Financial Symbiosis And The Race To The Top

In a previous article, I observed that small, tax neutral “offshore” jurisdictions such as Cayman, BVI, and Jersey play important roles intermediating capital for the “onshore” world. By facilitating access to capital without adding a layer of tax, they increase the amount of capital available and lower its cost, leading to more investment which in turn leads to higher rates of innovation and economic growth.

If that was all these jurisdictions did, they would fairly be classified as important symbiotes to the onshore economies. But they also play another valuable role: facilitating innovation in financial intermediation. Unlike their other functions, this innovation is not primarily driven by the jurisdictions’ low taxes; rather, it is a consequence of their adaptive legal systems and nimble, flexible regulatory systems.

Captive Insurance Innovation

Consider captive insurance companies. These companies, wholly owned by the insured, perform a similar function to self-insurance, but their corporate structure offers several advantages, especially as regards governance. In particular, whereas self-insurance should entail specific obligations to manage risk, a captive insurance company has a legal duty to provide adequate cover for insured risks. Captives thus have stronger incentives both to mitigate risks, for example, by requiring its parent entity to take actions that limit its exposure, and to ensure that they have sufficient capital to pay out following an insured event.

Captives also have advantages over conventional insurance in that they will be more familiar with both the specific risks a company (or group of companies) faces and its capacity to mitigate those risks. As such, they reduce the adverse selection problem that plagues insurance and drives up premiums.

Captive-like entities have existed since the 19th century but their modern form is said to have been invented in 1953 by Fred Reiss when he established the Steel Insurance Company of America as a subsidiary of Youngstown Sheet and Tube company in Ohio.[i] (Reiss borrowed the term “captive” from the term the company used for the “captive” mines it owned that sent their ores to the company’s mills.)

In 1962, the Kennedy Administration changed the US tax code with the intention of taxing the profits of US companies’ foreign subsidiaries. However, under the new rules it was possible for companies to deduct premiums paid to captives regardless of their location while deferring the payment of non-repatriated profits of subsidiaries. As a result, the establishment of captives in lower-tax foreign jurisdictions remained attractive.

Reiss seized the opportunity, establishing a captive management business in Bermuda. Aside from its tax neutrality, Reiss chose Bermuda in part because it offered a more straightforward approach to regulation than would have been possible in the US at the time and in part because its legal system was based on the common law, a familiar legal currency for the US companies he would service.[ii] Bermuda was also already domicile to an AIG subsidiary that managed its overseas underwriting and reinsurance business.

As other captive managers set up business in Bermuda, Reiss continued to innovate. Of note, his business facilitated reinsurance through a pooling facility funded by other captives. Other jurisdictions also began to attract insurance captive managers.

In 1969, the newly-formed Bermuda Monetary Authority (BMA) was given purview over captives, vetting new applications. The BMA effectively acted as a standards-setting body for the industry and helped improve the jurisdiction’s credible commitment to quality. The captives business in Bermuda boomed.

In the early 1970s, Reiss established a captive management business in the Cayman Islands, attracting business from the Bahamas where a new insurance premium tax had been introduced, making the jurisdiction less hospitable.[iii] Others followed and the jurisdiction’s role as a domicile for captives began to grow.

In 1976, Thomas Pyle, the CEO of Harvard University’s medical centres was looking to form a captive to cover liabilities for medical negligence in response to the exploding cost of such insurance from conventional insurers. He initially approached Bermuda but was rebuffed by the BMA because Harvard wanted to cover not only employees but also affiliated medical practitioners (when they were credentialed to operate at Harvard’s centres).[iv] The authorities in Cayman raised no such objections and so Harvard established its Controlled Risk Insurance Company (CRICO) in Cayman.

A 40-year retrospective in Patient Safety and Quality Healthcare in 2016 noted that “CRICO has become a leader in patient safety while continuing to serve its members’ needs by fostering a culture of safety, using data to identify risk and develop solutions, valuing professional relationships, and sharing its knowledge”.[v] Many other hospitals and health systems followed in CRICO’s footsteps, adopting a similar model and choosing Cayman as their domicile.

Captives domiciled in Bermuda, Cayman, and other tax neutral jurisdictions have demonstrably added considerable value to the US economy. And by improving safety and lowering costs, healthcare captives have arguably also directly contributed to saving lives.

But the competition created by offshore jurisdictions has also stimulated beneficial innovations in onshore governance.[vi] For example, in 1981 Vermont passed legislation that made it easier and less costly to establish a captive in the state. As a result, Vermont has increasingly attracted captives including some that might otherwise have chosen to domicile offshore.

Over the past 40 years, the captive industry has grown enormously with thousands of companies forming captives in dozens of jurisdictions. And innovation has continued, including new corporate forms such as the segregated portfolio company, first established in Guernsey in 1997 and subsequently adopted in Bermuda, Cayman and many other jurisdictions, in which numerous separate captives can exist within a single company with segregated liabilities.

