"If captives sit back as an industry and let this happen to them, they will end up with the short end of the stick," Chirico said.
Captives need to be properly capitalized for the risks they write, he said. If a single parent captive writes large risks for its parent, but isn't well capitalized, "it is a systemic risk," Chirico said.
But it might not make sense to hold captives to the same formal reporting standards as larger, more complex commercial insurers, Chirico said.
"They need to start talking about things that make sense for captives and things that don't. Proactive proportionality is the answer," Chirico said during the "State of the Captive Insurance Market 2012" webinar.
Some of the proposed regulations, such as Solvency II, would step up reporting requirements and require companies to formalize enterprise risk management. "That may not make sense for captives," Chirico said. When A.M. Best applies its rating criteria to captives, it addresses those same issues. "You can get to the same regulatory acumen without causing an undue burden," he said.
For instance, five executives from a new risk retention group visited A.M. Best, but said they didn't have an enterprise risk management binder. However, over the course of discussions, the executives were able to answer extensive questions related to the company's risks.
"Sometimes you don't have a formal binder, but it's part of your day-to-day operations," Chirico said. "These people who run captives live risk, and it comes out in ratings meetings."
Now that so many U.S. states have opened their doors to captives, Chirico said it could lead to a bifurcation of domiciles. "Captives are going to have a choice whether they go to a tough domicile that elects whether to adopt U.S. solvency initiatives or Solvency II, and that will speak to the quality of regulation," he said. "Let's face it, if captives start going belly up and not paying their claims, we're all going to be painted with the same brush."
About 25% to 35% of the commercial market has gone into the alternative market, "and it's not the bottom 25% to 35%," he said.
Captives continued to outperform the overall commercial insurance industry in 2011, according to an A.M. Best Special Report. While A.M. Best's composite of commercial insurers paid out an average of $1.01 for every dollar of premium taken in over the past five years, the 209 insurers in the captive composite only paid out 92.7 cents. Single-parent captives performed even better, paying out just 84 cents for every premium dollar taken in the past five years, Chirico said.
Net premiums written in 2011 for the A.M. Best's captive composite rose 9% to $8.354 billion, the first time NPW have risen in five years, Chirico said. The bad news is net income shrunk by 21% to $2.01 billion.
"Captive insurance companies are feeling the squeeze of the commercial market place," Chirico said. Captives are showing signs of stress from a challenging investment environment and continued soft market conditions, he said.
The financial performance of captives is likely to be topic No. 1 at the upcoming Vermont Captive Insurance Association annual conference, which gets under way on Aug. 7.
The decline in profitability was also exacerbated by an increase in taxes year-over-year because less of the net operating losses from the 2008 financial crisis were able to be carried forward, he said.