This is a new CFR feature – we’ll be looking for industry experts and interesting people to bring to our readers. CFR Editorial Board Chair Andrew Morriss sat down with Tom Jones and LJ Fallon, two long time participants in the Cayman captive insurance industry.
Tom is a partner at McDermott Will & Emery LLP in Chicago and has been active in the industry since the early 1980s; LJ is Senior Vice President of Legal Affairs for The Carle Foundation, Champaign-Urbana, IL, which established one of the early Cayman captives in the early 1980s.
CFR: Thank you for doing this – having two people involved with one of the pioneers in medical professional liability captives is a great way to kick off this feature. How did Carle come to choose Cayman?
LJ Fallon: Tom, since you were part and parcel of that, if you want to give your recollection and then I’ll fill in with what is in the historical documents.
Tom Jones: This story begins in the “dark ages” of captives in the health care field. A quick introduction is that the Harvard Medical Institutions pioneered the idea of self insuring hospital/physician liability risk. Basically, they believed they do it better than the commercial market.
So the Harvard team visited Bermuda to explore a captive insurance licence. For reasons they came to regret, the Bermuda Monetary Authority, actually the predecessor was called the Registrar of Companies, which regulated insurance at the time, turned Harvard down based on the belief that the risk of physician professional medical liability was too volatile to self insure.
Therefore, it wasn’t a line of business that would be suitable to put into a Bermuda captive. With Harvard’s usual modesty, they said ‘ok, we’ll do something else’, and they got out a map. At that point in time the Cayman Islands was in the early developmental stages of creating an offshore financial centre environment. That included, in addition to insurance, trusts, private banking, mutual funds, etc.
So Harvard met with the Cayman authorities. At that point in time Cayman had no captive insurance law, but Harvard agreed that if their captive would be licensed, they would help Cayman write an insurance law.
That law became the Insurance Law, 1979, which is the fundamental law to this day, although it has been amended many times. At that point the capability and interest of Cayman to get involved in medical professional liability captives was confirmed. Today there are more than 800 captives in the Cayman Islands and approximately one third are involved in health care risks. While a bit serendipitous, it was a fortuitous set of circumstances that put Cayman in the forefront.
When Carle got into this, there were at least a dozen health care captives in Cayman and it seemed like the easy route to go. There was at that point a good, independent captive manager in Cayman, a predecessor of Johnson & Higgins, which later sold out to Marsh.
LJ Fallon: The only thing I’d piggyback on Tom’s comments is that Carle as an institution is very focused on controlling its own destiny and I think that is what generated the idea that it should look at opportunities alternative to commercial insurance.
Years ago, we had a claim with separate insurance companies for the hospital and the physicians. There was some finger pointing, and it resulted in a verdict that was more than the organisations thought should have been paid. Based on that experience, the thought was – and this was the early 80s when the regulations on for-profits and not-for-profits weren’t as tight – within the Carle organisations that a captive provides a way to pool our overall enterprise risk and control our destiny.
It was at that time that the leadership looked at what was going on in the marketplace and saw what Harvard and others had done in Cayman. Carle then pursued that goal and engaged Tom and Wyatt as actuary to begin the process. The thought was to correlate the premium with Carle’s own losses, to facilitate shared defence for any future claims with Cayman being the venue that best offered these opportunities for this Central Illinois health care system.
CFR: You’re both long time participants in the industry, what’s happening next? What is the next big thing? What’s the trend everyone should be watching?
LJ Fallon: Tom, I’ll let you start and then add my comments on what we’re thinking about as insureds.
Tom Jones: We’re in an amazing transitional time what with federal health care reform, Dodd-Frank financial reform, etc. They’re all going to have repercussions to the captive industry generally and Cayman specifically. Not all of the implications are clear cut at this point in time, so my comments more in the nature of hopefully intelligent speculation.
The one big trend is clinical integration, which LJ can attest to among others, with the advent of the ACOs – Accountable Care Organizations. This is going to make providers much larger, with more services and more risks, although to achieve better care at a lower price they will have to be integrated risks.
The conventional wisdom is that this will stimulate captive growth. There should be more captives, if industry mergers don’t counter that, doing more things. Often the ACOs will involve disparate parts of the health care industry that are not necessarily under common ownership or control. The interesting part of that is that the way the federal tax law works in the US, if you are going to end up putting related and unrelated risk to any degree in the same risk pool, you pretty much have to do it offshore.
You typically can’t use an onshore captive because it would be fully taxable. So the tax outcome is much better for offshore captives, which would suggest that the Cayman Islands is well positioned to take advantage of this integration trend.
The other thing I’d just mention is the next step down the road is for providers who are going to take capitated risk, upside-downside risk, for providing unlimited amounts of care in exchange for a fixed fee. Perhaps they will put some corridor or quota share portion of that risk in a captive to try to pre-fund these exposures, and not just pay for variances out of their current cash flow.
