be beside the point because there may be little other alternative. If you don't like AIG's collateral demands, try and find another fronter (you probably won’t). And if you don't like fronting any more, then compare the cost of winding up the reinsurance captive and going back to traditional insurance. The answer may be that in this point in the insurance cycle the low return on capital may well be a cost of doing business. Hugh’s view:
I don’t think existing captive owners are going to move out of their
captives because of the credit squeeze or the low returns on capital.
There is a longer-term, strategic reason for this. The low returns today
are worth absorbing in view of what may be coming – lower rates,
more competition and maybe even more fronting companies willing to do
business with captives. I no longer think the theoretical immobilization
of capital issue to be a spurious issue, but I am coming to believe that
the collateral demands of insurers will be replaced by other credit finance
mechanisms in the near future. There are some collateral replacement “products”
out there in the marketplace now already. Can't get enough of Hugh's oft-irreverent views? You're in luck! Follow this link to all of Hugh's pearls of wisdom:
Hugh Rosenbaum, one of captive.com's friends and valued contributors, is a freelance consultant. Hugh can be reached by telephone at +4420 8883 6729 or by e-mail at hughro2@yahoo.com. Learn how you can spend a day with Hugh! Visit Hugh's Captive Consulting and Music Websites
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