Risk financing equation: retain to captive finance or transfer

18 October 2017

Optimising a captive insurer’s role with an overall risk programme is an ongoing process.

Forming a captive subsidiary to self-insure a portion of your organisation’s risk is a big decision, and the first step is to identify its key purpose in your corporate risk strategy.

According to Steve Arrowsmith, CEO of JLT Insurance Management, the decision to form a captive is often driven by the need to access improved coverage, reduce the cost of insurance and assert greater control over risk.

Coverage and cost saving are often the primary motivations, but once a captive is up and running, the wealth of loss information generated can significantly improve a company’s risk management and strategic decision-making.

"Governance and risk control often become a captive's most valuable benefit to the parent company," says Arrowsmith.

Before licensing a captive, prospective owners must first gather as much information about their risks and losses as they can, and work with brokers to map a captive placement over their existing risk programmes to determine which lines of business can be written profitably within the captive, how much risk to retain and the cost and return on capital.

Captives usually favour underwriting manageable exposures, while ceding catastrophic risks to the commercial market.

But Arrowsmith says: "Virtually any line of pure risk can be written within a captive, provided there is enough geographical or operational diversity to avoid risk aggregation."

It is, of course, important that the combined underwriting and operational running cost of a captive is comparable or preferably cheaper than transferring risk to a third- party carrier.

However, forming a captive does not necessarily mean removing a line of business from the commercial market altogether.

"A captive does not replace commercial risk transfer – it complements it," says Arrowsmith. "Far from sitting alone, the captive sits strategically within the parent’s risk programme and is driven by their risk appetite."

Participating alongside the commercial market allows the captive to choose a retention level at which it is comfortable, while maintaining the parent's long-term relationships with carriers.

It also means captives do not need to have huge retentions. "A common misconception is that captives are only for large corporations, but the entry point to owning a captive may be much lower than many people think," says Arrowsmith.

"It is feasible to run a captive with as little as $1 million of retained risk premium, provided there is a level of risk complexity."

Evolving participation

In the first couple of years of captive participation, it may be sensible to take small retentions within the captive while utilising significant reinsurance protection to allow the captive to grow a stable capital base and get a strong grasp of the business it is writing. Used prudently, a captive’s participation then evolves along with the parent’s risk profile.

"We recommend reviewing your captive’s role within your risk strategy every two to three years to consider how the captive sits within your five-year strategic business plan, what its capabilities are, and what it could potentially do in the future," says Arrowsmith.

"Corporates are good at predicting what will happen within their industries in the next 12 to 18 months, but often underestimate the role a captive can play in forward planning," he adds.

Through regular reviews, an owner may uncover economic and strategic benefits to increasing retentions or adding new lines of business into the captive.

An existing vehicle with a strong capital base should be able to absorb a degree of volatility, allowing the parent to underwrite fairly aggressively on new lines of business – though it is vital each new line of business can stand on its own feet without relying on existing lines for support, says Arrowsmith.

"If adding a new line, you need to thoroughly assess historical losses and exposure to establish which level of participation will generate the kind of performance you are looking for."

Captives can also act as 'incubators' of emerging risks within an organisation. "If the parent wants coverage with specific wording that is not available in the commercial market, for example, a captive might be a good place to build up loss experience with relatively small limits within a prescribed policy form," Arrowsmith explains.

Over time, data is gathered and the risk may become more attractive to commercial insurers. There are a number of reinsurers who are willing to work with captives to develop emerging risks in this way, provided the captive has enough 'skin in the game'.

These are just some of the ways a captive can be used not just as a stand-alone insurer, but as a strategic tool to help businesses plan, grow and overcome market challenges.

"Companies often say: 'We're not insurance people, so why would we set up an insurance company?' But you don't have to be an insurance expert to set up a captive," says Arrowsmith.

"You do, however, need a strong focus on risk management. If you are a company that is interested in your risk and understand your risk appetite, we can help you do the rest."

A captive's road to maturity

CAPTIVE CONCEPT

Assessment of parent’s risks, loss record and strategy while analysing the benefits and considerations of a captive vehicle.

FEASIBILITY

In context of commercial market conditions, determine risk retention appetite and appropriate captive structure (stand-alone, cell, rent-a- captive) that will deliver the desired risk financing objectives.

Domicile assessment against key selection criteria, namely: proximity to parent operations; strong, established captive-specific insurance legislation; a flexible, fair regulator; high quality local service providers (actuaries, lawyers and custodians) with a reputation for transparency; and affordable operational costs. Tax rates and capitalisation requirements vary by domicile, so should also be considered.

FORMATION AND LICENSING

Deliver against the critical path established to form your captive vehicle and engage service providers including Captive Managers.

Beyond co-ordinating and running operations on the ground, managers are increasingly providing risk consultancy to optimise performance and strong governance practices to demonstrate substance.

FULL MANAGEMENT

Once operational, managers will conduct regular reviews to ensure capital base growth in line with objectives, ensure profitability, re-evaluate risk retention, and identify expansion opportunities.

They will add value by increasing retentions/adding new lines to overcome market challenges, plan ahead and meet parents’ strategic objectives.

For further information, please contact Bernard Sze, Managing Director of Captive Management, Asia at Bernard_Sze@jltasia.com