Those are the two big areas but we are just at the beginning of the evolution of all this change.
LJ Fallon: It looks to me that as larger systems acquire other hospitals and physician groups as the Accountable Care Organization model rolls out and providers try to thrive in this changing health care environment this will result in formerly hospital based groups taking on physicians.
Those physicians might not have been part of the captive; they might have been part of a physician owned insurer, such as a PIAA company. In the future there will be more blended risk of both the hospital piece as well as the physician piece. So it seems to me that the captives are only going to grow larger. Maybe there will be fewer of them as the smaller entities that have captives are purchased or integrated into larger entities.
Again, I think some of the existing captives, no matter their size, may begin to diversify their risks by employing physicians who traditionally haven’t been part of that particular captive or any captive at all.
Tom talked about the capitated risk. Those of us who own captives continue to see a soft insurance market in some risk areas. In those situations, why bring that risk into the captive, let’s say directors and officers, when we can purchase that coverage in the commercial market at a reasonable price?
But if there are other lines of coverage, property for instance, that are a little bit harder in the commercial marketplace a lot of people are looking at the situation, saying ‘ok, do we now bring our property coverage or our property deductible into the captive?’
What exposures are health care organisations now covering within their captives?
We had a meeting this morning of our risk management board, and we discussed cyber liability insurance. We don’t have it. We’ve essentially funded our cyber liability exposure from operations.
Since we’re now looking at purchasing this coverage in the commercial market, one of the board members asked “is this something you would potentially put into the captive”? We’re looking at putting our workers’ comp insurance into the captive; something other captive owners have already done.
People will continue to look at the captive and the flexibility that exists with it to strategically place exposures into this insurance mechanism.
CFR: What are the biggest differences you’ve seen over time? What’s different between when you started and today?
Tom Jones: On the technological side, when Carle’s captive first began, it is hard to remember exactly the state of technology, but I think we were still using essentially telex machines. Faxes existed, but there was no email, certainly no ability to PDF documents. So everything moved a lot slower because it took time for air mail to get things to the Cayman Islands. On the operational/administrative side, what was perfectly acceptable then, today would be primitive, because of the distance. You could call, but it was very expensive to call, especially from Cayman to the US. The main change I’ve seen is the instantaneous communication capability has really made offshore and onshore captives essentially equivalent in terms of the operational aspects.
LJ Fallon: I agree wholeheartedly with that. I would say, at least for us, and probably for a lot of other captives, the exposure that existed in the 80s or maybe even in the early 90s, from a dollar perspective wasn’t nearly as significant as it is today.
At least in our case, I can’t give you an exact percentage, both the reserves and surplus have grown within the captive. In the past the captive was a relatively small piece of the Carle financial picture; it is really much more significant now.
It is a much more prominent piece not only of our financial strategy but also our financial structure than it was before. As a result, the captive gets more attention; there are demands on the actuary to produce more reports more frequently, demands on the captive manager to produce monthly financials versus quarterly financials, and frankly the whole transparency mandate in business operations, especially for not-for-profits, has really meant a keen eye on what’s going on with the captive. As with all of our operations, we want to make sure everything is handled and reported accurately.
CFR: Are you seeing any effect of the pressure from the US and the EU on offshore domiciles? Have you noticed any impact on the captive industry?
Tom Jones: Two elements to this question. First, impact from the multinational organisations that I think you’re probably referring to, like the International Monetary Fund, OECD, etc. As you know, they go to the various “tax haven” jurisdictions and do inspections/audits with the goal of promoting transparency and enhancing the ability to ferret out use of that domicile for tax evasion, terrorism, whatever purposes it shouldn’t be used for.
Cayman has been totally compliant, stayed ahead of the curve in this regard, and I think the question is, has that caused any difficulty, heartburn, whatever for the captive community in the Cayman Islands? The answer is “no”. The operational rules have been tightened up certainly on “know your customer”, anti-money laundering, etc.
Plus Cayman has signed numerous Tax Information Exchange Agreements with the US and over 20 other countries. But the captives, not just the ones I deal with, but also all the Cayman captives I know, are not interested in trying to hide anything, and so transparency is essentially a non-event only adding a little more paperwork. That’s it in a nutshell.
Do you want to comment on that LJ? Have you had any particular hassles?
For example, Cayman now is amending its insurance law, but that is being done in a very intelligent manner. I know that the new law will have little, if any, impact on the day-to-day operation of a Cayman captive.
LJ Fallon: I would agree. For a period of time in the past couple of years, the Cayman Islands Monetary Authority became a little more compliance oriented. CIMA’s interest in the business of the captives they regulate became a bit more focused, and so there were some additional requirements and documents that needed to be filed by the captive manager.
