Seeking captive value—part three

In the first of the series we looked at operational context and commercial insurance procurement and in the second one we looked at centralised insurance procurement and strategy. It’s time to sum up.

A single parent captive insurance company is an effective insurable risk financing tool for companies:

• That wish to retain risk within the group and benefit from the ability of an insurance company subsidiary to make provisions for incurred but not reported (IBNR) losses, notably with respect to longer-term liabilities;

• That are obliged by law or contract to procure insurance and wish to claw back the exposure and the cost, in whole or part, behind a fronting insurer (by way of reinsurance into the captive insurance company);

• That wish to retain insurable risk within the group that its various subsidiaries might not otherwise choose, or be able, to retain;

• Where the operating costs of the captive are lower than those of a commercial insurance company;

• Where reliable commercial insurance is not available, is not cost-effective, or is subject to unhelpful pricing fluctuations or unpredictable coverage;

• Where the company seeks to enhance the insurance claim recovery process by:

-  Ensuring smaller/undisputed claims payment are advanced and/or settled more quickly to the business units that have suffered the loss; and

-   Ensuring full access to loss adjuster reports and insurance company discussions over coverage issues and/or claim settlement propositions relating to the larger, more complex claims (by virtue of being a stakeholder in the claim settlement process);

• Where the captive looks to play the role of “incubator” for new insurance policy language to address emerging exposures where commercial insurers may be hesitant or reluctant to provide cover; and/or

• Where a captive retention can provide a seat at the table where significant insurance claim payment decisions are made.

A captive is an effective support for risk management initiatives when:

• The captive can be used to influence behaviours and risk management investment decisions to improve exposure profiles; and/or

• The captive, by virtue of being an insurance company and being allowed to make appropriate provisions for predictable losses, can take a multiyear view over the extent to which mutualisation of insured losses is implemented across the group.

There is a key point here: for companies that have reached a certain size and complexity, there are several sound business reasons that underpin the formation and operation of a wholly-owned insurance subsidiary dedicated to providing insurance support to its affiliated companies. The costs of running a captive are not insignificant so an initial feasibility study—and periodic stress-testing thereafter—should be used to demonstrate and support the business case.

Captives under the spotlight

It is might be wise for the Federation of European Risk Management Associations (FERMA) and the International Federation of Risk and Insurance Management Associations (IFRIMA), when conducting discussions with the OECD (and, indirectly with the G20 who have co-sponsored the base erosion and profit-shifting [BEPS] initiatives—of which captive insurance companies represent a small line of enquiry) to concentrate on the operational challenges (as outlined above) that a complex and highly-regulated world present to a corporate insurance manager.

Further, the choice of words used to present the arguments for single parent captives is important to minimise the possibility of misunderstandings.

By way of example, a recent article (FERMA and IFRIMA Step Up Campaign with the OECD—Commercial Risk Europe @ 13 February 2017) stated the following:

“The European and international risk and insurance management community has been working hard to convince the OECD and European Commission that captives are genuine risk management transfer tools.

The US Captive Insurance Companies Association and the European Captive Insurance and Reinsurance Owners’ Association responded to initial suggestions from the OECD that captives are potentially tools for abuse.

The two groups pointed out that:

• 6,000 captives worldwide operate in the same way as traditional insurance companies;

• Captives are an integral part of enterprise-wide risk management (ERM);

• Captives are the only tool available for multinationals to manage otherwise uninsured exposures;

• Captives give direct access to reinsurance to help solve risk transfer problems; and

• Captives allow their parents/owners to insure risks for which cover is not available in the traditional market.”

Of these five statements, probably only the fourth one is unassailable—but misses the important additional feature of a captive relating to acceptance of inward reinsurance.

The 6,000 captives cited include a number of different types of captive insurance company structure in different geographies so this probably isn’t useful. In addition, single parent captives do not operate in the same way as traditional insurance companies—they tend to operate a great deal more efficiently.

The claim that captives are an integral part of ERM is neither necessarily true nor helpful. In the first place, the term ERM can mean many different things in different organisations. Second, the ERM and insurance management functions can be completely separate and be subject to very different reporting lines. So this claim is not a strong one

The claim that captives are “the only tool available for multinationals to manage otherwise uninsured exposures” is not strictly true. A sophisticated management accounting system can be used to dampen or eliminate the impact of uninsured losses should the senior executive management team decide that idiosyncratic distortions to the recording of business division operating performance are not useful.

The last of the five statements is clearly untrue in the case of a single parent captive since it is a wholly-owned and consolidatable subsidiary. The assets and liabilities of the captive are reflected on the parent company financial statements. While there can be risk distribution between a non-insurance affiliate and an insurance company affiliate of the same group, there can be no risk distribution between the parent company and the single parent captive. The captive insurance company merely provides a vehicle for making reasonable provisions for predictable losses and IBNRs that have not yet occurred—an accounting feature that is not permitted to non-insurance company legal entities.

Summary

By focusing on the constraints of real world regulatory, cultural and organisational complexity—and the operational challenges that face a corporate insurance manager of a reasonable-sized company - the business case for a single parent captive (and therefore the value it can bring to the group within which it is situated)—should be relatively uncontroversial and demonstrable at any moment in time.

The development of captive insurance companies over the last 60 years—and single parent captives in particular—has not occurred by accident. Captives are a business-rational response to a diverse, fragmented, commercial insurance industry that sells a large number of heterogeneous products and services—to which has been added the complexity risk of a plethora of multiterritory regulation.

Perhaps the corporate risk management and captive management communities deserve a pat on the back rather than a slap on the hand.

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