Captives: An alignment of interests

Dan Sammons and Stephen Morton explain how closer collaboration between insurers, service providers and clients is essential when navigating hard commercial insurance market conditions

A hard insurance market has traditionally been a bellwether for captive growth. Previous hard markets have seen existing captive owners make more use of their risk retention vehicles, while also driving the formation of new captives. This hard market is likely to be no different. According to Marsh’s latest captive benchmarking report1, captive premium growth has continued to accelerate in 2020, with a current total of around $54bn in premium across all industries and captive domiciles.

Risk management organisations are urging insurance carriers and brokers to collaborate and build upon existing relationships in securing risk transfer programmes for their clients. It is a time to consider all  available tools and to work closely within the tripartite relationship to ensure an alignment of interests.

The current environment is thus presenting an opportunity for brokers and insurers to create joint, scalable captive solutions. Brokers are seeking to deliver creative solutions in response to client needs (e.g., release of trapped capital), while insurers are looking into alternative risk solutions to help them address and mitigate their challenging risks. The best-placed service providers will offer an expansive multinational network with expertise in local market practices and regulatory requirements, as well as the product breadth and ingenuity to provide programme structure flexibility.

The makings of a perfect storm 

There is much talk of a ‘perfect storm’ in the commercial insurance market. After a prolonged soft market, prices have been rising over the past two years. This is a result of increased losses, a reduction in capacity as insurers have stepped away from underperforming classes of business, and adverse loss reserve development.

Global commercial insurance premium increased by 20% in the third quarter of 2020, according to Marsh, with significant price hikes in US public D&O (up 60% on average) and UK D&O (up 100%) driving rates up by 40% globally across financial and professional lines. Geographically, composite pricing increased in all geographic regions for the eighth consecutive quarter, led by the UK (34%) and the Pacific (33%).

Persistently low interest rates have made it more difficult for carriers to balance diminished underwriting results with investment return, and most in the market now accept that rate increases in certain lines are needed for them to remain sustainable. However, the rising cost of insurance is a significant issue for commercial buyers, at a time when they are also dealing innowith a global pandemic and a possible double dip recession.

In the current environment, claims uncertainty and the resulting upward momentum in premium rates, have added additional layers of challenge. More broadly, the crisis has resulted in a global economic slowdown, widespread supply chain disruption and new and emerging risks relating to lockdown conditions, including the potential exploitation of cyber vulnerabilities created by a dispersed workforce.

In addition to pricing, insurance companies are increasing deductibles and terms and conditions are becoming tighter. Conditions have become more challenging for insurance buyers, as their premiums are increasing and at the same time they are forced to retain more risk on their own balance sheets. Remote working is adding a further layer of complexity as many organisations are in the midst of an extremely challenging renewal season, with discussions taking place via video conferencing rather than face-to-face. But there are risk financing and risk retention solutions to be found, with the help and support of the right broker and insurance partners.

For organisations that do not yet have a captive, it is not too late to consider forming one.

The role of the captive

The test for insurance buyers and captive owners is how to soften the blow of increased re/insurance premiums while ensuring broad coverage remains in place for the majority of exposures. In addition to offsetting higher rates with increased deductibles, there is an opportunity to boost self-insurance. A number of potential innovative and creative solutions can and are being adopted by captive owners to help them ride out the cycle.

Single-line captives can be opened up to new classes of business, for instance. This is particularly useful for insurance classes where commercial capacity is less plentiful or where certain risks are more difficult to place. Third party risks can also be considered, allowing captives to become a source of underwriting profit for the captive owner. 

Expanding a captive so that it becomes more diversified may offer greater capital efficiencies and access to lower-cost coverages. There is also the opportunity to include new and emerging risks, which can be ‘incubated’ in the captive, such as cyber or risks linked to supply chain, giving the parent company the opportunity to keep local operations running and to build up data and claims insights over time.

An effective claims infrastructure is a significant asset. Enhanced collection of loss data and integrated analytics tools provide the captives with real time insights enabling more effective risk management. Brokers and captive management providers can also assist here, offering risk engineering and risk control services. 

For organisations that do not yet have a captive, it is not too late to consider forming one. Over time, as the number of jurisdictions with captive legislation has grown, along with the range of captive solutions on offer (including cell companies), barriers to entry have come down. However, it is important to appreciate that captive insurance is not a magic bullet with which to circumvent a hard market. A long-term, strategic view must be taken when considering any captive insurance strategy.

An added dimension is the changing risk landscape. As organisations grapple with emerging and intangible risks, the need for new and innovative risk transfer solutions has grown. We are seeing an increase in interest in alternative risk solutions as commercial insurance has become more expensive and capacity harder to find.

Working together

There is no one-fits-all solution. Different clients will have different needs and the onus is on all parties, including captive managers, fronting insurers, brokers and risk and insurance managers to sit down and talk through the solutions available. Risk managers are having conversations with their CFOs in terms of how company capital should best be deployed at a time when cashflow is king.

There are a number of creative and innovation options to be considered, including alternative risk solutions and joint, scalable captive solutions, such as a multi-captive ‘mutual’ approach. For clients concerned about the impact of higher deductibles and how this may cause greater volatility on their balance sheets, loss portfolio transfer, for instance, can spread out of the cost of a severe claims year over, say, three to five years, offering capital relief and smoothing out the impact of a loss.

Single captive stop loss covers are becoming more challenging to place as there is a limited market for multiline products. While they are beneficial programme placements from a captive perspective, it is not always possible to enter into long-term agreements on cross-class aggregates when the market is hardening.

In this challenging operating environment there has never been a greater need for collaboration and flexibility in coming up with solutions for insurance buyers and captive owners.

Hence a more traditional approach may be required, with separate towers for different classes of business. Taking a line by line approach to insurance also offers clearer insight into maximum losses, helping to understand and mitigate any volatility within the overall book of business.

The value to clients of a traditional approach to self insurance is that they can widen their universe of potential re/insurance carriers, without necessarily paying a great deal more in premium. There is the option to invite more reinsurers to the table if each line of business has its own stop loss policy. That way the whole market can be involved and insurance buyers can be sure they are getting a more competitive placement.

In this challenging operating environment there has never been a greater need for collaboration and flexibility in coming up with solutions for insurance buyers and captive owners. Regardless of the insurance market cycle, alternative risk solutions will continue to offer value and complement traditional insurance placements.

For insurers and service providers this hard market offers us a real opportunity to differentiate ourselves and to have a different conversation with our clients from that of our competitors. It’s about ensuring we are ultimately arriving at the best solution for all parties and that relationships will remain strong well after the hard market has passed. All parties working together towards the same goal builds trust, understanding and long-term value.

^{This article first appeared in Captive Review, January 2021}

¹ https://www.marsh.com/us/insights/research/captive-landscape-report-2020.html