While Bermuda, Cayman and Vermont remain the top jurisdictions, Utah, Delaware, and Barbados are not far behind. Meanwhile, Guernsey and Luxembourg act as domiciles for captives in Europe, and Singapore likewise for Asia.[vii]

Blockchain Innovation

Like insurance captives, many blockchain companies have chosen to domicile in offshore jurisdictions because of the overly restrictive nature of onshore regulation. For example, in 2017 the US Securities and Exchange Commission (SEC) warned that blockchain tokens may be viewed as securities that would require registration[viii] – an expensive and time-consuming process that is ill-suited to the fast-moving world of blockchain. The SEC has subsequently made good on this threat, taking action against many blockchain companies that permitted US persons to participate in initial coin offerings (ICOs).[ix] Meanwhile, in 2017, China and South Korea simply banned ICOs.[x]

By contrast, Switzerland, Singapore, Malta, Gibraltar, Bermuda, and several other jurisdictions generally took a more permissive approach from the outset and have since explicitly defined what constitutes a digital asset and established clear rules as to whether such assets are securities.[xi] Meanwhile, although Cayman did not have specific digital asset law until 2020, it was already domicile to several blockchain companies, including Block.one, which held the largest ICO to date, raising over US$4 billion in 2018.[xii]

The permissive approach taken by these jurisdictions has paid dividends, as they have become domicile to many of the world’s blockchain companies. The Swiss canton Zug has become known as Crypto Valley and is home to hundreds of blockchain startups. Malta, likewise, is home to many innovative blockchain companies. And Cayman has become the largest domicile for crypto hedge funds—building on its success not only as a domicile for blockchain companies but also as a domicile for other kinds of hedge funds.

And as with offshore captives, offshore blockchain companies are generating benefits both offshore and on. The innovation that has occurred as a result of blockchain companies domiciled offshore has now fed back into the US, where more conventional venture capital is being deployed into blockchain projects and retail investors are able to participate indirectly through publicly traded VC funds and ETFs.[xiii]

More broadly, the US, UK, Hong Kong and Singapore have now all established processes for the tokenisation of securities which offers potentially instantaneous and very inexpensive settlement, thereby avoiding costs and delays associated with the conventional settlement process.[xiv] Meanwhile, hosting assets on a blockchain potentially reduces custodial risk. Over time, it seems likely that these approaches will become more accepted and more widespread.

Blockchain, of course, has applications well beyond finance. Various industries already using blockchain-based systems to track the movement of goods across supply chains.[xv] The insurance industry is using blockchain to improve the efficiency of claims.[xvi] Owners of intellectual property—from artwork to music—are using blockchain-backed non-fungible tokens (NFTs) to distribute their assets and verify ownership.[xvii]

While many developments in both captive insurance and blockchain are now taking place “onshore”, they have been made possible in no small part by the more responsive regulatory approach to the nascent industries taken by many “offshore” jurisdictions which should properly be viewed as important symbionts of the “onshore” world. Moreover, competition between jurisdictions, both onshore and off, has led to innovations in governance that had created a virtuous circle—a race to the top.

Footnotes:

[i] The name captive certainly can be traced to Reiss, but the form arguably was developed by Lufthansa in Germany in 1924. https://www.captiveinternational.com/article/the-sexiest-man-in-captives-and-other-trivia 

[ii] https://www.mondaq.com/insurance-laws-and-products/21811/the-development-of-the-bermuda-reinsurance-market

[iii] James Rawcliffe, “Cayman: Bright with Ambition,” in CICA: 40 Years of Captive Leadership, Cayman Islands Captive Association, 2012

[iv] Ibid.

[v] Susan Carr, “CRICO Celebrates 40 Years in Patient Safety,” Patient Safety and Quality Healthcare, December 9, 2016. https://www.psqh.com/analysis/crico-celebrates-40-years-in-patient-safety/

[vi] See, for, example Andrew Morriss, “The Role of Offshore Financial Centers in Regulatory Competition,” in Andrew Morriss (ed.) Offshore Financial Centers and Regulatory Competition, pp. 102-146, Washington, DC: The AEI Press, 2010.

[vii] https://www.iii.org/article/background-on-captives-and-other-risk-financing-options

[viii] Jay Clayton, Statement on Cryptocurrencies and Initial Coin Offerings, Securities and Exchange Commission, Dec. 11, 2017, https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11; 

[ix] https://www.sec.gov/spotlight/cybersecurity-enforcement-actions

[x] Oscar Williams-Grut, “South Korea Bans ICOs,” Business Insider, Sept. 29, 2017, http://www.businessinsider.com/ico-south-korea-bans-icos-2017-9; Jon Russell, “China Has Banned ICOs,” TechCrunch, Sept. 4, 2017, https://techcrunch.com/2017/09/04/chinas-central-bank-has-banned-icos/

[xi] See e.g.: https://thelawreviews.co.uk/title/the-virtual-currency-regulation-review/singapore; https://www.pwc.com/mt/en/publications/technology/pwc-malta-blockchain-alert.html

[xii] https://www.cnbc.com/2018/05/31/a-blockchain-start-up-just-raised-4-billion-without-a-live-product.html

[xiii] https://pitchbook.com/blog/vc-firms-investing-in-blockchain-and-cryptocurrency

[xiv] https://www2.deloitte.com/content/dam/Deloitte/cn/Documents/audit/deloitte-cn-audit-security-token-offering-en-201009.pdf

[xv] https://hbr.org/2020/05/building-a-transparent-supply-chain https://www.hilldickinson.com/insights/articles/can-blockchain-technology-revolutionise-shipping-industry

[xvi] https://www2.deloitte.com/ca/en/pages/financial-services/articles/blockchain-in-insurance.html

[xvii] https://cointelegraph.com/news/online-content-streaming-is-dead-long-live-the-music-nfts

Julian Morris FRSA
Julian Morris has 30 years’ experience as an economist, policy expert, and entrepreneur. In addition to his role at ICLE, he is a Senior Fellow at Reason Foundation and a member of the editorial board of Energy and Environment. Julian is the author of over 100 scholarly publications and many more articles for newspapers, magazines, and blogs. A graduate of Edinburgh University, he has masters’ degrees from UCL and Cambridge, and a Graduate diploma in law from Westminster. In addition to his more academic work, Julian is an advisor to various business and a member of several non-profit boards.