At a meeting with CIMA, we got the impression that some of the changes internationally had impacted what was going on in Cayman resulting in CIMA’s desire to be a little bit more intent on preventative regulation. A desire to know exactly who they were regulating caused CIMA to want to have face to face meetings with the captive boards. So I know there was at least one year, maybe two years, where we met with CIMA.
They did ask questions about funds within the captive, changes in risk profiles, etc. I think that was in order to satisfy themselves that the business being conducted offshore, in Grand Cayman, was legitimate and appropriately monitored.
Tom Jones: Let me add a different element, the impact of EU Solvency II – on captives generally and Western Hemisphere captives in particular. It is a little early to say, because Brussels hasn’t yet issued any final rules on to what extent captives will be covered.
But it is the conventional wisdom these days that to the extent captives have to comply with all the Solvency II rules, it is going to be very deleterious to future desirability of owning a captive. As you probably know, Bermuda announced last year that it was going to seek “equivalence”.
In fact, Bermuda been chosen to be one of three jurisdictions becoming a test case for equivalence with Solvency II mandates. Bermuda did that because their large “cat” companies need equivalence to get regulatory recognition in Europe. Conversely, Guernsey and Jersey and a few other places have said we definitely that they will not seek equivalence.
The Cayman Islands have not officially announced anything, but have let it be known in an unofficial but pretty forceful way that it will take a lot of convincing to get Cayman to seek equivalence.
The posture now is that ‘we don’t think this is appropriate for the philosophy and implementation of Cayman insurance regulation’.
So the impact of Solvency II remains to be seen. But if Brussels continues to pursue the inclusion of captives, and Bermuda is unable to figure out a way to carve out its captive community, it is obvious that there will be more captives thinking about re-domiciling to non-equivalent places like Cayman than equivalent places like Bermuda.
CFR: What has been the impact of the global financial turmoil on the captive industry?
Tom Jones: In terms of investments, they went down and then they went back up. The financial market is cyclical. I can recall a huge spike in interest rates in ’93 causing a lot of captives to become technically under water, ie insolvent.
At that point, Cayman and Bermuda regulators both exercised patience, which turned out to be wise. In ’94, the bond market popped back and these captives were all back above water. So, this is nothing new that there is turmoil in financial markets.
But in terms of affecting captives, nothing occurred like happened to the mutual fund industry, where there were over 10,000 mutual funds in Cayman and, I think, there are 9,000 or less in Cayman now.
The captive industry is resilient. Captive start-ups are just as robust today as they’ve ever been, whether pure captives, group captives, onshore, or offshore, despite the soft insurance market.
And there’s the continued evolution of the law – Cayman recently let it be known that it’s looking very carefully at enacting an incorporated cells statute, following in the footsteps of DC, Vermont and a few other places. Bermuda is starting to think about it, too.
I view the captive industry as, I don’t want to say impervious, but let’s say not directly substantially affected by financial turmoil. It might even boost the industry in some instances.
CFR: How does it help?
Tom Jones: Everyone is looking for expense savings. Cost of capital is dear, so a CFO may not want to tie money up in a captive, but the upside is they believe they are going to save money on addressing their cost of risk over time.
CFR: How has Carle’s captive strategy evolved over time?
LJ Fallon: When we first set the captive up, it truly was to address Carle’s medical malpractice and general liability risk and to address the problems that existed in the commercial insurance market in the early 80s. Over time, as exposures have changed or increased, for instance with directors and officers exposure, errors and omissions exposures, – the board of our captive – has considered whether or not these are exposures to put in the captive.
Again, given the unpredictability of or discomfort with some of these exposures, and the ability to insure them commercially at a reasonable premium, the board has always made the decision that it would not include these exposures in the captive. With our captive, we were affected by some increase in frequency and severity in the late 90s and early 2000s.
It turned out that those predicted experiences, in terms of severity in payments on claims, did not come to fruition. So we built up a fair amount of surplus in our captive, and I believe from what I have heard from captive managers and actuaries, that other captives have experienced the same positive effect.
This gives us an ample surplus base in our captive and the ability to consider whether we are willing to take on some of these more volatile risks – cyber liability or even directors and officers, or a portion of them.
Other than use of the captive, because ours always had physicians as well as the hospital, we’ve always had a mix of insureds within our captive, including some unrelated third party business.
The thought is that now as health care organisations evolve and Accountable Care Organizations launch, we feel, although we don’t have any definite plans at this point in time, that if we did acquire another hospital or integrate with another physician group, we could in an efficient manner put those exposures into the captive.
So we’re poised in this health care reform era to have an insurance tool that is flexible and would allow us to pursue an acquisition or integration more effectively because we’ve got this vehicle available to us.
I think a lot of organisations that are interested in partnering or being acquired, if they can join an organisation that has a captive in place already like Carle, find that a very attractive feature. Particularly so when the partner has a long and successful history of operating a captive in Grand Cayman.
CFR: Thank you both – we appreciate your time.